Smith & Nephew: Innovation Key To Justified Premium Rating

Smith & Nephew (SN.L) appears to be successfully adapting to challenging environments in established markets, while addressing opportunities in emerging markets. The company has made significant progress in reducing its cost base, while maintaining innovation, in the US and Europe, at the same time as capitalising on opportunities in BRIC and other emerging market countries. The shares trade at a premium to its US med tech peers, but its greater growth prospects justify this.

Tailoring operations in established markets
S&N is continuing to simplify its operations to adapt its business to the new trading environment in Europe and the US. In these territories, market growth has slowed and pricing pressure has increased significantly. To respond, it has reduced its workforce by c 7% and merged its endoscopy and trauma, and reconstruction divisions to create advanced surgical devices (ASD). It is now mid-way through rationalising the number of stock keeping units (SKU) by 43,000 in this new division.

Punching above weight in the emerging markets
Emerging markets are the key driver now for S&N’s growth. In the nine months to September, these countries accounted for 11% of group sales but contributed 43% of its growth. S&N has a focused strategy that targets the BRIC countries and selected other markets. In China it is particularly well established with a complete business operation, including manufacturing facilities. S&N has also made considerably more progress in these markets that most of its larger US rivals.

Innovation key in all markets
In the established markets, innovation is vital for growth to offset pricing pressure and to stop commoditisation of markets. The recent acquisition of Healthpoint strengthens its position in the fast growing bioactive wound healing market and provides a promising product pipeline. In the emerging markets, process innovation is important (more challenging for a technological innovator like S&N), as it looks to develop product ranges for the mid-tier market with suitable pricing points.

Valuation: Premium rating justified
S&N trades at a FY12 P/E of 14.1x compared to main peers, Stryker (13.4x) and Zimmer (12.4x). We believe that this premium is justified by the strength in endoscopy and its innovation capability in the established market operations. Also, S&N is better positioned for growth in the emerging markets than its rivals.

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