Could Smith & Nephew Plc Be a Good Value?

Procedures volumes have started picking up and pricing pushbacks from payers has eased, leading many stocks in the orthopedics space to log good runs. Smith & Nephew plc (NYSE: SNN  ) has done better than peers/rivals like Stryker (NYSE: SYK  ) and Zimmer over the last twelve months, but oddly enough it may yet offer more value. The company's knee business appears to be regaining some share and the acquisition of Arthrocare (NASDAQ: ARTC  ) should be a highly synergistic opportunity to grow in a space that offers better prospects than major joint reconstruction.

Arthrocare looks like a good fit
Sports medicine and ENT tool specialist Arthrocare had long been regarded as a "when, not if" acquisition candidate, and it would seem that the recovery in the orthopedic market and the settlement with the government in January of 2014 finally cleared the deck for a deal. Smith & Nephew announced in February that it will acquire the company for roughly $1.5 billion (net) in cash.

Within the approximately $3 billion sports medicine space, Smith & Nephew is the #2/#3 player, running neck and neck with Johnson & Johnson (NYSE: JNJ  ) at around 18% to 20% share (and both trailing privately held Arthrex at around 25%). Within sports medicine, Smith & Nephew offers a robust product line up that includes access systems, electro-surgery systems, cameras, and soft tissue repair products, including products for hip arthroscopy like Healicoil PK, Osteoraptor, and Bioraptor suture anchors.

Arthrocare has approximately 5% to 8% share in sports medicine, but brings more than just added scale. Arthrocare isn't particularly strong outside the U.S., but Smith & Nephew is and can leverage Arthrocare products through its OUS sales channels. Arthrocare also augments Smith & Nephew's shoulder business and brings its well-regarded Coblation resection technology (which Smith & Nephew has licensed for some time).

Arthrocare also brings a portfolio of ENT products that account for nearly 30% of sales. The ENT category is not really much of a growth market and competing with Medtronic is no picnic, but it is still a profitable, cash-generating business.

Can Ortho regain some momentum?
Smith & Nephew has tried to stand apart in the major joint (hip and knee) market by developing products for younger, more active patients. That has not really helped, though, as the company has been a share-loser in hips and knees over the last few years.

On the positive side, the company's new Journey II knee platform appears to be driving some share regrowth, and I've spoken with multiple orthopedic surgeons who believe that the company's new Journey II BCS may be a best-in-class product. The knee business has also benefited from the company's Verilast technology, which supports a marketing claim for a 30-year wear life.

The hip business is not so strong, as legacy issues in metal-on-metal implants and resurfacing have coupled with a lack of innovation to lead to share losses. With the FDA less positive these days on wear claims, it seems less certain that Smith & Nephew will get to make the same wear claims as in the knee business.

I have my doubts about Smith & Nephew's long-term staying power in major joint reconstruction. Hospitals have increasingly consolidated their buying practices (dealing with only one or two manufacturers), and the company's low double-digit share in hip and knees makes them a more marginal competitor in the U.S.. Given the high ongoing product development and marketing support demands to stay in the major joint market, I see this business getting more and more challenging for Smith & Nephew in the future. With that, it may not be unthinkable that the company would look to sell it to a larger player or Biomet (a close peer in terms of major joint market share).

Better leverage to better markets
Major joint reconstruction markets have started looking stronger of late, and that has been welcome news for Johnson & Johnson, Stryker, and Zimmer (the leaders in hips and knees). Even so, it's hard to be excited about the long-term growth potential for the market given the reimbursement pressures in the U.S. and the growth of local rivals in markets like China.

Outside of major joint reconstruction, though, Smith & Nephew looks better-positioned. The company's trauma business may be a little sub-scale, but the sports medicine and arthroscopy businesses are both strong in terms of market share and growth potential (likely offering 5% to 6% long-term growth versus around 3% to 4% for major joints). So too in wound care, where the company has an uncommonly broad offering of devices, bioactives, and other products for a market that is also poised to outgrow major joint reconstruction (and has some leverage to the growing diabetes epidemic).

The bottom line
With a sizable presence in emerging markets and faster-growing categories like sports medicine, Smith & Nephew has a better growth profile than most of its large peers in orthopedics. The company also has a relatively clean balance sheet (even post-Arthrocare) with which to pursue other growth and consolidation opportunities. I am looking for long-term revenue growth of 5% (including Arthrocare), with FCF growth in the high single digits on synergies and greater cost efficiencies. Discounted back, that supports a price target of almost $85.

Admittedly, an $85 price target doesn't make Smith & Nephew a screaming buy, particularly as there are still reasons to be concerned about the long-term competitiveness and profitability of the major joint recon business. On the other hand, with the run in so many other names there are not a lot of better value options and Smith & Nephew may yet have some juice left in it.

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Related Tickers

10/1/2014 4:02 PM
SNN $83.07 Down -1.12 -1.33%
Smith & Nephew CAPS Rating: ****
ARTC $0.00 Down +0.00 +0.00%
ArthroCare Corp CAPS Rating: *
JNJ $104.30 Down -2.29 -2.15%
Johnson & Johnson CAPS Rating: ****
SYK $81.33 Up +0.58 +0.72%
Stryker CAPS Rating: *****

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