Smith & Nephew PLC Q2 FY2021 Earnings Call

Please note, 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 filings with the Securities and Exchange Commission. Now I would like to hand the conference over to the 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. Welcome to Smith & Nephew's first half results. And as mentioned, with me on the call is our CFO, Anne-Francoise Nesmes. I'm very pleased to report a good first half and another quarter of solid progress for the group, which sets us up well for the future. Firstly, we continue to recover from COVID. More of our end markets are now approaching or in some cases, actually even exceeding pre-COVID levels of activities and our business is recovering well with them. Secondly, we're on track to meet our '21 guidance. And to remind you, we expect a 10% to 13% underlying revenue growth and a trading margin of 18% to 19%. And finally, we're delivering on our strategic priorities for the year. Our work in commercial execution and efficiency is progressing on growth, recent launches and acquired assets are performing well across the portfolio. So in a moment, I'll take you through our performance in the quarter. Then, Anne-Francoise will cover the financials for the first half. And I'll update you on some of our strategic progresses. So turning to the next page, I'll begin with the highlights of our first half. For the first half, revenue was $2.6 billion, that's 21.3% growth over the first half of 2020 on an underlying basis, and 27.8% on a reported basis. This does include the benefit of 3 extra trading days. Now I'll talk about comparisons to 2019 as well in a couple of slides. Trading profit was $459 million, which is a 17.6% trading margin, and adjusted earnings per share were $0.388. We have preserved our dividend through the pandemic and the interim dividend for 2021 is again unchanged. Now shifting to the revenue by region. Let me start with some comments about the markets around the globe and especially how they continue to respond to the COVID pandemic. So in the U.S., procedure volumes have continued to recover. Some categories are now above pre-COVID levels and with very few remaining formal restrictions at this time. Conditions have also improved on balance in other established markets, although with a mixed picture by region. In Europe, surgery volumes rose sequentially but are still behind pre-COVID levels, while in Japan and Australia, the situation has weakened in the quarter as infection rates rose leading to more postponements of surgeries. In China, end market volumes returned to growth as early as April 2020, and they have actually maintained the recovery since. In the first quarter, we saw headwinds in hips and knees in China, though that is due to a change in ordering patterns by distributors ahead of the forthcoming volume-based purchasing tenders of VBPs. In many other emerging markets, procedure volumes remained significantly affected following recent outbreaks. Now on the next page, as you saw previously, our total revenue for the quarter was $1.3 billion with 40.3% underlying growth. The growth rates largely reflect the trends in the prior year rather than the underlying development in the business, especially because the peak impact of COVID on our business was in the second quarter of 2020. Moving forward, of the 3 franchises, 2 are now back to above pre-COVID levels on an underlying basis. This is Advanced Wound Management, which was 5.1% above the second quarter of 2019, again, showing the benefit of our work to improve commercial execution. Sports Medicine & ENT was 1.3% ahead of the 2019 quarter, even with a slower recovery in ENT procedures. Orthopaedics isn't there yet, being 6% below 2019. I'd point out 3 factors here; not having a cementless knee remains a relative drag, the headwinds I mentioned in China from the ordering patterns from distributors ahead of the VBP, and we've had some near-term supply constraints in certain product lines. Now specifically on the next page, let's look at the individual segments. In Orthopaedics, we believe the higher growth in Knees versus Hips reflects a greater COVID impact in the second quarter of 2020 as the comparator. When we look through that prior year effect, the recent trend of a stronger Hip business has indeed continued, supported by the great progress of our OR3O Dual Mobility rollout. In Knees, we continue to work towards cementless options as stated, and we remain on track to launch actually towards the end of this year. Trauma & Extremities included strong growth from EVOS and external fixation as case volumes returned. Finally, Other Recon growth was driven by U.S. sales of CORI, our next-generation robotics platform. We're now expanding into new regions and have had launches in India, Australia, and the United Arab Emirates in the quarter, with regulatory approval in Japan. Moving on to Sports Medicine & ENT, Joint Repair delivered good performance across both the meniscal and shoulder categories with sales of acquired products, NOVOSTITCH and REGENETEN more than doubling. We also announced the U.S. launch of FAST-FIX FLEX, the next generation of our leading meniscal repair family, which gives better access to around 40% of tears that are hard to reach with currently available technologies. Arthroscopic Enabling Technologies also saw strong growth from recent launches with sales of LENS and FLOW Wand more than doubling, and after the 510(k) clearance in Q1, the DOUBLEFLO fluid management system also launched in the second quarter. Despite the 45% year-on-year growth, the ENT market remains challenging as tonsil and ear tube markets are showing slow recovery, particularly in pediatrics, and procedure volumes remain well below historical levels. The focus currently lies on training surgeons and targeting early opportunities in specific U.S. states. Finally, moving on to Advanced Wound Management, all 3 segments of the franchise showed growth over pre-COVID levels. Performance was strong across multiple brands as we continue to build on our improved commercial execution. In Advanced Wound Care, the recent acceleration in Europe continued and all other regions contributed to overall growth. Bioactives growth came from both SANTYL and the skin substitute portfolio, all returning to above pre-COVID levels. Finally, Advanced Wound Devices returned to growth as well, helped by the ongoing recovery in elective surgery. Negative pressure remains the main driver of the segment with RENASYS continuing to win business in the post-acute setting. And with that, I'll hand over to Anne-Francoise to take you through the first half financials.

