Smith & Nephew PLC Q4 FY2020 Earnings Call

Certain statements in this presentation are forward-looking statements. These statements are based on management’s current expectations and are subject to uncertainty and changes in circumstances. Actual results may differ materially from those included in these statements due to a variety of factors. More information about these factors is contained in the company’s filing with the Securities and Exchange Commission. Now I would like to hand the conference over to your speakers today, Roland Diggelmann, Chief Executive Officer and Anne-Francoise Nesmes, Chief Financial Officer.

Thank you very much, operator. And a very good morning to all of you. I hope this finds you well and safe. Welcome to Smith & Nephew’s Full Year 2020 Results. We are looking forward to when we can hold these meetings in person again, but for now, and for today, I'm calling in from Switzerland. I’m joined from London by our Chief Financial Officer, Anne-Francoise Nesmes. Before we get into the details of the results, I’d like to make a few opening comments. Now 2020 was a year of challenges for the industry, of course, in contrast to the very high expectations we had for Smith & Nephew back at the start of the year. Even so, I've been delighted and proud with our response. Throughout the year I've seen our team stay really focused on our purpose, continuing to support customers and patients in what proved to be a rapidly changing environment. So when we get into the details, it's clear that the work to improve the sustainable growth of our business has also continued. Recent launches and recently acquired products are performing very well across the entire portfolio. There is also increasing evidence that the work undertaken to improve execution is delivering results. The resilience of our business has meant that we've been able to maintain our investment in R&D and M&A in 2020. We will continue to invest in ‘21. This will accelerate our business in the mid-term. The headwind of COVID, excuse me, isn't finished, of course yet. But as we saw in quarter three of 2020, our business can really rebound strongly. So I'm excited about our prospects as the world hopefully returns to normal. After we cover the 2020 financials, I'll take you through what more we're doing over the coming years to deliver enhanced growth and efficiency. Importantly, this includes an intense period of new product launches, through ‘21 and beyond. So first, I’ll cover the highlights of our full year numbers. Full year revenue was $4.6 billion, which is a 12.1% underlying decline and 11.2% reported. That reflects the impact of COVID on our business for the year with a significant recovery in the second half. The resulting negative operating leverage led to trading profits of $683 million and a trading margin of 15%. Adjusted earnings per share were $0.646. While the COVID pandemic was truly a headwind through the year, the resilience of our business and the strength of our balance sheet meant that we were able to maintain our progressive dividend policy. We therefore propose an unchanged payment of $0.375 per share. Now, looking at the sales in the fourth quarter, revenue was $1.3 billion and was 7.1% underlying negative and 5.8% reported, with two more trading days than in the prior year. We had a strong start in the quarter, a continuation of the recovery that we had seen in the third quarter already. Then from mid-October onwards, there was again a slowing of elective procedures as COVID infections rose again, particularly in the US and in some large European markets. Encouragingly, our expectation that the effects of a second wave of COVID would not resemble the first has played out. Healthcare systems have generally proved to be much better prepared to maintain non-COVID care and our teams have continued to support them. Now, slide seven shows the details of the regions. In the US, we can see the effect of the second wave in quarter four; formal restrictions on elective surgery had been lifted as we entered October. However, some localized and temporary restrictions started to come back. By the end of the year, around 20 states had recommended partial procedure restrictions in place again. We also saw more frequent postponements of surgery due to patients testing positive for COVID or COVID-related staff shortages at hospitals. Other established markets declined by 6.2% in the quarter, which is unchanged from quarter three, but with big variations by country. For instance, our UK and Japan businesses improved, while France and Italy saw significant slowdowns. We expect to see continued impact in the first half of this year. Emerging markets also declined at a similar rate as in quarter three, though we saw strong end user demand again grow in China, offset in the quarter by shifts in stocking patterns. Overall channel inventory ended the year at around normal levels. Of the other emerging markets, India and much of Latin America continue to be under significant restrictions. Looking at franchise performance, businesses most driven by elective surgery were again expectedly the most sensitive to a second wave. Orthopaedic reconstruction, Sports Medicine, and ENT were most affected, while Trauma and Advanced Wound Management continued to be relatively resilient. When we look past the COVID effect, the details show very encouraging signs of progress for our growth strategy, through strong performances from new launches and acquired products across franchises. In addition, improved commercial execution benefits became more apparent in wound particularly. As I mentioned earlier, the detail of Advanced Wound Management has some very encouraging signs for the franchise. Overall, the evidence is increasing that the focus on better commercial execution is translating into improved performance. So I’ll now pass over to Anne-Francoise to take you through the details of the full financial.

