Smith & Nephew faces difficult Q3 amidst Covid-19 and supply chain pressures

Smith & Nephew plc, the British medical equipment manufacturing company listed on the FTSE100, published their Q3 results on Thursday 4th November for the period ended the 2nd October 2021. In this quarter, Smith & Nephew’s performance was heavily affected by the resurgence of Covid-19 and the Delta variant in the United States alongside the impact of the volume-based procurement rollout in China. The group announced that after the first nine months of 2021, they were narrowing their expectations for the full year; their revenue growth expectations now sit at the low end of previous guidance at around 10-13%, with their trading profit margin around 18-19%.


In this article, I will break down their Q3 update and determine what to do with Smith & Nephew.


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Business Model

Smith & Nephew develop and produce products across three franchises: Advanced Wound Management, Sports Medicine & ENT and Orthopaedics.

In their Advanced Wound Management franchise (which accounts for 30% of the company’s revenues), the company creates products for the treatment of acute and chronic wounds, including leg, diabetic and pressure ulcers, burns and post-operative wounds.

In their Sports Medicine and ENT franchise (which accounts for 30% of the company’s revenues), they produce specialised instruments, technologies and implants, which are necessary to perform minimally invasive surgery of the joints, including the repair of soft tissue injuries and degenerative conditions of the knee, hip and shoulder.

In their Orthopaedics franchise (which is their largest segment, accounting for 40% of the company’s revenues), they create joint replacement systems for knees, hips and shoulders as well as ancillary products such as bone cement.

In terms of customer base, Smith & Nephew’s products in their Advanced Wound Management franchise are sold to wholesalers and intermediaries, while products in the other two franchises are sold directly to hospitals, ambulatory surgery centres and distributors.

This image depicts Smith & Nephew's three franchises, Orthopaedics, Sports Medicine & ENT and Advanced Wound Management. It provides a short summary of each franchise, as described in the paragraph above the image.
Source: Smith & Nephew's FY'20 Presentation

Recent Performance


This table shows Smith & Nephew's consolidated revenue analysis for the third quarter Q3 2021 TO Q3 2020 by franchise. Key points are explained in the paragraph below the image.
Source: Smith & Nephew's Q3 Report

Smith & Nephew released their Q3’21 report on Thursday 4th November. Their Q3 overall revenue was $1,266 million, up 5.5% from the comparable period in Q3’20 and up 1.6% in the comparable period in Q3’19. Smith & Nephew’s revenues suffered in 2020 due to the poor performance of their Orthopaedics franchise, a segment that has caused trouble for Smith & Nephew since the start of Covid-19.

As seen from the table above, their Orthopaedics franchise has fallen from the Q3’20, down -0.7%, with underlying growth of -5.9%. (Underlying growth is adjusted for FX & disposals).

In Sports Medicine & ENT, revenue was up by 8.3% from Q3’20 with underlying growth of 6.5%. The segment also grew from Q3’19, up 3.9% (see Table Two below for Q3'19 figures).

In Advanced Wound Management, revenue was up 12.1% with an underlying growth of 10.9% from Q3’20. The segment was also up 6.3% Q3’19. This was the company’s fastest growing segment in Q3’21.

This table shows Smith & Nephew's Q3 2021 TO Q3 2019 consolidated revenue by franchise and by geography. Key points are explained in the paragraph above the image.
Source: Smith & Nephew's Q3 Report

Q3’21 has been Smith & Nephew’s weakest quarter to date in 2021. Revenue growth has slipped profoundly compared to the first half of the year due to the struggling Orthopaedics franchise. Performance in Orthopaedics was held back by numerous factors.


Firstly, the consequences of the Delta variant on elective surgeries, notably in the US. As seen from the slide below, knee replacement in particular had a large impact YTD from the comparable period in 2019. Excluding knees from the franchise, Smith & Nephew’s Orthopaedic segment grew from 9M’19 by 1.7%. However, the knee replacement segment caused the entire franchise to lag, at -16.8% compared to pre-pandemic levels in the 9M’19. As the US represents around 50% of Smith & Nephew’s business, a decline in elective procedures in this geography has a profound impact on results.


