Smith & Nephew (LSE: SN), rated a BUY by Jefferies
One beneficiary of the demographic shift towards an older population in developed countries should be Smith & Nephew. It is Britain’s largest maker of artificial hip and knee joints (53% of sales), keyhole surgery products (22%) and advanced wound dressings (25%). Yet the stock has dropped this year. That’s because profits came down at its flagship orthopaedics arm due to hospital budget cuts and non-essential operations being postponed. In the third quarter, overall earnings before interest, tax and amortisation (EBITA) margins slipped 3.1% to 19.8%, on like-for-like revenues up 5% to $1.03bn.
The good news is that waiting lists cannot carry on lengthening forever, and Smith & Nephew’s chief executive, Olivier Bohuon, is busy reducing costs. He expects “to see material improvements from the fourth quarter onwards”, when margins should return to 24%.
Smith & Nephew is an emerging markets story too. Its ‘rest of the world’ division is racing along at a double-digit clip, and already represents 28% of the business. Indeed, it is fast catching up in size with the more mature American (41%) and European (31%) regions. Bohuon believes “the biggest opportunities” lie in the Bric (Brazil, Russia, India and China) countries. In 2010, sales to China and India were $120m, and “the goal is to grow this five times by the end of 2015”.
As for possible pitfalls, the healthcare sector poses the usual challenges associated with greater regulation, product recalls, competition, foreign-exchange risk and fiscal austerity measures. Nonetheless, with the baby-boomers entering retirement and emerging markets requiring improved medical treatment, the prospects look good.
Smith & Nephew is often touted as a takeover target. In 2010, Johnson & Johnson was rumoured to have tabled an indicative bid in excess of 750p. Then, earlier this year, there was further speculation that US peer Stryker would pitch in with a 850p-900p offer. In my opinion, Smith & Nephew will eventually lose its independence to a bigger player.
The City is forecasting 2011 turnover and underlying earnings per share (EPS) of £2.6bn and 47.1p respectively, rising to £2.8bn and 51.2p in 2012. That puts the stock on a price/earnings (p/e) ratio of less than 12. This is far too low for such a science-rich organisation, especially as the prospective dividend of 10.8p (2% yield) is four times covered by earnings, meaning there’s plenty of scope for a substantial hike in the future. I value the group on an 11 times EBITA multiple. After adjusting for net debt of $196m and a $304m pension deficit, that generates an intrinsic worth of around 700p a share. Investment bank Jefferies has a price target of 730p, and fourth-quarter results should be out in mid February.
Rating: BUY at 587p
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments. See www.moneyweek.com/PGI or phone 020-7633 3634 for more information.