Smith & Nephew PLC Q2 FY2023 Earnings Call

Good morning. Welcome to the Smith & Nephew Second Quarter and First Half Results Call. I am Deepak Nath, and joining me is Chief Financial Officer, Anne-Francoise Nesmes. I am pleased to report another strong quarter of growth. In Orthopedics, we’ve improved our underlying dynamics and are set up to accelerate growth in the second half. The momentum in sports medicine and advanced wound management has continued. So these results have given us the confidence to increase our full year growth guidance. We saw the moderation we expected in the U.S. after a very strong Q1, but that was more than offset by improving execution globally and the increasing ability of our organization to take part in stronger markets. Margin development in the first half was in line with our expectations, and this should represent the peak of the macro-driven cost pressures. In the second half, we expect a clear step-up in both trading margin and cash generation, as we drive productivity gains and start to bring down days of inventory. And importantly, we’re continuing to build the foundations for sustainable performance by delivering a 12-point plan. Overall, I’m pleased with the progress of the plan. And as with any initiative of this depth and breadth, there are varying degrees of completion, but most elements are either on track or ahead, and we’re already seeing the benefits coming through. Product availability in Orthopedics was much better than it was on the back of our own operational improvements, although external supply interruptions and shortages continue to hold back overall group performance. Later on, I’ll share with you the updated KPIs on operations and how we’re positioned to convert those into better outcomes in the coming quarters. So our high cadence of innovation has continued right across the portfolio, and we’ve added new growth drivers in robotics and in extremities. We’re also pleased with our progress on a number of other initiatives, including order to cash excellence, pricing management and the pursuit of cross-unit business unit deals in ASCs. For now, I’ll hand over to Anne-Francoise to take you through the detail of the quarter.

