Smith & Nephew PLC Q3 FY2023 Earnings Call

Good morning and welcome to the Smith & Nephew Third Quarter Trading Report Call. As mentioned, I'm Deepak Nath, and I am the Chief Executive Officer, and joining me is Chief Financial Officer, Anne-Francoise Nesmes. So before I begin today's presentation, I just want to draw your attention to our announcement today that John Rogers will succeed Anne-Francoise as Chief Financial Officer in the first quarter of next year after the publication of our annual report and accounts. John is an experienced FTSE-100 CFO, having held the post at WPP and Sainsbury's, and I have no doubt his financial acumen and expertise in leading transformation programs will be tremendous assets to us. As I've said before, I'm very grateful to Anne-Francoise for the time she has given us to ensure an orderly handover and her continued support as we close out 2023 and complete this new transition. So now let me turn to our Q3 results. I'm pleased to report another good quarter, which maintains our momentum from the first half. Orthopedics growth has stepped up as expected with one of the highest growth quarters for many years. Importantly, the strong underlying performance in Sports Medicine and Advanced Wound Management has also continued. There are ups and downs across the portfolio as you'd expect, but the overall picture is of strong innovation-driven growth backed by improving execution. We're also advancing the 12-point plan with encouraging signs of delivery on outcomes. Our operational improvements under the plan are continuing to drive key metrics toward their targets, particularly around product availability. In Orthopedics, you can see that translating to better revenue growth for more lines of the business. Our productivity measures are also progressing. We've made cost savings as planned for 2023, and for the longer term, we announced the closure of two of our smaller factories within our network. With nine months done, we're refining our guidance for the full year. We now expect revenue growth to be towards the higher end of our 6% to 7% guidance range, reflecting our good momentum and improving execution. And on profitability, we're seeing the expected step-up in the second half with the seasonal uplift and cost improvements coming through. There is some additional headwind in China, and we're reflecting that with trading margin guidance now of around 17.5%. I'll come back to our outlook shortly, but first we'll take a look at the detail of the quarter. Third quarter revenue was $1.4 billion, representing 7.7% underlying growth with all business units and regions contributing. Anne-Francoise will cover the performance of the business units in more depth in a moment, but you can see that Orthopedics has continued to accelerate as the year has progressed, with a slower quarter in Advanced Wound Management. Looking by region, growth was broad-based with 7.2% growth in the US, 7.8% in other established markets, and 9.2% in emerging markets. Within emerging markets, China sales were down 1.4% with improvements in knees and hips performance, but a slowdown in Sports Medicine with some significant moving parts. To cover that and the rest of the business unit detail, I'll now hand over to Anne-Francoise.