Thank you, Roland, and good morning, everyone. As Roland has covered the Q2 revenue performance in detail, I will now move to the overview of H1. This slide shows the evolution of our revenue by franchise in the first half. As you can see, all 3 franchises contributed to the recovery in overall revenue, which was $2.6 billion. Orthopedics, our largest franchise, grew by 19.2% on an underlying basis to $1.1 billion for the half year. Sports Medicine & ENT grew by 28% to $0.8 billion, and our Advanced Wound business grew by 18% to $0.7 billion, in part reflecting the greater resilience of the franchise in 2020. The picture by region is very similar. The U.S., other established markets and emerging markets all contributed to growth. We are pleased with our performance in H1, and you can see our improved position in our P&L. Our half-year revenue was $2.6 billion, up 21.3% compared to 2020 on an underlying basis. On a reported basis, revenue grew 27.8%, including a foreign exchange tailwind of 470 basis points and a 180 basis point benefit from acquisitions. Trading profit grew by 166% to $459 million, resulting in a 17.6% trading margin. The margin expansion reflects improved trading compared to 2020, together with strong control over discretionary costs. However, compared to pre-COVID levels, we are still seeing headwinds, notably increased investment in R&D, M&A, and new launches as expected, along with ongoing COVID-related negative leverage from fixed costs and higher logistics and freight costs. Adjusted earnings per share grew by 189% to $0.388, with financial leverage driving growth above trading profit. We are proposing to keep our interim dividend unchanged, having maintained it through 2020, in line with our progressive dividend policy. Moving to cash flow, we generated positive trading cash flow of $404 million in the period, with trading cash conversion at 88%. We continued to invest in capital expenditure as we progress changes to our manufacturing network. You should expect that CapEx may increase further in the second half, both from the manufacturing investment and also from instrument sets to support expected product launches. The working capital outflow of $76 million was primarily driven by higher receivables resulting from a return to revenue growth in the period. Overall, our free cash flow was positive at $160 million, a significant improvement over the prior year. We continue to have a strong balance sheet with access to significant liquidity, with net debt ending the period at $2.2 billion, which is an increase of just over $250 million. Of that, $237 million came from the acquisition of the Extremity Orthopaedics business, which closed in January. Even with a higher net debt, our recovering profitability meant that the leverage ratio came down to 1.6x adjusted EBITDA at the end of the period. I'll now move to our outlook. The first-half results are consistent with the market view we set out in April, and we are on track to meet our guidance for 2021. Our target remains for underlying revenue growth of 10% to 13% and a trading margin range of 18% to 19%. After a 17.6% margin in the first half, the range implies less margin seasonality in 2021 than we normally see, and that's what we expect. Factors contributing to that: a planned increase in OpEx, with events like AAOS taking place in the second half of the year that would typically come earlier, the marketing and promotional spend that we had paused in 2020 and that is now returning as markets recover, and a greater effect in the second half from some inflation in costs, including higher global logistics and freight costs. As before, we face unknowns around COVID and have made some assumptions about the course of the pandemic. Conditions improved in Q2, as we expected, and our targets continue to assume that surgery volumes are largely unconstrained by COVID in the second half. With that, I'll hand back to Roland to cover the strategic progress.