Thank you, Roland. And good morning, everyone. I will start by outlining the key elements of the P&L first, before getting into further details. As you will see on slide 13, our full year revenue was $4.6 billion, down 12.1% compared to 2019 on an underlying basis. On a reported basis, revenue declined 11.2%, including a foreign exchange headwind of 20 basis points and a 110 basis point benefit from prior acquisitions. Trading profit declined by 42% to $683 million, resulting in a 15% trading margin. Now clearly, this reflects the impact of COVID on our business. Our IFRS operating profit was $295 million after restructuring costs, acquisition, amortization, legal, and other charges incurred in the year, which leads to a profit of $259 million after all of these costs. As a result, our operating profit margin was 6.5%. Adjusted earnings per share at $0.646 declined by 37%, and basic earnings per share declined by 25%. Importantly, we proposed to keep our full year dividend unchanged from 2019 in line with our progressive dividend policy, reflecting the resilience of our business and the strength of our balance sheet. Now Roland has covered in detail the Q4 revenue performance. So what you see on this slide is the full year revenue performance by franchise. Orthopaedics, our largest franchise declined by 14% to $1.9 billion for the full year, while Sports Medicine and ENT with revenue of $1.3 billion declined by 13%. Our Advanced Wound businesses were more resilient and declined by only 0.1%. Moving to slide 15, as indicated during the year, the trading margin was down year-on-year, reflecting the various elements driving the margin decline from 22.8% in ‘19 to 15% in ‘20. Clearly, the impact of COVID-19 was significant. We experienced lower gross margins from factory underutilization and increasing provisions, as well as negative leverage from SG&A costs before the actions we took. This accounts for almost 9 percentage points of the dilution. We delivered approximately $280 million of cost savings compared to our original budget for the year, predominantly from variable costs such as variable pay, third-party commissions or travel, providing a 2 percentage point offset to the margin pressure. However, throughout the year, we've been determined to maintain and protect R&D expense as we believe innovation should drive future growth. As a result, the R&D ratio stepped up to 6.1% of sales in the period from 5.2% in the prior year, and also rose in absolute dollar terms. We expect M&A and R&D dilution to continue into 2021 as we invest behind innovation. Adjusted earnings per share was $0.646 and declined by less than trading profit due to the benefit from a one-off tax provision release related to the conclusion of tax audits and other settlements. The tax rate on trading results for the year to December 31, 2020, was 11.3%. I should also mention that our basic earnings per share was $0.513 compared to $0.686 in 2019. Moving to slide 17, we generated positive trading cash flow of $690 million in the period with trading cash conversion at 101%, driven by working capital movement. We continue to invest in capital expenditure as we progress changes to our manufacturing base, and we saw working capital inflow of $82 million. This was primarily driven by a decrease in receivables from the revenue decline in 2020, as well as improved cash collections in several markets. Overall, our free cash flow was $437 million after all of the cash flow movements shown on this slide. Within the restructuring charges, we incurred $117 million restructuring costs. It is worth mentioning that APEX initiated at the end of 2017 incurred restructuring costs of $49 million in 2020. This program is now substantially complete and will deliver annualized benefits of around $190 million, or $30 million more than we originally guided, with one-off costs of around $290 million, which is $50 million more than we originally planned. I will talk about our current program focused mostly on driving efficiencies in operations and supply chain later. Roland has already mentioned that we have a strong balance sheet with access to significant liquidity. Our net debt increased by just over $150 million to $1.9 billion, including approximately $100 million spent on the acquisition of Tusker Medical. For clarity, closing net debt includes $204 million of lease liabilities. We finished the year with a leverage ratio of 1.8 times adjusted EBITDA. We completed the $240 million acquisition of Integra's Extremity Orthopaedics business shortly after the year-end. I'm pleased to say that our liquidity position remains strong, and in October we also closed our debut USD bond with proceeds of $1 billion. This provides attractive long-term funding which will be used to invest behind the group's strategic objectives. Finally, I would like to talk about the outlook for 2021. We expect the impact of COVID-19 on our customers and markets to continue into the first half of 2021 and the timing and extent of recovery remains uncertain. Our intent is to revisit our financial guidance as the year progresses and provide updates as the situation becomes clearer. In terms of revenue, we expect to deliver substantial underlying growth in 2021 compared to 2020. We expect established markets to recover faster than emerging markets, as vaccines are rolled out supporting the recovery of elective surgeries. We also expect our Hip Implants to continue to outperform Knees, and our Sports Medicine and ENT franchise to rebound strongly as markets recover. Advanced Wound Management growth strategy should continue to improve, as our recent commercial changes deliver benefits. For the trading margin, there are several moving parts to consider. At the gross margin level, there will still be some headwinds from the impact of COVID-related to 2019. We expect the negative leverage to exceed the incremental benefits of cost savings in 2021. We are also importantly continuing to invest behind the growth strategy. Compared to 2019, you should expect around 100 basis points dilution from higher investment in R&D, approximately 150 basis points of dilution from recent acquisitions, including the Extremities business. Transactional FX will be another headwind of around 100 basis points. Lastly, the tax rate on trading results for 2021 is expected to be in the range of 18% to 19%. So quite a lot to take in here. But with that, I'll pass you back to Roland.