Thank you, Deepak. So I'll start with Orthopedics, which grew 8.3% underlying. This follows a 3.9% growth in quarter one and 5.8% growth in quarter two. So even with more difficult comps, we've continued the positive momentum we've seen in the early part of the year. Knees and hips growth included a better quarter in China, as Deepak just mentioned. The effects of VBP are now fully lapped, and China is back to being accretive to overall recon growth. When we look at our established market recon business, there are green shoots. Some regions are further along than others, but our commercial improvements are taking shape. US product availability is improving, and we are gradually stepping up set deployments across small categories, and I'll come back to that in a minute. Other reconstruction growth of 58.5% was driven by the ongoing adoption of robotics. We exited the quarter with over 25% of our knee procedures being placed with a robot and with contract wins across the sites of care, including large academic medical centers and ASCs. We're also seeing good progress with our increased range of indications. Using revisions is already approaching the overall new utilization, and we saw the first cases completed with our new store solutions offering in the third quarter. Trauma and extremities have become an important part of the orthopedics growth story, and it was the biggest sales contributor than hips in the quarter for the first time despite us exiting some markets last year, as you may recall. Underlying growth was 10.4%, with the acceleration coming particularly from EVOS and from strong double-digit growth in the US. Trauma is demonstrating what we're aiming for across orthopedics. We invested over many years to build out our plates and screws platform, starting with the EVOS MINI plates, then adding small and completing our offering with the launch of EVOS Large in 2022. Our operational improvements on the 12-point plan established better supply and replenishment of imports. And in the last two quarters, we've also stepped up the deployment of sets. Putting all of that together with better commercial execution is translating into sustainable higher growth. The next leg of growth is also ready to follow as we broaden the rollout of our EVOS Shoulder System. The delivery of the 12.9 milestones is continuing to progress, and one area where that's particularly done is in our product availability across the portfolio. There are still differences between categories, both on the supply KPIs and on the financials. And clearly, US orthopedics is an area where there's still more to do. So on slide seven, you can see some of the detail. Firstly, if you look at the chart to the left, implant availability is moving in the right direction. Overall, orthopedics non-set LIFR remains on an improving path ahead of our projected plans, and the value of overdue orders is continuing to fall. There is some variation within that, of course, and that's a factor in some of the differences you can see across segment. Availability of JOURNEY II with OXINIUM has been lower than the average, and the greater US penetration of this construct makes it particularly relevant to the US knee growth. The good news is that JOURNEY LIFR was stepping up as we exited the quarter and should also be on an improving path from here. A second factor to be aware of is the importance of set deployments. And again, the categories of US orthopedics are at different stages of progress towards our goal. Trauma is an early example of what success looks like. EVOS product availability has been at or above target for almost all of 2023, but set deployment only stepped up strongly in Q2, and we've seen a clear inflation in revenue growth in Q3. Hips and knees are still following. In US hips, instrument deployments have started to step up through Q3 and are getting closer to the target fulfillment level. Continuing this and maintaining the implant availability should also be followed by better growth in the coming quarters. Knees are earlier in the process and further from their target, but we've started to see positive momentum later in Q3. Together with improving JOURNEY II and OXINIUM supply, we're on the same path that we've seen playing out in orthopedics. Moving to Sports Medicine Madison and ENT, which were 11.1%. A multiyear stream of internal and external innovation was again central to our growth, and that was further helped in the quarter by better product availability. There are still some areas that are constrained, but we're seeing steady improvements in fill rates and overdue order levels that can keep supporting our growth in the coming quarters. Sports Medicine remains a very attractive area of our portfolio, and we're continuing to invest in further opportunities. Within Sports Medicine, Joint Repair grew 11.3%, with broad-based strength across procedures in established markets. REGENETEN again grew strong double digits, and we are still adding new legs of growth six years after acquiring the product through rotation medical. Geographic expansion has continued with launches in Japan and India, and work on further REGENETEN applications beyond the shoulder is ongoing. AET grew 1.7% in the quarter with WEREWOLF Fastseal 4K and our double flow freed management system. As I mentioned, the headwind in the quarter was a slowing market in China on both consumables and capital. Without China, growth would have been three percentage points higher in joint repair and four percentage points higher in AET. There was slower buying in joint repair as wholesalers reduced inventory in anticipation of the VBP process. There were also market-wide delays in purchasing around the widely reported ongoing anticorruption campaign. We expect China to remain a headwind in Q4, and of course, we know this interest in VBP. So I wanted to give you an update on the current state of development. The policy has still yet to be fully published, so many of the details are not yet known. For example, we still have to hear the full tender rules or details of the entry prices. Timing has also not been confirmed, but our current assumption is for a process before year-end with the outcomes of the tender to be implemented in the second quarter of 2024. On the scope of the VBP, our understanding is still that the tender will be limited to joint repair only. However, with more information, the scope looks to be wider than it appeared from the initial data request we talked about before, and we now expect it to cover around 1.5% to 2% of group sales. Now moving to the ENT. ENT growth worth of 40.2% was driven by our core tonsil and adenoid business. As we expected, demand growth has started to moderate as we lap more of the post-COVID recovery, but improving product availability meant that the quarter also benefited from clearing a significant volume of back orders. The process is almost complete, so we will expect to return to a more normalized level of growth as we exit 2023. And finally, Advanced Wound Management grew 3.6% underlying. Within that, Advanced Wound Care and Advanced Wound Devices continued with the trends we've seen in recent quarters. AWC growth of 3.2% was mainly driven by Europe and came across the categories of dressings. 21.3% growth in Advanced Wound Devices reflected continued double-digit growth on both our traditional negative pressure platform, RENASYS, and our single-use device PICO, and we're continuing to both gain share and expand the market. The slower quarter for the business unit as a whole was driven by bioactives, which was down 4.8% in the third quarter. The decline reflects a strong comparator from the third quarter of 2022 and also delays to SANTYL shipments in the early part of the quarter as we fully completed the transition of production to our Fort Worth facility. Our shipments are now back to normal with bioactives exiting September strongly, and the segment should return to more typical growth against a more normal comparator in Q4. And with that, I'll hand back to Deepak.

Thank you, Anne-Francoise. On revenue, 7.5% underlying growth in the first nine months positions us well to meet our full year target. There are a few moving parts to keep in mind for the remainder of the year. On the positive side, we should see higher growth again in Advanced Wound Management, mainly due to improvement in bioactives, and we should continue a positive momentum in orthopedics. As headwinds, we expect slower Q4 in Sports Medicine with low to mid-single-digit growth. This is due to the combination of the pre-VBP effects and the broader market slowdown in China, as well as a strong comp from Q4 of 2022 in the rest of the world. Also, as Anne-Francoise just mentioned, ENT growth should normalize after Q3. Putting all of that together, the portfolio as a whole is well positioned, and we expect full year growth to be towards the higher end of our 6% to 7% guidance range. On profitability, the dynamics so far in the second half have been as we described with our H1 results, which is encouraging. The drivers for the expected H2 margin step-up are all coming through. These being the usual seasonal uplift, the unwind of one-time commercial costs from H1, and our planned cost reductions. There's still more to do. But as you may be aware, the fourth quarter is typically our highest sales quarter and therefore, our highest margin quarter of the year. The progress we've made already in Q3 means that the remaining uplift to hit our full year targets is well within the historical range. The change is the headwind from China that we've highlighted. As you know, our guidance included some pre-VBP impact. There are now other moving parts in China as well. And while we are working to offset these, there's only so much that can be done in the remaining quarter of the year. Reflecting that, our expectation for trading margin is now around 17.5%. Overall, I'm pleased with another strong quarter, progressing the fixed orthopedics, and continuing to invest in and drive sports medicine and mood. The portfolio is moving in the right direction. Our 2023 financials are trending as expected, and the 12-point plan is advancing. It's a wide-ranging program where we're on track for most areas and with green shoots in the areas there's still more to do. We've talked a lot so far about fixing our operations, but there's much more to Smith & Nephew than that. The returns from our multiyear innovation investments are an important growth driver, too. We'll talk more about that aspect at our Meet the Management event on November 29, and I encourage you all to join us in London. With that, we can move to your questions.

