EUR 850.00 For Business Accounts Only

Morningstar | Smith & Nephew's New Organizational Structure Holds Potential for Operating Leverage Gains

As new CEO Namal Nawana has ramped up organizational changes for Smith & Nephew, we’re intrigued by the possibility of increasing growth while holding costs level—something Nawana and CFO Graham Baker discussed in the quarterly earnings call. However, we’re reluctant to give the firm too much credit for improved operating leverage until we see more signs of progress, thus we’re leaving our fair value unchanged for now. As Smith & Nephew remains a midsize competitor in a field of much larger rivals at a time when size has become more important, we see little to change our thinking on the firm’s narrow moat rating and negative trend.

We were pleased to see hips, sports medicine, and advanced wound devices all deliver outsize quarterly growth at 4%, 8%, and 11%, respectively, on an organic and constant-currency basis. We expect some of this strength can be sustained in the near term as Nawana shuffles personnel and shifts organizational focus to emphasize differentiated technology. However, some product lines face greater challenges due to factors outside the firm’s control. For example, wound-care bioactives sales fell 7% on an underlying basis, which reflects some of the ongoing difficulties the larger advanced wound-care market has been dealing with due to fiscal restraint in European countries.

We weren’t surprised to hear that the Navio hand-held orthopedic robot was also a key driver of the 11% quarterly gain in the Other Surgical category. Considering the sustained strength rival Stryker has seen with its Mako robot, we anticipate growing interest in Smith & Nephew’s robot, especially if the clinical data on Mako (expected in March) will be as favorable as the preliminary view suggests.

We’re most heartened to hear Nawana and Baker contend that Smith & Nephew will be able to raise its growth profile while keeping operating expenses under control. We’ve long been critical of the firm’s relatively high selling, general, and administrative spending, which has run historically about 1,200 basis points higher than that of Zimmer Biomet. We recognize that SG&A at orthopedic firms generally tends to consume a larger proportion of sales compared with cardiac device companies, which reflects more sales rep time spent preparing trays and attending procedures. Nonetheless, it is hard to justify why Smith & Nephew’s SG&A should exceed Zimmer Biomet’s by such an extent, when the latter firm is closer to a pure-play orthopedic firm and we would reasonably expect that more of its salesforce would be engaged in that type of labor-intensive support of surgeons. Containment of SG&A spending seems to be directly related to the new organizational structure that Nawana is implementing, and management commentary suggested several layers of personnel could be eliminated by shifting to this structure that is centered around the different product categories (instead of by regional geography). If Smith & Nephew could close that SG&A gap with Zimmer Biomet to 200 basis points by 2022, this would translate into 63% upside to our fair value estimate.