Thank you very much, Anne-Francoise. I'd like to finish by spending some time on our priorities for ‘21. Our first one is to return to top-line growth and recapture our momentum. Organic growth is a key driver of shareholder returns, of course, and is what enables positive operating leverage to our P&L. In a moment, I'll go into some detail of what you should expect to see from us in the next two years. Second, we will be driving further improvements in our operations. This will free resources in the mid-term for investing, including into R&D, and offset margin dilutions from M&A. And thirdly, of course, we will continue to respond to COVID. The global rollout of vaccination programs offers a route back towards normality, but it's clear that COVID will still have a significant impact on the business, at least in the first half of the year. Now starting with revenue growth. We've talked at length about the first stage of accelerating the business with a new commercial model and new leadership. Early results were positively broad-based growth acceleration through 2019. At the same time, we’ve also ramped our investment in future growth, with a hike in tuck-in M&A and an increased R&D ratio. The next stage, of course, is to deliver on those changes and investments. Firstly, we’ll work to maximize the potential of our current portfolio. Our recent launches and initiatives are still at early stages, such as the OR3O Dual mobility cup, CORI Robotics and our focus on ASCs. There's a great opportunity to keep growing these and to bring them to more of the world. This will build on our improved execution across the franchises and regions. Secondly, you will see us deliver the value from our acquisitions. We’ve brought in synergistic assets across the portfolio, like the Extremities assets from Integra, TULA for ENT, and GRAFIX and STRAVIX in Bioactives. As we emerge from COVID, you should see that these segments have moved to structurally higher growth rates as a result of these deals. And thirdly, we have an intense period of new product launches planned over the next two years and will continue to invest more in R&D in 2021. You should expect to see these launches across the franchises, bringing differentiated technologies, including in high growth categories. This slide highlights several key projects for ‘21. All product launches are subject to regulatory approval. In Joint Replacement, we’re planning for the first launch of our new cementless knee in the second half of the year. This is probably the one portfolio gap that we’ve needed to address. The aim is to access this high growth segment, and a crucial part of our plan is to accelerate in Knees. In Sports Medicine, we’re looking to enhance and are already leading our position in meniscal repair, with a new generation of Fast-Fix and will continue to upgrade on Tower. In Advanced Wound Management, we aim to build on our recent acquisitions with new versions of GRAFIX, STRAVIX, and LEAF, and will launch the next generation of PICO. There is more activity beyond what we show on the chart, of course, we're targeting further regional launches of existing products and are working on products specifically tailored for the needs of our second largest market, China. With these innovations, we’ll bring you the details of the technology closer to launch, and the overall picture of new growth opportunities across the whole portfolio should be apparent. Importantly, I believe we have already demonstrated the commercial excellence to realize the value of our innovations. Now this slide shows four examples where the delivery of new technology has driven growth inflections across their respective segments. After the launch of OR3O in late 2019, our Hip business moved from growth in line with our peers, to now leading our peers for three consecutive quarters. Our addition of REGENETEN to our Sports Medicine business at the end of 2017 has driven Joint Repair to accelerate from mid-single digits to double-digit growth. In Arthroscopic Enabling Technology, successful launches in Tower brought a segment previously in decline back to mid-single-digit growth. PICO has been a success story in Wound Management since launch, maintaining growth momentum for almost a decade. These examples demonstrate that where we have innovation in a category, we can significantly enhance our growth rates. With a step-up in investment in R&D and M&A, we’re poised to replicate this across more of our portfolio than before. Now, Anne-Francoise will speak to our second priority: driving further operational improvements.