Thank you, Anne-Francoise. I'll now move on to update you on the priorities that we set out for '21 at the start of the year. Our first priority is to return to top-line growth and to recapture momentum. The second priority is to drive further operational improvement, and of course, to respond effectively to COVID. This shows the components of our first priority, which is growth. Last quarter, we highlighted the wound franchise as a case study in driving commercial excellence. The results from that have become more visible in numbers in the recent quarters. I'd like to spend a bit more time on the second component of our growth story, which is delivering value from acquired assets. We began a more intense period of M&A from the first half of 2019, aiming at accessing external innovation, being in high-growth markets, and generating value through sales and cost synergies. We have been active across all 3 franchises. In Orthopaedics, the deals have increased our exposure to high-growth segments. The transaction with Integra brought us scale in the Extremities business. With Brainlab, Atracsys, and other digital assets, we have built out our portfolio of digital surgery technology. In Sports Medicine & ENT, we've added exciting new products that tuck into our existing offering that are building on the successful strategy of commercial execution of REGENETEN. These include NOVOSTITCH PRO from Ceterix and Tula from Tusker, both of which have the potential to change the standard of care in meniscal repair and ear tube placement, respectively. In Wound Management, the deals have expanded our portfolio offering in high-growth categories, bringing the Osiris skin substitute products to our portfolio, enabling co-selling with OASIS, while Leaf is sold alongside our foam dressings and skin care offerings as part of our portfolio solutions for pressure injury prevention. We're still in the early stages of most deals, but we've accumulated evidence of operational and financial delivery. I'll start with Rotation Medical, which has been part of Smith & Nephew since early 2018 and is an important example of a tuck-in acquisition where the business case has had time to play out. The operational steps we've taken to drive REGENETEN, such as selling through a larger sales force and bringing it to new regions, will also be repeatable with other acquisitions. Importantly, this has translated into successful financial outcomes. REGENETEN was a key driver behind the acceleration of joint repair from mid-single-digit growth to double-digit growth. When we acquired Osiris in 2019, cross-selling was an important part of the business case. Now, after completing commercial integration, both existing Smith & Nephew Bioactives products and acquired products are being sold by our combined sales forces. Finally, Osiris is at an earlier stage than Rotation, but we're now seeing the acceleration of Bioactives that we expected. The trading profit contribution is ramping up, and the transaction is adding to group margins for the first half. Brainlab was a very different type of acquisition, driven much more by technology. The deal was structured around a development partnership involving robotics and digital surgery, and that's also progressed really well. We have key projects on track, such as bringing Brainlab's leading technology to our core robotics platform, helping us move into new indications. The Extremity Orthopedics assets are early in their time at Smith & Nephew, but we are making good progress on integration. We've also started training large sales teams on the new products, with the existing Smith & Nephew sales force now selling total shoulder and ankle replacements while former Integra sales reps are now selling Smith & Nephew technologies such as EVOS SMALL and SPATIAL FRAME. When it comes to returns, Rotation has already met the hurdle of ROIC exceeding WACC before the pandemic, while other transactions are at different paths of integration maturity, with varied effects from COVID on their deal models and timing. However, the majority, including Osiris, remain on track to meet our ROIC hurdle, which is set at 5 years post-acquisition. Shifting to key pipeline progress in '21, launching our expanded pipeline aligns with our commitment to innovation. I covered 2 launches in Sports Medicine, FAST-FIX FLEX, which launched in July and has treated its first patients, and DOUBLEFLO, which launched in April as a systematic upgrade to our arthroscopic tower. We have also made progress with our CORI robotic surgery system, first launched in the U.S. in 2020. We have now also launched in India, Australia, and the Emirates, and we expect to further develop the platform in the second half by adding HIP software and the Digital Tensioner, a novel gap balancing device for use with CORI in knee surgery, pending regulatory approval. The second priority is driving operational improvements. In February, we announced a new operations transformation and process efficiency plan targeting around $200 million in annualized cost savings. Optimizing our manufacturing network is an important workstream, and we have announced plans to sell or close 5 of our smaller factories, with much of the production ultimately consolidated into larger sites as this process continues. This rationalization will simplify the network, supporting greater efficiency and automation. The construction of our new large-scale, high-tech facility in Malaysia is nearly complete and expected to begin production in 2022. Once operational, it will support more future growth from a lower-cost location and increase our presence in a high-growth region. This will also make our manufacturing supply chain more resilient to the types of challenges and supply constraints we're seeing. To summarize, our progress in the second quarter shows we are on track to achieve 2021 guidance and recapture growth momentum from before the pandemic. Looking at each franchise, the Wound business showcases growth with improved execution, value from M&A in Bioactives, and the success story of innovation in devices. Sports Medicine was performing well going into COVID, and we are picking up right where we left off as the market recovers. In Orthopaedics, we're in good shape in 2 of the 3 categories, with Hips and Trauma, and with more drivers to come, like the next-generation shoulder and the cementless knee. While the effects of the pandemic have not completely subsided, we're emerging from COVID with most of our portfolio either outperforming or with new drivers coming soon, showing our ability to convert opportunities into improved growth, which ultimately drives our P&L leverage. Thank you, and I'll take your questions.