This image shows Smith & Nephew's franchises in terms of revenue growth compared to the 9M'19 (first nine months of 2019). It shows that in their Orthopaedics franchise excluding knees, there was growth of 1.7%. However, their knees segment fell by -16.8%.
Source: Smith & Nephew's Q3 Earnings Call Presentation

Alongside this, the company was also affected by supply constraints, which restricted their ability to benefit from the rebound in elective surgeries during the period. The company’s main global orthopaedics facility, located in Memphis, was affected by the combination of a tight US national labour market and competition for local workers in the industry, resulting in temporary staffing shortages at the facility causing a lag in production.

Secondly, as mentioned previously, there are increasing global shortages in certain raw materials and in electronics. Shortages affecting Smith & Nephew are those in materials such as resin, silicone and then in electronic components and circuit boards. These shortages are likely to persist for some time. Smith & Nephew have stated that they have adjusted production schedules to try and work with this issue. However, this remains worrying.


A further challenge facing the company is the rollout of volume-based procurement (VoBP or VBP) in China. VBP began in 2018 and originated as a series of drug procurement policies aimed at encouraging generic substitutions and bringing down the cost of drugs that have passed their exclusivities. During the period, China announced its VBP tendering programme for hip and knee implants, where it is moving to large national tenders with materially lower prices. Smith & Nephew was successful in multiple categories of hip and knee implants with their global and local brands where they tendered. The uncertainty ahead of implementation, however, continued to hold back distributor ordering patterns in the quarter, resulting in less growth than expected. This disruption in ordering patterns has currently cost Smith & Nephew an estimated $10 million. The VBP tender will come into effect in March 2022, so Smith & Nephew have until this date to negotiate new pricing with their distributors. Analysing this information, I think we will see some further pricing headwinds to come in one of S&N’s key markets.

Competitors

This image shows Smith & Nephew's competitors in each of their franchises including each competitor's market share. Key points are explained in the paragraph below the image.
Source: Smith & Nephew's FY'20 Annual Report

Smith & Nephew has a variety of different competitors in each of their segments. In their Hip and Knee Implants segment in their Orthopaedics franchise, their two biggest competitors are Zimmer Biomet (with 33% market share) and Stryker (with 22% market share). In Trauma and Extremities in their Orthopaedics franchise, DePuy Synthes (a division of Johnson & Johnson) and Stryker are their biggest competitors, at 40% market share and 22% market share respectively. In their sports medicine segment, Arthrex is their biggest competitor, with 33% market share. And finally, in their Advanced Wound Management franchise, the biggest individual competitors are 3M and Mölnlycke.


Speaking In the Smith and Nephew earnings call, the CEO was unclear how Smith & Nephew’s direct competitors were affected by supply chain logistics, distribution issues or inflation. Answering the question "To what extent are these things [logistics and raw materials...] affecting everybody […] or are there some areas where you are disproportionately affected resulting in you losing share?" he responded:


“I can’t speak for our competitors but I would expect it is the same […] whether they are seeing it in the same context or the same rigour I cannot comment on”


Given such a competitive environment in medical devices, I would expect the CEO to understand his competitors supply chains better, unless potentially he is choosing not to reveal the fact that Smith and Nephew has experienced more supply challenges than its peer group.


Taking a look at Zimmer Biomet’s Q3 results for the period ending September 30 2021 (Smith & Nephew’s Q3 was to period end 2 October 2021) you can see that their knees segment also experienced a decline in revenue growth, although not as steep as Smith & Nephew.


The table shows Zimmer Biomet's net sales by product category for the three months ended September 30 2021 and 2020. The table shows that Zimmer Biomet's knees segment only declined by 0.1%.
Source: Zimmer Biomet's Q3 Report

Looking now at Stryker, the company experienced a slight growth in their knees segment, reported at 0.8% to the comparable period in 2020.