Thank you, Deepak. Good morning, everyone. So I’ll start with the second quarter revenue, which was $1.4 billion, representing a 7.8% underlying growth and a 6.6% reported growth. Performance was broad-based, with all business units and all regions contributing. I’ll come to the detail in a moment, but you can see that Orthopedics accelerated compared to Q1, and Sports Medicine and Advanced Wound Management continued to perform well. Looking by region, established markets growth has remained above historical levels. Our U.S. business grew by 6.3% following a very strong first quarter. Other established markets maintained their performance and grew 8.5%, with elective procedure volumes remaining at a high level across Europe and Asia Pacific. Emerging markets grew 11%, largely driven by recovery in China, where surgical activity returned to more normal levels after COVID outbreaks earlier in the year. I’ll now go into the detail of each business unit. Orthopedics grew 5.8% underlying. Growth in knees and hips reflected us lapping the impact of VBP. As a reminder, the lower VBP pricing from the tender was gradually implemented during the second quarter of 2022. So while China still reduced growth by around 2 points in knees and 4 points in hips, that headwind will fall away for the rest of 2023. Other Reconstruction growth of 21% was driven by the ongoing adoption of robotics, and our installed base of capital is increasingly nicely across both hospitals and ASCs, passing 650 units in total with a growing funnel. Customers are showing their confidence in the platform by buying second and third CORIs in multi-system deals. The range of surgical applications is being recognized, with the majority of deals, including our hip software. Trauma and Extremities grew 2.5% on the line. This was the first quarter after lapping the trauma exit in China. Further growth uplift should come as we lap other markets exiting in the second half. Looking beyond those effects, we see our investments starting to pay off. U.S. Trauma grew 7% in the quarter with EVOS launch pace driving growth and demonstrating the value of a complete solution by increasing the use of small plates. In Extremities, we reached another innovation milestone with the 510(k) clearance and launched AETOS, our next-generation shoulder. Improving Orthopedics performance has been a key priority, and we are now seeing multiple trained Breakers lining up in quick succession. Deepak will cover shortly the progress we’ve made in improving implant availability and how we are resolving supply chain challenges faced during instrument deployments in the quarter. We have the highest pace of CORI sales activity we’ve seen. EVOS growth has accelerated already, and the AETOS shoulder makes us competitive for the first time in that large, high-growth category. So putting this all together, we’re excited about what’s to come for Orthopedics in the coming quarters. Now moving to Sports Medicine and ENT, which grew at 12% based on a multiyear stream of innovation across both capital and consumer, both playing an important role. Product availability remained somewhat constrained in the quarter with restricted capacity at some component suppliers. However, we were still able to drive an attractive level of growth. Looking by segment, joint repair grew 12.5% with broad-based strength across procedures and regions. REGENETEN, our shoulder repair products and our knee repair portfolio all grew at double-digit growth, with knee growth helped by the new ACL solutions that we launched earlier in the year. AET grew 4.6% in the quarter, with WEREWOLF Fastseal and mechanical resection being major contributors, offsetting a slower quarter in video. And of course, I know there is interest from many of you in any developments around the VBP in China. Our team remains in close contact with the Chinese government, and we expect a policy to be finalized later in the year. ENT growth of 38.9% reflects the continued post-COVID recovery in our core tonsil and adenoid business. We expect a return to a more normalized level of growth later in this year, as we lap more of the market recovery. So ENT continued to be an attractive growth area beyond this for us. Now moving to Advanced Wound Management, which grew 6.2% underlying. Within that, Advanced Wound Care grew 2.7%, mainly driven by our foam dressings and a strong quarter in Europe. Bioactives with 3.1% underlying, saw slower growth in Q1, mainly due to a normalized prior year. Skin substitutes remain the primary driver of bioactives. Our portfolio has been growing ahead of the market, and we believe the outstanding clinical evidence around graphics in particular positions us for continued strong performance. Finally, Advanced Wound Devices grew 21.4%, reflecting double-digit growth from both our traditional and single-use platforms, with similar drivers to recent quarters. In the traditional segment, we are driving account conversions to RENASYS with a good pipeline of other opportunities, and we are continuing to expand the single-use market with the increasing penetration of PICO. Accelerating growth in negative pressure is a key component of the 12-point plan, as you know. Now I’ll move to the financials for the first half. Revenue was $2.7 billion in the first half, up 7.3% on an underlying basis compared to H1 2022. Reported revenue was up 5.2%, including a foreign exchange headwind of 210 basis points from the strength of the dollar against major currencies. As you can see in this chart, growth was balanced across all businesses, with all three units contributing. Now moving to a summary P&L for the first half. Gross profit was $1.9 billion, resulting in a gross margin of 69.8%, which is a 110 basis point decrease from the prior year. Operating expenses grew faster than sales, driven by increased spending on sales and marketing, resulting in trading profit of $417 million with a margin of 15.3%. I’ll explain the drivers of the lower margin on the next slide. Slide 12 shows a more detailed trading margin bridge. There were three major headwinds compared to the first half of 2022, with the first two representing what we expect to be the peak of the macroeconomic pressures. They were around 400 basis points from raw material and staff cost inflation, and another 120 basis points from transactional FX. As you know, transactional FX arises from the strong dollar in a disproportionately dollar-based manufacturing cost base, delayed from our hedging program. The final headwind was around increased selling and marketing spend, part of refreshing our commercial approach for growth in orthopedic transport that came to 110 basis points. However, there were also significant positive offsets in the first half. We saw around 220 basis points of positive leverage from volume and pricing growth, around one-third of which was driven by the 12-point plan. There were also significant productivity gains with around 150 basis points from operations and procurement savings, and 100 basis points from other cost-saving initiatives, including restructuring. I’ll come to the outlook in a moment, but one thing you can see from this bridge is that the headwinds are here to stay for some time. The headwinds are either one-off in nature or should significantly ease over the next period. The increase in Orthopedics and Sports commercial spend is not intended as a repeating exercise. We currently expect transactional effects to be broadly neutral in 2024, and this first half should represent the peak of the pressure from input cost inflation. Looking further down from the P&L, adjusted earnings per share declined by 8% to $0.349, slightly more than trading profit mainly due to higher interest expense with our average net debt higher than in the first half of 2022. The interim dividend of $0.144 per share remains unchanged. Trading cash flow in the period was $110 million, with trading cash conversion of 26%, but lower than in 2022, due to a working capital outlay of $326 million. We reduced our receivables as a result of the order to cash initiative in the 12-point plan, but the biggest driver of the working capital increase in the first half was inventory. We added some stock to support acceleration in negative pressure wound therapy, a compelling opportunity that requires some upfront inventory, expected to gradually consume as the segment grows. Additionally, we had some accumulation of both products and instrument sets that are not yet deployed and are currently being held as inventory due to ongoing supply constraints for a small number of components, which hold back assembly and deployment. While some areas still face tight availability, general improvements mean we are now able to apply tighter controls on raw material buying, and we expect the level of raw materials inventory to come down in the future. Overall, we are committed to reducing DSI, and you should expect to see clear progress by the end of the year.