Our first question comes from Patrick Wood of Bank of America.

Perfect. I'll keep it to 3, please. Maybe just on the first one, very fast recovery on Wound Care. I guess I thought Hips and Knees and Orthopedics would be the first ones to recover, and then Wound Care would be a bit later. Why do you think Wound Care has been so much stronger in the short term than Ortho? As a second question, could you give us some color on how you saw things move through the quarter? I imagine everything has a lot of volatility, but towards the back end of the quarter, it seems like things were picking up a little bit relative to the first part of the quarter. So what was the general exit rate? And then, last one, just a small technical one. I'm curious if you can roughly quantify the destocking effect you saw in China? Was that material in the quarter or just nothing?

Patrick, thanks for your questions. On Wound Care, it's a combination of factors. Wound has been resilient to the pandemic with a significant portion of sales coming from the chronic markets. We've had early wins that we're now seeing we've successfully converted, alongside ongoing execution and focus on commercial execution. There was also a shift in ordering patterns from late 2020 into early '21, although you saw that mostly in Q1. Overall, we're very pleased with our progress across the Wound franchise. On the quarter, from start to end, we continue to see some improvement, although it's hard to quantify in broader terms. Geographically, we've seen strong recovery in the U.S. and solid volume increases in China, but a slow recovery across major European markets. The challenge moving forward is the limited visibility to potential further outbreaks or variants that could impact us, with elective surgeries being the first to get deferred. As for the destocking effect in China, yes, we noticed it in our sales numbers as distributors anticipated the introduction of the VBP, which led them to withhold orders. From a market perspective, the volumes are robust and at pre-pandemic levels, which is positive. The VBP has been delayed a couple of times, and we expect the award in Q3 or Q4, but the full-year impact will likely not be material for us, although we observe it in our ordering patterns.

If I may add to Roland's comment on China, that affects the ordering pattern and the value of that inventory in the channel, which also impacts the margin.

Our next question comes from Chris Gretler from Credit Suisse.

