The medical device industry has undergone considerable consolidation in recent years, leaving a small number of competitors, and offers long-term growth potential due to increasing longevity, an aging population and an expanding middle class.
One company that could benefit from these developments is Smith & Nephew PLC (SNN, Financial) (LSE:SN), a global provider of medical products focused on the repair, regeneration and replacement of soft and hard tissue, which include hip and knee implants, tissue repair systems and arthroscopic-enabling technologies. Founded in 1856, the company has a market cap of $12.30 billion and an enterprise value of $14.75 billion.
While the U.K.-based company is much smaller than competitors like Stryker Corp. (SYK, Financial), Zimmer Biomet Holdings Inc. (ZBH, Financial) and the medical devices segment of Johnson & Johnson (JNJ, Financial), it has proven to be as nimble and formidable by pioneering impressive innovation in the areas of orthopaedics, sports medicine and advanced wound management.
Generating about $5.3 billion in trailing 12-month revenue as of June 2022, Smith & Nephew competes in global markets worth around $42 billion, which grew at a rate of approximately 4% annually prior to 2020. After a decrease in demand for elective surgeries during the Covid-19 pandemic, investors and management alike expect to see a rebound over the next several years, which should result in improved profitability.
While Smith & Nephew generates more than half of its sales in the U.S., it has a growing business in China and a number of emerging markets.
Further, the company operates through three business segments: Orthopaedics, Advanced Wound Management and Sports Medicine & Ear, Nose and Throat.
Historically, Smith & Nephew has had excellent operating margins of 18% to 20%. However, the high number of deferred elective surgeries during the pandemic drove it down into the low teens. Now that there has been a recovery in demand for voluntary procedures, I expect the operating margin to bounce back in the coming quarters, and the stock should follow suit.
Commenting on the outlook for the year during the company's third-quarter earnings call, Chief Financial Officer Anne-Francoise Nesmes said, "Our performance in the third quarter keeps us on track for the revenue growth target we set at the start of the year. With the work to improve Orthopaedics and the ongoing momentum in Sports Medicine and Wound, we expect much stronger growth to continue into Q4. With just one quarter remaining, and based on what we can see today, we expect to come in at around the middle of our 4% to 5% underlying growth target. Our trading margin guidance of around 17.5% is unchanged."
Smith & Nephew's balance sheet is solid with a debt-to-equity ratio of 0.54 and a good Altman Z-Score of over 3.
The diagram below shows the company's operating cash flow. While core free cash flow (orange line) is recovering well, it still has not reached its previous high. As a result, Smith & Nephew remains somewhat of a recovery play.
Valuation
According to the GF Value Line, Smith & Nephew's stock is trading in significantly undervalued territory currently. The intrinsic value estimate from GuruFocus is based on the company's historical price multiples, past returns and estimates of future business performance.
Conclusion
I think Smith & Nephew is an appealing opportunity because it is making some good headway in developing countries where larger competitors are not as well entrenched as in developed markets. The industry has high technical and regulatory barriers to entry and a dwindling number of global players. Although the company is slow-growing, it also has the demographic tailwinds of an aging population behind it.
Further, despite its smaller size, Smith & Nephew has made a name for itself in the orthopedic, sports medicine and wound care markets through meaningful innovations, such as its hip resurfacing implant and knee replacements with Verilast technology. However, as the market consolidates, its position as a midsize competitor leaves it vulnerable to cost-saving measures by hospital customers. Its market share in the hips and knees space is relatively small, so shifts in this market are slow due to significant switching costs. According to Morningstar, the company's strong show of innovation has only resulted in a 2% gain in market share over the past decade, highlighting the difficulty of getting hospitals and practitioners to switch who they buy from. This, along with its smaller user base, could lead to the company being locked out of more health care systems in the future as hospitals consolidate around more dominant vendors.
There is a decent chance Smith & Nephew, which lacks the optimum size to compete in the consolidating Medtech industry, may end up getting acquired by a larger player. Such an acquisition may require a significant control premium. Nevertheless, the expectation for its share price to return to the high $30, low $40 range appears to be reasonable.