Thank you, Anne-Francois. I’ll start with a reminder of the transformation underway at Smith & Nephew. Firstly, we’re becoming a higher growth company, targeting consistent 5%-plus growth by 2025. That’s more than in the past, and we have a clear path to get there. We’re fixing the foundations of Orthopedics, ensuring the continuing strength of sports medicine and advanced wound management, which are already outperforming and converting the increased R&D investment into innovation-driven growth. Each of these elements is a step-up from where we were pre-COVID, building a more attractive growth profile than we’ve had in the past. We are also committed to driving profitability and returning our trading margin to at least 20% by 2025. We’re coming through a period of elevated macro pressures, and we’re rebuilding a margin through manufacturing and COGS optimization, productivity improvements, and growth leverage. The 12-point plan provides detail on how we do this. We’re now approaching the halfway point of the two years, and this overview shows where we are today based on the milestone completion for each underpinning initiative. Taken as a whole, the plan is showing good progress. The varying stages of maturity reflect the breadth of the program, including some initiatives that could move forward immediately and others that would require longer preparation, such as portfolio streamlining or manufacturing optimization. We are now well advanced with rewiring Orthopedics. We’ve refocused the commercial organization, simplified the management structure, introduced enhanced commercial processes, and rolled out a new growth-oriented incentive structure. Our renewed demand planning process is in place and starting to bear fruit, and our asset utilization is moving in the right direction, which set turns now around 30% higher than at the start of 2022. With better foundations in place and the delivery of key R&D projects in robotics and in extremities, we’re poised to start delivering on the second block of initiatives, winning better market share with our technology. I’ll drill into more detail of our progress in a moment, but on improving productivity, we’re quite advanced in our initiatives on value and cash processes. We’ve implemented better pricing across our portfolio, and we’re driving DSOs down while inventory days should follow in the back half of the year. What will still take time is the work around manufacturing optimization. We’ve identified opportunities in our network, and there’s a process to follow before we can move ahead. These initiatives represent an important part of the midterm margin improvement target. The initiatives to accelerate Sports and Advanced Wound Management are overseen by the same governance structures, driven with urgency. With both initiatives able to move quickly at the start of the plan, we’re starting to see progress in competitive conversions and negative pressure, as well as cross-business unit deals into ASCs, which have more than doubled just in 2023. Orthopedics is still our biggest lever for changing financial outcomes, and it is where we’ve had the most work to do, particularly around commercial delivery. The good news is that the fix in our Orthopedics foundations is underway. Our KPIs of product availability have continued to improve, and the value of overdue orders has continued to fall, halving since the peak in 2022 and reducing by another 25% since the beginning of the year. We’ve also shown data on LIFR or line-item fill rate. LIFR measures the percentage of customer orders filled, serving as an indicator of demand fulfillment. Our target is to bring our non-set LIFR to match best industry practice. Our KPIs continue their improvement path and have progressed to about 85% toward our goal from the trough level. The gap to our industry standard is now small. LIFR for key priority products is moving in the right direction. Particularly, EVOS SMALL has reached and maintained the target level, while JOURNEY II, our key product in reconstruction, is more than 80% of the way there. An important part of how we’ve made this improvement has been the new planning process we introduced a little over a year ago, better matching supply to demand at both the volume and mix level, enabling these improvements in order fulfillment. This has occurred alongside other measures, like improved logistics, with a 60% improvement in customer replenishment speed and significantly better scores for the health of kits already deployed in the field. Putting all of that together, we’ve reduced total production while continuing to improve product availability. This ultimately will enable reductions in inventory and manufacturing capacity. To convert implant availability into sales growth, we need to step up deployments of new instruments to customers. The sheer number of components in an instrument set makes this a complex process. It relies significantly on third-party providers, and just one missing component can halt deployment. This has occurred recently due to supply chain disruptions resulting in incomplete sets. Even so, we’ve made good progress in resolving these challenges. For example, in trauma, which was challenged in Q1, we had over a 3300% increase in EVOS sets deployed in Q2. We expect this pattern of increased set deployment to follow in hips and knees in the second half, supplemented by redeployment of around 10% of existing sets across our network. I referred to this last year around this time. A greater pull-through of available implants should follow from this. Innovation is another key component of our growth plans. You