Roland and Anne-Francoise, I have 2 questions. First, regarding the supply constraints, could you elaborate a bit more on the magnitude of the impact you've seen, and how likely it is to affect the second half? Then for the second question, can you elaborate on your full-year growth guidance of 10% to 13%? If I analyze your first-half performance, you're already kind of at the low end without anticipating any growth for the second half. Could you elaborate on the assumptions here, especially concerning constraints in those markets?

Chris, thanks for your question. It's difficult for us to quantify the specific effects; we don't have hard numbers at this stage. But the significance was important enough to bring it to your attention. The supply issue primarily affects orthopedics. We've experienced freight and logistics delays, along with labor shortages especially in Memphis, where the majority of Orthopaedics products are produced. We are addressing this, of course, and this issue aligns with labor shortages across other industries in the U.S. We expect improvement going forward. Regarding the growth guidance of 10% to 13%, we anticipate a mixed picture regarding external recovery factors. The U.S. market continues to perform well, while Europe is slowly increasing and emerging markets are lagging behind, along with potential complications that could arise due to the ongoing pandemic. We also have 4 fewer trading days in Q4 than in 2020, which affects our outlook. However, we remain confident in achieving our sales guidance and trading margin expectations.

I appreciate your comments, particularly on the acquisition performance or acquired businesses.

Our next question comes from Tom Jones of Berenberg.

I had 2 areas I wanted to touch on—guidance and pricing. On the guidance front, how would you quantify the current constraints on surgery volumes in the context of your largely unconstrained remark? Are we somewhat, largely, or completely constrained? Regarding H2, although many assume improvement in the U.S. and Europe, what about smaller markets where vaccination is less advanced? Would that push you toward the lower end of your guidance? On pricing, given the return of inflation, do you anticipate you can start pushing prices back up?

Thank you, Tom. It's difficult to define exactly how constrained the markets are. In summary, we are confident we will meet our margins and guidance. We expect further improvement in the environment and recovery patterns. In terms of regions, the U.S. market continues to perform well, Europe will progressively improve, and emerging markets will show a slower recovery due to vaccination rollout and healthcare system constraints. We have factored this in, but we're optimistic about achieving our goals for sales and trading margins.

Just to confirm our trading margin guidance: we feel comfortable with it. Our guidance is always based on a range of scenarios. We've signposted impacts in factors such as R&D investment, M&A, FX, and operational leverage from COVID, which also links to production levels not being at pre-2019 levels. The guidance does include all elements we foresee at this point.

Perfect. Just a follow-up on the cost side. Given these supply issues have been visible for a while, have you maintained your margin guidance despite potential margin pressure? Why should we assume continued pricing declines? At what point could prices potentially increase?

That's a good question. We've discussed concerns about the risk of price pressure increasing due to the current fiscal environment. Price erosion continues at historical levels, with challenges in price increases. There may be exceptions with innovation-driven product launches. As a result, revenue, volume growth is crucial for driving leverage.

Our next question comes from Kyle Rose from Canaccord.

I wanted to start on wound. Can you provide better insight into how much of the Bioactive growth is due to cross-selling opportunities versus natural market recovery? Regarding devices, are we starting to see expected contracting wins from RENASYS fully realized? And on the Ortho side, when should we expect cementless options to be available on CORI? How are purchase trends from upfront versus volume-based agreements?

On Wound, the biologics growth results from multiple factors, including market recovery and cross-selling success. We're also pleased with RENASYS's performance, but contract wins are part of a longer execution process. Regarding Orthopaedics, we aim to launch the first component for cementless LEGION by the end of this year, with full impact expected in 2022. The CORI platform's adoption is positive, showing an increase in procedure counts; we're flexible on commercial models, adapting to market needs. Yes, we're also committed to the markets we're in and are focused on tuck-ins rather than larger transactions at this stage, focusing on technology-driven acquisitions. We're thankful for our strong balance sheet, allowing us to observe market developments.

Our next question comes from Michael Jungling from Morgan Stanley.

I have 3. On the 2021 guidance, can you comment on how close you were to raising organic sales growth guidance for the year? Roland, can you talk about the recent share price underperformance and what it would take to change it? Finally, do you think that one of the divisions is underappreciated and whether spinning one out with Smith & Nephew holding a material share would be sensible?