As I mentioned, the APEX Efficiency Program is now substantially complete. We over-delivered on the benefits we guided for at initiation, with savings now around $190 million annually. We've also started the next step in improving our long-term efficiency. Our approach has two elements: one focused on driving a transformation in our operations, and the second element targeting continuous improvements in our processes. On operations, we will simplify and increase the flexibility of our manufacturing and distribution networks. We will also optimize processes, implementing global lean manufacturing and increasing automation. On the process side, we’ll simplify end-to-end processes throughout the company, aiming for better alignment across Smith & Nephew to work together more smoothly. This is a complex transformation that will take time. Overall, we expect the program to run for five years, with work already having started in late 2019. We’re targeting around $200 million of annualized cost savings by the end of 2023, with total restructuring costs of around $350 million. I’ll now hand back to Roland to cover our third priority.

Thank you. The third priority is to continue to respond effectively to COVID. Our COVID response this year will build on what we’ve already implemented in 2020, including supporting customers, protecting our employees, and controlling costs. With our customers, we expect both in-person and remote service to continue and will enhance our digital capabilities to support that. For example, in ‘21 we’ll launch Education Unlimited, a new medical education platform spanning all our franchises. For our employees, we’ll continue ensuring flexible and COVID-secure working environments, using novel wearable technology to support social distancing. While COVID still impacts our end markets, we’ll control discretionary expenses like travel, events, and other elements included in the guidance Anne-Francoise has given. In summary, I’m proud of how Smith & Nephew has responded to the challenges in 2020. We've demonstrated our financial and cultural resilience, maintaining focus on supporting customers and advancing our strategy for growth. As the recovery from COVID comes into sight, our recent investments in innovation and our portfolio are ready to translate into growth momentum. I'm truly excited about the pipeline of new technologies approaching launch, and by the potential of our recent acquisitions. There’s still work to do managing through the pressures of at least the first half of the year, but we have clear priorities and look forward to updating you as we progress through the year. Now, we'd be happy to take your questions. Thank you.

We're now taking our first question from the line of Lisa Clive from Bernstein.

Hi there. Three questions for me. First on the R&D spend, I understand the need for increased investment for new product launches. But how do we think about the right level for R&D spend going forward, considering the growing demand for clinical data across Med Tech? Second, just on Robotics, how should we think about adoption? Is it about penetrating your own base? And within your surgeon base in the US, what is adoption today? Is it 5%, 15%? Where do you think you could get to? Lastly, can you remind us of what market share Smith & Nephew reached previously before it had to withdraw the RENASYS platform? And are you back to those levels? Thanks.

Thank you, Lisa. I'll address your questions in order. Regarding R&D and clinical data, absolutely, there is a heightened need for clinical data. This is beneficial for larger players who can demonstrate product efficacy. Regulatory requirements like MDR also drive this need. On R&D, innovation drives adoption and success in this industry. We had a step-up in ‘19, protected R&D during 2020, and we're increasing it in ‘21. We’re around 6% of R&D as a percentage of sales. I wouldn't give an exact number since we want to focus on opportunities, but it is in the right place now. About Robotics, adoption usually initiates with your own customers. With CORI, we’re optimistic and believe we can capture market share, given it offers a differentiated solution. While we arrived late to the market with CORI, we believe it's a versatile and flexible solution that doesn’t require a CT scan, which is beneficial—especially in ASCs. On RENASYS, I believe we reached about $100 million in revenue before the withdrawal in 2019. There’s a significant trajectory for RENASYS as it is a very strong product. I hope that answers your questions, although I don’t have a specific market share figure for RENASYS.

Okay. Thanks very much.

Thank you, Lisa.

Our next question comes from the line of Michael Jungling from Morgan Stanley.

Thank you, and good morning. I also have three questions. The first one relates to your 2021 guidance. Why aren’t you able to deliver more numeric guidance, as you have done previously? It seems like you have less visibility than other companies by not providing this. Second, regarding inventory obsolescence, I noticed the $80 million charge for the full year. Can you provide more color on this? Lastly, I've noticed that your stock performance since COVID-19 is materially underwhelming compared to peers. What do you believe is lacking that investors aren’t seeing with your stock?

