Smith & Nephew

We hold a 2.9% position in Smith & Nephew in the Evenlode Income Fund. 

We think S&N is fundamentally a good business operating in structurally growing markets driven by aging populations and rising healthcare spending. In Orthopaedics and Sports Medicine instrumentation systems require extended learning curves that underpin loyal relationships with surgeons. It has number 1 or 2 positions in most categories in Sports, but has had operational challenges in Orthopaedics where it has a weaker competitive position as the number 4. In Wound Management, S&N has a leadership position in key categories, with significant product IP and breadth. 

Sports Medicine and Wound Management (which together account for c60% of group revenue) have generally performed well in recent years, growing in line or better than market, driven by good product innovation following a step-up in spending on research and development, which has increased, relative to sales, by more than c1ppt over the past 5 years to 6-7% of sales. S&N’s problems have been in Orthopaedics, which accounts for c40% of revenue. We’ve had a number of expert calls with people from S&N and competitors, and reached the conclusion that the problems in orthopaedics are very much solvable. They have started to demonstrate progress, particularly under new CEO Deepak Nath, who joined in April 2022. In particular, the product gap versus leading peers has been closed with the cementless knee launch and roll out. Manufacturing and supply chain challenges that led to product shortages are also being addressed. A 12 point plan initiative was launched in 2022, with focus areas on optimising manufacturing, improving execution and streamlining the orthopaedics portfolio. Their investor event in November highlighted good progress with key KPIs tracking progress against this plan and they are now more than 65% through this initiative. 

In terms of numbers, we think management’s medium term targets for organic revenue growth of 5%+ and 20%+ operating margins (2023 Visible Alpha consensus: 17.3%) look realistic. Market growth is around mid-single digit across its 3 main franchises, and we think S&N can grow in line or above market on a sustainable basis. The Visible Alpha consensus is for organic sales growth of 5% over the three years to 2026. The cash return on operating assets were strong (mid 20s) in the 2010s but weakened during covid as non-essential surgeries were postponed, and the operational challenges in Orthopaedics led to poor performance in the past few years. We expect improving inventory management and margins in orthopaedics to drive a recovery in returns over the coming years. There is significant upside in orthopaedics which has generated 17-18% margins in recent years, compared to 30% before the pandemic.  

We assess each business in the Evenlode universe across 10 key risk scores (moat, pricing power, long term industry outlook, economic and operational sensitivity, diversification, balance sheet, cash generation, management and cultural quality, ESG and Liquidity). We recognise S&N’s weaker competitive position in orthopaedics through a slightly weaker moat score (B vs A for competitor Styker, for example). The maximum position size we have set for S&N is 3.5%, based on a consideration of its scores across the 10 metrics.

The assumptions in our Cash Flow Return on Investment valuation model reflect the risk scores we have assigned to S&N’s.  We use a 10 year delay and mid-single-digit growth. For context, we assign delay periods from 5 years up to 20 years (in 5 year increments), and growth rates from low single digit up to low double digit and teens. S&N’s valuation looks attractive, with the CFROI valuation implying an annual return of 9.3%. Spot metrics also look attractive with a 15x 2024e P/E ratio and 5.6% 2024e free cash flow yield. VA consensus forecasts c12% earnings CAGR through 2026, driven by a recovery in orthopaedics, with group margins hitting management’s 20% target in 2026.