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Smith & Nephew, a medical equipment and supplies manufacturerNew York Stock Exchange:SNN) (OTCPK:SNNUF) has had disappointing performance in recent years, but at its core it is a business that dominates in the premium-priced sector. Long-term growth prospects.
My last post on this name will be in September 2022. Smith & Nephew: Still a buy despite short-term challenges I rated it a Buy. The stock has risen 14% since then. I continue to believe the share price undervalues the long-term potential of this proven business and continue to rate the stock a Buy.
The business is showing good sales growth
Last year, the company’s revenue grew 6.4%.
Full-year earnings announcement
However, while sales grew steadily, profits were mixed. Both operating profit and operating profit margins were Earnings per share increased strongly, while sales declined.
The company has been discussing its growth plans for the past few years. Revenue increased 6.4% While that impressed me, the bottom line wasn’t so great: In 2019, the company made $6 million in after-tax profits. Last year, that figure fell to $263 million, despite rising revenue.
Business is changing, but one step at a time
The CEO spoke in a confident tone as he announced the company’s full-year results.
We enter 2024 as a fundamentally stronger business and look forward to delivering strong growth and further margin expansion this year.
actual, First QuarterThe year-on-year sales growth rate was 2.2%. That’s fine, but it doesn’t qualify as “good.” Arrogant management comments like this that don’t accurately reflect the company’s actual performance always make me question the quality of its management.
Company’s first quarter trading announcement
The company maintained its full-year outlook for underlying revenue growth of 5.0% to 6.0% (4.3% to 5.3% at exchange rates as of April 26, 2024) and operating profit margin of at least 18.0%.
The company continues to talk about what I consider to be the fundamentals of the business, from supply chain to commercial execution, in its earnings calls. At a quarterly level, that makes some sense, and of course, they are important. But at this point, it gives me a niggling sense that the company’s growth plans are as much about repairing the fundamentals of the business as they are about adding substantial new growth drivers. I wrote this nearly two-and-a-half years ago: Smith & Nephew: Valuations become more attractive And its continued relevance troubles me.
That said, growth is growth, and both types of growth will be welcomed, although hopefully fundamental improvements will require a limited time before the low hanging fruit is achieved.
My main takeaway from the first quarter results is that the business is moving in the right direction, albeit perhaps much slower than ideal, and that the US market (by far the company’s largest) has gotten off to a slow start to the year. Revenues in the US market fell 0.6%, while other geographic segments (“other established markets” and “emerging markets”) posted revenue increases. US hip and knee implants remain a tough market for Smith & Nephew, but the company says market supply and commercial execution have improved under new management.
Commenting on the first quarter results, the CEO said:
Our 12-point plan remains on track, with progress in Orthopedics again evidenced by strong growth across most segments, and we expect the remaining segments to improve as the year progresses.
However, recent growth and innovation plans seem, in my view, to be bringing about incremental rather than transformational change. I outlined my growth plans in my 2022 article. Smith & Nephew: Valuations look more attractive. The doubts I had about that piece remain with me to this day.
One of the goals was to target consistent organic revenue growth of 4-6% by 2024. In its current full-year outlook, the company expects to “achieve underlying revenue growth in the range of 5.0%-6.0% (4.3%-5.3% based on April 26, 2024 exchange rates),” which may or may not be the same thing. In my view, organic and underlying revenue are moving targets, and exchange rates are a reality and should have been factored into the original target.
The second goal was to achieve at least a 21% trading margin by 2024 (and higher thereafter), but the outlook for this year is now “at least an 18.0% trading margin.” In other words, I believe the growth plan is not set up to achieve the specific goals originally set out, as I feared when it was planned for 2022.
The business has strengths including a large operation in the high-margin U.S. market, a well-known brand, and an attractive product line, such as hip and knee implants made with advanced load-bearing technology produced in a proprietary manufacturing process. Weaknesses include inconsistent commercial execution, mitigated but not fully resolved product supply issues, and a crowded field of competitors.
I continue to view Smith & Nephew as a solid business with challenges to address, rather than an exciting growth story that deserves a high earnings multiple due to its superior growth prospects.
Evaluations continue to provide value for patients
That being said, the current P/E ratio of 44 seems too high for this business.
This reflects the company’s lackluster earnings over the past few years. If the company can return to $500 million or more in revenue in 2021, it would trade at about 22 times forward earnings. That’s not a bargain, but it seems reasonable or somewhat generous for a medical device company.Multi-TLS) on the 26th, striker (S.Y.K.) is the 29th.
Smith & Nephew still has work to do to get back to where it was a few years ago, but a focus on improving the fundamentals of the business should be enough: the company remains strong in premium-priced product markets that benefit from robust demand.
If the growth plans ultimately prove successful and after-tax profits exceed those of a few years ago (which is undoubtedly the plan), I think the current share price is worthwhile, but it will take patience for that to happen.
During a conference call last month, the company’s new chief financial officer outlined the key risks to the company right now:
Obviously, we expect the impact of the China VBP — essentially the change in pricing terms in China — to start to impact us beginning in May of this year. And as we’ve already highlighted, we expect this to translate into a 5% headwind across our sports joint repair business in our forecast. So, we’re already factoring in 5% to 6% into our overall outlook for the year. But that’s probably the one major area of uncertainty as it unfolds throughout the year.
In my view, all these risks are manageable.
So the question now is, can Smith & Nephew deliver over the next few years? I think the answer is probably yes, but not a resounding yes. And secondly, what’s going to drive the stock price higher?
I think the situation is more complicated here: the stock’s trend line has been trending downward over the past few years, and even now the stock doesn’t look cheap, at least based on reported earnings.
To turn this around, I believe the company needs to prove this year or next that it can turn around its after-tax profit stream and get closer to the $500 million level it achieved a few years ago. If the growth plan (the 12-point plan) can’t achieve that, it has failed. If it can achieve that (and it should), I believe it will help reverse the long-term decline in the stock price.