The image shows Stryker's supplement sales growth analysis for their Q3 three month period in 2021 and 2020. The table shows that their knees segment grew by 0.8%.
Source: Stryker's Q3 Report

Future Growth Drivers


In terms of future growth drivers for the company, they are aiming to strengthen their commercial model by restructuring the Orthopaedics and Sports Medicine franchises under a single leader. This new structure is intended to leverage Smith & Nephew’s leadership in Sports Medicine and help the Orthopaedics portfolio grow. This decision was made in anticipation of care becoming more decentralised — with the expectation that as more Orthopaedics procedures move to ambulatory surgery centres or to outpatient settings, Smith & Nephew can capitalise on the good relationship they have with these facilities in their Sports Medicine franchise to improve the performance of the Orthopaedics franchise.

The company will also address the large gap in their Orthopaedics portfolio with the launch of their cementless knee — a gap that is almost certainly affecting their performance in comparison to their competitors. The cementless knee technology uses 3D printing of titanium to generate a network of pores to allow bone fixation to occur. This technology has already been proven in Smith & Nephew’s hip segment. This area has an estimated value of more than $400 million in the US, and it is growing faster than the rest of the market. This decision marks an important step in turning their heavily-lagging knee segment towards growth. Previously, S&N’s customers would switch to competitors’ brands if they wanted to use cementless knees on their patients. S&N hope that their introducing cementless knees to their already well-established brands in the US, Legion and Journey II, will encourage surgeons that already trust these brands to use their cementless options rather than competitors. The cementless knee will also mean that Smith & Nephew can approach larger centres who previously wouldn’t consider taking on brands without both cement and cementless options.


Currently, in each of the company’s targeted geographies, there is a backlog of elective surgeries averaging at around 2-3 months in the US (as the US is a for-profit market, their backlog is worked on quickly), 6-9 months in Central European markets and in excess of 12-24 months in the UK. As this backlog is worked upon, growth should be seen in each of these geographies (Covid-19 permitting) over these respective timeframes.


Financials


The table shows Smith & Nephew's revenue growth, gross margin, operating margin, debt to equity ratio and ROCE over the period 2016-2020, including estimates for 2021. Key points are explained in the paragraph below the table.
Source: The Twenties Trader

Looking at Smith & Nephew over the previous five years, you can see that revenue growth has been uninspiring. Even prior to Covid, growth was an average of 2.3%, vastly underperforming peers in the medical devices space. 2020 put Smith and Nephew’s turnaround on ice, with revenues falling 10%, which are expected to return to pre-Covid levels this year.


Profits, however, have been quite good, with a 70% average gross margin, showing that despite fierce competition in the various product lines, Smith and Nephew still wields some pricing power. The company has also been quite good at turning this into operating profit, with an 18% operating margin in the good years (2016-2018) which fell in 2019 and has remained low throughout the pandemic. In the medium term I would expect Smith and Nephew to return operating margins to the 18% level. However, supply constrains may prevent the business from doing so for the next year or so.


Thankfully, the business isn’t carrying too much debt, despite executing portfolio expanding acquisitions. The debt to equity ratio has grown to just over 1x debt to equity as of 2020.


In review of these financials, Smith and Nephew would be a ‘good’ business in terms of financial metrics, if revenue growth started to pick up reliably.


Valuation and Summary


Smith and Nephew trades on a P/E of 36 for forecast results in 2021, which is expected to fall to a P/E of 24 times expected earnings in 2022.


Smith and Nephew has all of the ingredients to be a quality business. However, when it comes to execution, critical errors lead to perennial underperformance. Prior to the pandemic, Smith and Nephew were underperforming peers with paltry revenue growth (in a hot sector nonetheless).


Missteps such as the lack of innovation in Orthopaedics (no cement-free knees) and worse than peer group supply chain issues show that Smith and Nephew is struggling compared to the mammoth medical device companies based in the US.


Sector peer Stryker trades on 32 times 2022 earnings and has significantly better growth and fundamentals than Smith and Nephew. I would suggest avoiding the British company.


The image compares Stryker's, Zimmer Biomet's and Smith & Nephew's share price over a five-year period. The image shows that Stryker has experienced substantial growth over that time period (at around 150%), whilst Zimmer Biomet and Smith & Nephew lag behind, at just under 50% and around the 30% mark respectively.
Source: Google Finance

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At the time of writing, The Twenties Trader did not own shares in Smith & Nephew plc.


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