Michael, these are interesting questions. It's challenging for me to comment on the guidance’s internal review; however, we felt confident in our performance based on broader market uncertainties. On share price, it's largely about execution—delivering on our strategy and utilizing our new management team to drive growth and transformation. Concerning divestitures, we haven't considered that currently; our franchises are well-positioned with promising growth opportunities, and we plan to continue driving innovation and product development.

Our next question comes from Hassan Al-Wakeel from Barclays.

I have 3, please. Based on what you've seen year-to-date, how do you think about pent-up demand going forward, especially in key markets for Q3 and Q4? Assuming the recovery continues, are you able to signal whether the top end of guidance is more likely? Also, any update on CORI performance and whether you believe you're gaining market share in robotics?

There is undoubtedly pent-up demand, but it's challenging to predict precisely when it will materialize. Overall, our recovery patterns are reflecting broader healthcare trends, notably the faster recovery rates in for-profit markets like the U.S. versus slower recovery in public healthcare systems. On the adoption of CORI, we're pleased with performance and feedback, indicating strong growth in both hospital and ASC settings. Our product's versatility and benefits suit the ASC model well.

Regarding our guidance, we remain committed and are confident about fulfilling our targets. We are monitoring various scenarios based on market conditions and potential setbacks in recovery.

Our next question comes from David Adlington from JPMorgan.

I have a couple of questions. Considering your revenue guidance, it seems conservative based on your existing performance. Can you elaborate on the margin pressures impacting gross margins, particularly how they could evolve next year?

Yes, I mentioned that Q3 presents a tougher comp relative to Q2 due to strong recovery last year, and that may affect our guidance for the second half. However, I am confident in achieving our sales goals. Regarding gross margins, we've seen headwinds due to FX, M&A, logistical costs, and production volumes being lower than pre-COVID levels; our projections include various factors impacting margins.

I concur with the points made by Roland, particularly regarding the evolution of gross margins and how they are affected by numerous operational factors.

Our next question comes from Kit Lee from Jefferies.

Regarding Hip and Knee performance, can you clarify if the underperformance is primarily due to supply constraints or other factors? And about the trading profit margin, I believe you've mentioned 200 to 300 bps of seasonality between first half and second half. Does that remain applicable this year?

Yes, the performance variability can be attributed to multiple factors, including regional sales mix, significant performance trends within markets, and any supply chain constraints. Overall, we believe we are well-positioned for H2. Regarding margins, the factors impacting our trading margin indicate less seasonality than typically observed, primarily due to shifts in sales and marketing timing and investments.

Correctly, this year's trading margin guidance indicates less improvement than we traditionally experience, influenced by cost pressures, operational constraints, and timing of expenditures across various projects in our strategy.

Our next question comes from Veronika Dubajova from Goldman Sachs.

I'd like to clarify the nature of the supply constraints you're seeing, specifically in relation to product availability. Will the revenue lost due to these constraints be recoverable in Q3 and Q4? Also, could you explain the dynamics between Q3 and Q4, especially with the summer holidays? Lastly, regarding ASCs, can you provide insight into how that shift affects pricing and margins?

Regarding supply constraints, we're working hard to resolve them, though it will take time to see full recovery in product availability. The lost revenue may not be entirely recoverable, yet we are making significant efforts to rectify the situation. In terms of seasonal demand and recovery in July and August, we are experiencing diverse responses from customers, making it challenging to establish clear patterns. As for ASCs, we see a shift that enables incremental volume; however, it also brings different pricing dynamics reflecting changes in how procedures are reimbursed.

To confirm, we remain confident in our guidance despite ongoing issues, and we are transparent about our approach to manage them effectively.

That was our final question. So today's Q&A session has come to an end. I'll hand the call back over to Roland and Anne-Francoise for any closing remarks.

Thank you, operator. Thank you all for your interest in Smith & Nephew. Thanks for your questions. Wish you a great day ahead.