may recall that we expect more than half of our growth to come from products launched in the last five years. We stated that we expect to launch 25 new products in 2023, a clear increase from our average of around 18 over the previous three years. I’m pleased to report that we’ve delivered 13 in the first half of this year, which is a notable increase from our past and is well on track to meet our full-year expectations. This includes our AETOS shoulder system, which is essential for our growth plans in trauma and extremities. AETOS is designed with both patient and surgeon benefits in mind, aligning with market trends towards minimally invasive short-stem devices. Short stems are easier to implant and have improved bone preservation. Furthermore, it’s compact trade system for procedures allows for shared instruments between the short stem, existing long-stem shoulder, and future variants. We’re also advancing a stemless variant and bringing compatibility with CORI. Adding AETOS to our offering enables Smith & Nephew to be competitive in the shoulder market, one of the fastest-growing segments in Orthopedics with a $1.3 billion market growing around 9%. This new shoulder opportunity, along with the completed EVOS platform in plates and screws, positions trauma and extremities for a higher growth rate. We’ve added a further feature to CORI with a saw-based solution providing an adjustable cutting guide, fitting into the existing CORI total knee workflow without the need for additional incisions required by traditional pins. This adds versatility to CORI, appealing to a broader range of surgeons with varying preferences by offering both milling and sawing options. This is another step in our journey to enhance CORI’s functionalities at an accelerated rate. The delivery of this project highlights the speed of innovation previously driven by the 12-point plan and the agility of our teams in bringing these features to market. We received FDA clearance in June and expect the rollout to begin in the second half of the year. Finally, I want to mention a further development in our plans to strengthen the underlying foundations of the business and how we operate. With the early changes from the 12-point plan more settled, it’s now an appropriate time for us to move to a more focused operating model. We’ve begun realignment of our commercial model from franchises and regions to global commercial business units, with verticalized teams for Orthopedics, sports medicine, and wound management. ENT has already transitioned to this structure. This is a better way of operating, driving accountability, faster decision-making and execution, and increased customer focus across our portfolio. The previous regional marketing organizations will roll into these global business units, providing a single point of accountability for upstream and downstream marketing and sales, ensuring better alignment and resource allocation across regions and countries. Each business unit is led by dedicated presidents for Orthopedics, Sports Medicine, and Advanced Wound Management, with full global P&L responsibility. In this structure, industry veteran Brad Cannon focuses solely on leading the transformational changes required in Orthopedics. Scott Schaffner, already leading sports medicine, has joined the Executive Committee as Business Unit President. We remain committed to cross-business unit opportunities, driven through the governance of the 12-point plan structure. Earlier this year, Dr. Vasant Padmanabhan expanded his role to President of R&D and our ENT business, already operating in this model. Vasant's blend of clinical and technical expertise, business acumen, and experience in bringing novel therapies to market will strengthen our focus on ENT. Last month, Dr. Rohit Kashyap joined as President of Advanced Wound Management, following Simon Fraser’s decision to retire. Rohit, a seasoned leader with significant global multi-functional experience in wound care, is a vital addition to our team. I’m looking forward to seeing the impact from these changes and the caliber of talent we’re attracting to drive growth. We have the opportunity to hear from the presidents in due course, including at our Meet the Management event planned for November 29th of this year. In summary, I’m pleased with how the first half of 2023 has developed. We’ve delivered growth ahead of our plans across all three business units and have improved our fundamental positioning through continued operational fixes and innovation investment. There’s still work to do in some areas. We’re in the early stages of our productivity initiatives and stepping up profitability and cash flow generation in the second half. As we deliver that, we will exit this year with momentum that puts us solidly on course to meet our midterm commitments. Before I finish, I’d like to say a few words about Anne-Francoise and her decision to step down as CFO next year. I am saddened to see her leave as a colleague. I understand her reasons for feeling that now is the right time to reflect on her next career steps as we make progress with Smith & Nephew’s transformation. It’s hard to encapsulate Anne-Francoise’s impact during her time as CFO. She was instrumental in navigating the financial challenges during the pandemic and laying the foundation for the 12-point plan. She has also championed our culture and purpose and has been a strong leader. I am grateful for her support and counsel during my time at the company, and I appreciate that she has given us ample time for a successful transition. Now, I’ll take your questions or we can take your questions.

