Smith & Nephew needs transplant

Half hidden, half champion

In its third quarter results last week Smith & Nephew reported shrinking margins in its Orthopaedic division, the result of tightening healthcare budgets in developed countries and selling highly specified products in developing countries when cheaper products would be more profitable.

Since Orthopaedics earn the company just over half its revenues, it’s a serious problem, and the company’s response is to cut $150m in annual costs, partly by transplanting some manufacturing to low-cost economies, and partly by combining the Orthopaedic division with its Endoscopy division.

With the company under pressure, I think there may be an opportunity to add it at a relatively cheap price to the Thrifty 30 portfolio.

I hesitate to utter the words ‘competitive advantage’ after my recent scepticism , but Smith & Nephew has many of the credentials of a hidden champion. It’s big, but not massive, focussed on specific market niches, global, and claims to be a market leader in some respects.

The numbers, straight from one of my screens (data source: Sharelockholmes.com, 1 Nov) are:

So, consistently high return on equity (the company targets 24%) and relatively low gearing. Exactly what you’d expect from a Nifty share at first glance. Maybe it’s worth 2.7 times book value, the implied 11% earnings yield puts it in the buy zone, just.

The Smith in Smith & Nephew is Joseph Smith, who opened a Chemists shop in Hull in 1856. The Nephew was his nephew, he took over forty years later. The company grew into a medical conglomerate and in the 1990s it rationalised. Today it’s a medical device company specialising in:

1. Orthopaedics (2010 revenues over $2bn): for example knee and hip implants and therapies
2. Endoscopy (2010 revenues $855m), minimally invasive surgical devices.
3. Advanced wound management (2010 revenues $912m), devices that speed healing and prevent infection.

Although Orthopaedics is the biggest division, it operates in by far the biggest market so, according to Smith & Nephew its market share is just 11%. It competes against big names, Zimmer, Stryker, Biomet, and DePuy, a Johnson & Johnson company. Hermann Simon identified all four as hidden champions in his book Hidden Champions of the Twenty First Century.

Zimmer, DePuy  and Biomet are based in Warsaw Indiana (pop. 12,145), the ‘orthopaedic capital of the world” and Stryker is 80 miles away in Kalamazoo, Michigan. Strong local competition can drive companies, like athletes, to greater performance and give the cluster a competitive advantage over rivals further afield. Smith & Nephew’s orthopaedic division in Memphis is 600 miles away, and there can’t be too many champions since market leadership is a criteria.

The bad news is even the orthopaedic champions are struggling. Stryker recently announced a 5% cut in its workforce, which it blamed on a soft market for orthopaedic joints and a new medical device excise tax.

Smith & Nephew’s relatively weak position in what appears to be an increasingly commoditised market may help explain why it’s succumbing to pricing pressure in Orthopaedics, but not in Endoscopy and Advanced Wound Management, markets in which it claims 22% and 18% market share respectively.

All three divisions operate in what are conventionally regarded as growth markets. Hip replacements and devices for treating pressure sores, for example, benefit the aged, and its endoscopy products target sports injuries.

On its web pages describing the Endoscopy and Advanced Wound Management divisions, the company emphasises training, product support, and collaboration with medical staff in product development, which are typical hidden champion strategies to add value and embed products in their niches.

If I add this half-hidden half-champion to the Thrifty 30 it will be a rare occasion. The first time I’ve added a company valued at more than £500m by the market (its market capitalisation is nearer £5bn – and that’s not a typo Mr Monevator), and only the second or third time I’ve added a company at more than twice book value.

But I’m getting ahead of myself. I want to have a closer look at the last ten years.