Smith & Nephew plc (SN.) Ordinary USD0.20

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Smith & Nephew’s third quarter sales grew to $1.5bn, reflecting underlying growth of 5.0% (6.2% expected). All divisions contributed to growth, but Sports Medicine and Orthopaedics were both lower than expected.

Full-year guidance for revenue growth (around 5%) and trading profit margin (19–20%) were unchanged. Free cash flow guidance has been raised to around $750mn (previously over $600mn). This guidance includes an expected net impact of $15-20mn from tariffs.

The $500mn buyback has been completed.

The shares were down 11.3% following the release.

Our view

Smith & Nephew’s third-quarter sales fell short of expectations. Despite the re-iteration of full-year sales and profit guidance, the miss prompted a knee-jerk sell-off, unwinding some of this year's recovered sentiment. The improved cash-flow outlook and implied step-up in second half margins may go some way to steadying nerves if the final quarter of the year goes to plan.

The medical device maker operates through three segments; Orthopaedics - offering hip and knee replacements, Sports Medicine - a soft tissue repair business, and Wound Management - providing materials to manage injuries and prevent infection.

The Orthopaedics division has been a problem child for the group, hampered by a lack of scale. Operational improvements have had some success in overseas markets and there are some early signs that this can be replicated in the US.

The division’s biggest revenue generator is knee replacements. In the US this category is underperforming the wider market as the group shifts from older product lines to its next-generation implants. Commercial traction in recently launched devices will be a key theme to monitor.

An ageing population and growing affluence in emerging markets are both tailwinds for surgical procedure growth. But Smith & Nephew is not just sitting and waiting for the market to drive its sales growth. It's continuing to develop and launch new products, cross-sell its wide product range across its territories, and introduce existing products into new areas of treatment.

We see innovation as its biggest weapon for gaining market share. The group’s negative pressure wound therapy products continue to evolve as management targets a multi-year growth opportunity. Its regenerative therapies for sports injuries are also seeing strong sales momentum.

But the group does face some challenges. Underlying operating margin targets have been kicked down the road several times and are materially behind the original recovery plan. High levels of competition in some core product areas and markets could prove to be a further brake on margin growth.

There’s a prospective yield of 2.5% on offer which, while not guaranteed, is well supported by the improved outlook for cash flow.

Despite a post-result drop, the valuation looks about right to us, leaving sentiment vulnerable if management falters again. With a refreshed strategy due in December, a clear and credible plan to accelerate growth is essential to unlock further upside for investors.

Environmental, social and governance (ESG) risk

The healthcare industry is medium/high risk in terms of ESG, depending on subindustry. Across the board, product governance is the most acute risk, with business ethics, labour relations and data privacy also contributing. Providing reasonable access to healthcare as a basic service is also a growing issue, with greater concerns surrounding the social implications of for-profit healthcare companies.

According to Sustainalytics, Smith & Nephew’s management of ESG risks is strong.

The company does not appear to be caught up in any significant controversies. Its strong position in the hip transplant market leaves it exposed to higher litigation risk than some peers. Smith & Nephew addresses this risk via the relevant product safety certifications. There are also strong programmes in place for whistleblowing, and bribery and corruption, as well as an adequate cybersecurity programme. However, the company’s clinical trial programme has scope for improvement, as does its approach towards diversity and inclusion.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by LSEG. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment.

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