Hi there. Thanks for taking the questions. Jack Reynolds-Clark from RBC. So just starting with the revenue upgrade. Obviously, it implies a change in your assumptions around kind of growth through H2. Just wondering how much of that is coming from kind of your changes in assumptions around market growth versus execution? Second question on pricing, I think you mentioned 2.2 percentage points of kind of leverage coming through on volumes and pricing. Wondering kind of how much of that is pricing—how much of that is the result of your own pricing initiatives versus the generally more favorable pricing environment? Then on CORI, obviously helpful detail in your release around the CORI replacement. I’m just wondering what your utilization level of CORI is at the moment? I think last time you disclosed it was around 20%.

Yes. So let me talk about the revenue picture. Our step-up in the second half reflects seasonality. But the confidence comes from the fact that our revenue growth has come across all of our business units. It’s Orthopedic, it was sports, so there’s room, and we expect that to continue. The primary driver for us in increasing our guidance is our own commercial execution. There is, of course, market tailwind, primarily an Orthopedics factor, and we expect to better capitalize on that. As you recall, we have not always taken advantage of that market tailwind in years past. So we expect enhanced commercial execution underpins our confidence in the step-up in growth in the second half of the year. Pricing is a component of that. We’ve been—this is one of the elements of the 12-point plan. Actually, Anne-Francoise has been personally leading that initiative. So, it’s about our reaction to inflation and our ability to pass some of that price onto our customers. However, the more fundamental work we’re doing focuses on greater price discipline across our portfolio, and that work should persist beyond the current inflationary period.

Sorry to interrupt because you referred to the 220 basis points. We have seen—regarding the second half, we have seen positive price momentum in the first half, and we’re maintaining strong discipline. We are not disclosing the split, but you can assume that there is a product pricing built in that compared to the historic price deflation we used to see. So we’re now in positive territory for price and managing it very effectively.

I give our teams a lot of credit for the discipline driving around that. And coming to your third question regarding CORI, we’re pleased with the utilization. So, we’re interested not just in the placement of CORI; the numbers of CORI are less important. What’s more important is how that CORI placement drives our Orthopedics business. That utilization I mentioned of 20% has further improved. It’s a key metric we track. We don’t report it every quarter, but as I’ve said in previous discussions, it’s a means to an end; the number of CORI placements is of secondary importance to me.

Hi. Hassan Al-Wakeel from Barclays. I have three questions, please. Firstly, again on the management change, Deepak. We’ve clearly seen a lot of management change at Smith & Nephew over the years. I wonder if you can elaborate on why this is happening now, especially early on in your turnaround? And related to this, Deepak, do you remain confident in the medium-term margin highlighted, given the significant ramp required beyond this year of in excess of 250 basis points over two years? Secondly, the strength in knees looks to be driven outside the U.S., with U.S. growth of 2.8% below some of the peers who have reported. What do you attribute this to, and how do you consider the cementless knee ramp in the U.S.? Finally, I would love some commentary around how you see the U.S. environment and backlog—has the increased utilization peaked? When do you expect a more normalized level of growth?

Hassan, the first question on management changes. On one hand, I talked about building strong foundations and moving from a franchise to a business unit structure. Greater accountability and improving decision-making speed, removing inefficiencies, and simplifying operations are key to this transition. While some changes were associated with the move, others were independent. In wound, for example, Simon Fraser's retirement was a personal decision. The appointment of Rohit Kashyap resulted from this. I had previously discussed Brad Cannon's focus on Orthopedics due to the significant changes needed in that area. Taken together, I believe we are better positioned as a company moving forward. Do I have confidence in the midterm guidance? Absolutely. We’ve maintained our guidance of at least 17.5% for the year. We’ve provided insights into the components of that from H1 into H2. I am fully confident in our ability to deliver that. The guidance we provided for the midterm does not assume exceptional tailwinds but is built on more or less normalized macro factors or procedure environments. However, we do see a tailwind. We saw that in Q1 and are continuing to see it, although to a lower level than in Q1. It’s difficult to assess how long these will persist, but we are working through the performance improvement program, and it can be challenging to parse our share recovery from market dynamics.

