Smith & Nephew's third quarter results have left investors rather underwhelmed. Underlying revenue grew by 4%, with conditions in China becoming more challenging in the quarter. The group are also battling significant foreign exchange headwinds.2015 guidance was maintained, but 2016 is likely to be tougher, if current exchange rates prevail. The shares fell by 6% in early morning trading.
Q3 highlights (underlying basis):
Underlying revenue grew by 4% to $1,105 million. Reported revenue was down -4% reflecting a -9% currency headwind offset by a 1% benefit from acquisitions. Revenue grew by 4% in the US and 1% in Other Established Markets. Emerging markets grew by 8%, significantly lower than Q2 (+14%), reflecting slower sales in China.
Sports Medicine and Trauma grew by 2% (Q2: +4%). Sports Medicine Joint Repair was weaker than expected, held back by China, where the group saw de-stocking in their distribution channel.
Reconstruction grew by 3%. The Knee Implants franchise had another strong quarter (+6%) but hip implants fell by 2%. Advanced Wound Management grew by 6%, led by Advanced Wound Care (+6%) and Advanced Wound Devices (+17%). Advanced Wound Bioactives slowed to +2% in Q3 (Q2: +6%), leading to lowered guidance for the divisional full year outcome.
Acquisition of Blue Belt Technologies:
Smith & Nephew has agreed to acquire Blue Belt Technologies for $275 million, securing a leading position in the fast-growing area of robotics-assisted orthopaedic surgery. The company is currently loss making so is expected to dilute group trading profit margin by around 60 basis points in 2016, with the business becoming profitable in 2018.
Outlook for FY 15 and 16:
FY 15 guidance for higher underlying revenue growth and a year-on-year improvement in trading profit margin is maintained. But the impact of dollar strength is growing and the group have suggested that margins will suffer a 100bp headwind next year. Further guidance will be provided at the Q4 results in February 2016.
Olivier Bohuon, Chief Executive, commented:
"We are pleased with our progress in 2015, with the third quarter again demonstrating that our actions are delivering a strong performance... Our experience working with Blue Belt Technologies and our customer insight has convinced us that robotics will become mainstream across orthopaedic reconstruction in the foreseeable future. This acquisition is a compelling strategic move, with the combination of complementary products and R&D programmes creating a platform from which we can shape this exciting new area of surgery."
A slowdown in China and currency pressures will act as a material drag on margins in FY 2016, if current exchange rates prevail. It is unclear how much can be offset through efficiency savings, so we expect analysts to take a more cautious stance and reduce their earnings forecasts for FY16.
Short term headwinds aside, the longer term outlook for Smith & Nephew remains favourable, in our view. Ageing populations in the West, combined with improved access to healthcare in the developing world, provide a favourable demographic backdrop. In China, for example, only 300,000 reconstruction procedures are performed annually, compared with 1.1 million in the US, despite China's population being around four times larger.
Cash flows are strong and the balance sheet is in good shape, giving Smith & Nephew plenty of ammunition to expand into faster growing categories. The acquisition of Blue Belt Technologies takes the group into next-generation robotics-assisted technologies.
The shares still trade some way above their long run average P/E rating, and offer a yield of 1.8% (variable and not guaranteed) which isn't an obvious attraction. However, the medical devices industry is consolidating and Smith & Nephew is the smallest of the four big players (the others being Stryker, Johnson & Johnson and Zimmer), making it a potential bid target.
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