Thank you, Michael. I’ll take the first question. Some peers have provided numeric guidance while others have not; we chose the latter due to visibility impacted by COVID. This will largely dictate the recovery ability. I’m confident we will rebound quickly after restrictions lift, looking back at our second quarter performance last year, where our sales were down 29%, but rebounded to only minus 4% in Q3. The timeline for vaccine rollout and control of the virus remains uncertain. As for inventory, I'll pass this to Anne-Francoise.

In terms of the inventory provision, we have signposted an increase of $80 million due to excess inventory and bad debt provisions. Our inventory obsolescence provision is mostly a mathematical calculation. We have not changed our accounting policy, and we provide for inventory obsolescence based on demand estimations. The provisions increased because our demand estimates reduced over the last few years, resulting in a simple mathematical calculation. We’re not necessarily expecting more write-offs. We also took specific provisions, as mentioned in H1 around NAVIO, since we’re upgrading to CORI.

Regarding the share price, Michael, we recognize this is a difficult question to answer. It’s possible Brexit-related concerns in the London Stock Exchange have contributed to our stock performance. That said, I see a great opportunity for growth with our pipeline and investments in R&D. I'm optimistic we can deliver future growth.

Thank you. If you could follow up on the provision for doubtful debts, have you recycled scrapped inventory?

Yes, we have indeed scrapped some inventory, but the majority of the provision is driven by inventory levels and usage.

Our next question comes from the line of Tom Jones from Berenberg.

Good morning, thanks for taking my questions. I have two. First, regarding the margin outlook. You've mentioned further COVID-related headwinds impacting gross margin. Can you estimate the net impact on margins in 2021? Second, it seems you have a substantial amount of cash not generating returns. What’s your timeline for deploying it, and are you considering M&A?

Tom, regarding gross margin, it is driven by both revenue growth and production costs. We expect COVID's continued impact on production levels, particularly in the first half of 2021. The previous year's impact in 2020 was material, but forecasting exact outcomes for 2021 is challenging due to the ongoing pandemic. We expect gross margin will be negatively impacted temporarily. Regarding cash deployment, we are in a strong liquidity position, having sold off excess inventory during COVID. We will continue to focus first on reinvesting in growth, while also maintaining our progressive dividend policy. M&A remains a top focus, and we are well-positioned to execute our strategy. Capex increased somewhat in 2020 primarily to support our Malaysia factory and manufacturing network.

Okay, thank you very much.

Our next question comes from the line of Kyle Rose from Canaccord.

Great, thank you for taking my questions. I have three. First, on the CORI product, can you level set expectations for timing on its impact on procedural throughput across your Knee and eventually Hip business? Second, do you believe you're underperforming your peers more from a pricing or an ASP perspective in US Knees? Lastly, can you provide guidance for Q1, given the ongoing pandemic impact?

On CORI, I believe we’ll start seeing its impact soon. The rollout has been impacted by physical restrictions, but I expect strong uptake across surgical procedures. On US Knee performance, we are facing challenges both from price and volume loss. The cementless integration will play a role in rectifying this, and we believe it will enhance both our volumes and market share. Regarding guidance for Q1, we expect trends in Q4 to continue given COVID's impact, especially in the US and EU markets. We anticipate a swift recovery when conditions permit, but this quarter may experience delays from weather-related cancellation issues. Overall, I see pent-up demand building.

Thank you.

Our next question comes from the line of Kit Lee from Jefferies.

Good morning and thanks for taking my questions. First, regarding your Sports Medicine and Extremities portfolio. Given the recent Integra acquisition, where do you see the biggest gaps today in that portfolio? Are there any plans in the pipeline to address them? Second, could you elaborate on the trading profit margin guidance? How does the current 2021 guidance factor into the mid-term margin outlook?

In Extremities and ENT, we don’t see any significant gaps. The markets are fragmented but we're optimistic about our TULA solutions and believe demand will return as COVID subsides. In Sports Medicine, our existing portfolio is robust, and we will continue developing complimentary solutions internally and externally. For margins, our priority remains driving growth. Trading margins will recover as we bounce back from COVID; we aim to get back to the low 20s margin levels as the recovery progresses.

Just to clarify, the Integra acquisition rolls up into the extremity segment under Trauma in Orthopaedics.

Great, that's helpful. Thank you.

There are no further questions on the line, please continue.

As there are no further questions, I would like to thank you all for your interest. Hope to speak to you soon and see you at some point soon. Thank you for dialing in. Have a good day.