On the management change, can you provide clarity on why it's happening now and what's been the impact on your organization moving forward? It seems to be a critical point in your turnaround strategy.

In terms of the specific changes, it allows for an emphasis on accountability, speed of decision-making, and addressing the necessary changes in our structure to evolve. We have a stronger operations team drawn from the industry, which is key to our transformation. In terms of overall strategy, these changes are crucial for our growth ambitions, and I believe our positioning as a company will improve significantly.

Hi. Yes. David Adlington from JPMorgan. I have three questions. Firstly, on the supply constraints, could you provide more details about what they are, how significant a headwind they've been, and when you expect to resolve them? Secondly, regarding free cash flow guidance for the full year, do you expect to be in positive territory? Lastly, concerning the Chinese VBP, are you expecting any destocking, and is that factored into guidance?

I’ll address the supply constraints first. Currently, we primarily rely on third-party suppliers for specific components in our sports products. We've experienced challenges with certain components, not every category but specific suppliers facing labor or raw material issues. There are about six or seven components currently impacting our production pace, down from a longer list in the past. It’s those components slowing our delivery, especially for orthopedics, where our ability to plan and fulfill orders optimally has been a challenge.

In terms of free cash flow, we expect to see improvements as we address inventory issues that have impacted our cash flow significantly in the first half. We may not align with historical free cash flow levels this year, but we anticipate nearing those levels as we reduce inventory. Regarding Chinese VBP, we're in close contact with the government and have plans ready to address any destocking we anticipate once policies are finalized.

Yes. Thank you for taking my question. My first one relates to your EBIT bridge into the second half. The second-half weighting of EBIT seems historically high. Could you clarify this further? I also noticed the FX guidance regarding 120 basis points. How does that fit into your 1H and 2H margin bridge? Finally, I’d be curious to hear about divisional margins compared to two years ago. Where are you seeing higher or lower margins by division?

In terms of the weighting of EBIT in the second half, it’s fair to say that this year reflects an above-historical percentage, which is driven by returning to our seasonal uplift while factoring in productivity improvements and cost savings. The FX impact is absorbed mostly in the cost of goods—our U.S. cost base is largely dollar-based. Therefore, when we provide guidance at 17.5%, it’s after accounting for a 120 basis point erosion from FX, recognizing the steps we're taking to improve margins as we move forward. From a divisional standpoint, we are witnessing good improvement in Orthopedics driving our midterm margin guidance. Sports is also showing progress. A slight dilution in our wound segment results from investments behind negative pressure. Overall, each division is tracking positively, and I can confirm our expectations for growth and profitability moving forward.

In terms of R&D investment, we've maintained a consistent level of funding, and this has not diluted margins. The prior years of investment have positioned us well to advance our innovation strategically. I remain optimistic about the alignment of our innovation efforts with our growth initiatives.

Hi. Good morning. Deepak, Anne-Francoise, thanks. I actually still have another three questions. The first is just on the dressing business in wound care. Now, could you discuss that? It looks like at least from our perspective that you are losing share there. Could you maybe discuss how happy you are with the performance there? The second question would be on AETOS, on CORI. I think you mentioned that in your prepared remarks; could you specify the timing when you expect that to become available? The third question is on cost inflation. Given where we stand right now, how should we expect that to go into ‘24? Is it easing substantially now in the second half?

In terms of the dressings in the wound area, you're right, share dynamics can fluctuate. However, I’m pleased with how our portfolio is performing overall. The breadth and richness of our portfolio have strong growth drivers with Advanced Wound Care leading performance. We see substantial growth in skin substitutes driven by our strong clinical data, which should continue to contribute positively moving forward. Negative pressure wound therapy offers additional momentum. Regarding AETOS and its availability alongside the CORI system, we are effectively sequencing our programs. While I wish we could bring AETOS to market immediately, comprehensive planning is necessary. We're pleased that CORI has the form factor suitable for the shoulder market and we are pushing to release it as soon as we can. Stay tuned for detailed updates in our upcoming events.

As for cost inflation, we anticipate that pressure will ease into 2024, which has been factored into our guidance. We expect cost inflation will stabilize around normalized levels as we address our inventory and production processes effectively. This will help us maintain our profit margins and operational performance moving forward.