Thank you. Our first question today comes from Robert Davies with Morgan Stanley. Your line is open.

Yes, thank you for taking my questions. My question is, I guess, on the progress you're making from a growth perspective on the orthopedic side. Obviously, a large part of that was driven by the other Recon segment. But just maybe walk us through the underlying trends you're seeing in both hip and knee and any significant sort of regional variations you've got there? And then my second one, your commentary around the margin outlook for the full year of around 17.5%. I guess there's some debate about whether that's doable with the investor community. But looking forward through 2024 and beyond, are you still comfortable with the 20% margin target and even with the sort of new moving parts that you've highlighted today? Thank you.

Hey, Robert. So first off, in orthopedics, we're pleased with the overall growth, as I mentioned, the other recon, which reflects the uptake of CORI, not only in terms of placements but actually also utilization. We're now up to 25% of our US business flowing through robotics, which is encouraging. But in addition, as Anne-Francoise mentioned, it's not just CORI, but it's actually trauma as well that's contributing to growth. On top, you've got hips stabilizing and knees continuing to grow, where the soft spot remains the US. So in terms of regional variations, the market continued to be strong in Q3, not as robust as Q1 or Q2, but continues to be strong. The fact is on the back of the operational improvements we're making, we were able to participate in the market upside, which was not always the case, as you'll recall, Robert. If I look outside the United States, our commercial execution on top of product availability, which is coming from operational improvements, has enabled us to really participate in that growth. In the US, we're continuing to do that. Hips are better than knees. The reason knees are behind primarily has to do with continuing supply challenges, particularly on OXINIUM. So when you look at the product mix in the US, the particular constructs and particular SKUs in the US were impacted, and that also had an impact both in replenishment and sub delivery. The good news is that as we exited September, we saw a significant improvement in OXINIUM supply that contributed to sets starting to flow again in the US. So I expect the momentum we built up in September to continue into Q4. So hopefully, that gives you a bit of color on the drivers of growth and the regional variation. So in terms of margin around 17.5%, obviously, we've indicated that we expect a step up in 2024 and in 2025. We expect more of it in 2025 than we do in 2024, but it's not going to be a hockey stick; it won't be linear. We don't expect a hockey stick from 2024 to 2025. So I continue to feel good about where we're positioned relative to our midterm guidance. As you mentioned, there are more moving pieces. There are more headwinds than at the time that we issued the guidance, the primary headwind being China, particularly on the sports VBP. But on top of that, there's been some effects from the anticorruption campaign that's rolled out in China, and we saw the impact of that in Q2. So that remains an uncertainty. But even with that factored in, I feel at least at this point good about our ability to hit our midterm guidance.

Thank you. Maybe just one follow-up around the advanced wound bioactive. Could you just give us a little bit more color on where the softness in that particular business came from in the quarter?

Yeah. So first off, there was a comp topic, Q3 2022 versus this. Secondly, we made the decision several years ago to transfer production in-house. We had previously been manufacturing Coral. In Q3, we completed the transfer into our Fort Worth facility. That was done for resilience reasons. It was done as part of our cost reduction or productivity program. As we transferred that production, we hit a couple of bumps within the quarter that we were able to resolve and get back on track actually as we hit September. So we're in a good place as we exited Q3, and we expect that to continue into Q4. So we get into more normalized comps in Q4 and with our factory now humming in Fort Worth, we expect that to normalize.

Our next question comes from Veronika Dubajova with Citi. Your line is open.

Hi, guys. Good morning, and thank you for taking my questions. I will keep it to two as well. The first one is just, I know you're not going to give us 2024 guidance, but just curious about some of the moving parts that you see as you move into next year. Maybe if you could comment, one on how you feel about the market. And obviously, I think J&J made some pretty strong comments recently about how they expect sort of elevated utilization on volume growth to continue? And also, do you think 2024 is the year when we start to see some improved momentum in knees and hips on a full-year basis? And maybe for Anne-Francoise on that as well, just in terms of the P&L moving parts, I'm thinking FX and inflation, if you have any high-level thoughts at this point in time to help us as we think about 2024, that would be super helpful. And then my second question is just maybe a follow-up to comments that Deepak already made, but just for avoidance of doubt. Obviously, now that you have more clarity on VBP, do you still feel confident in your ability to achieve the 20% midterm target and what are some of the offsets that you see against that sort of increased scope of the VBP process?

Thanks for the questions, Veronika. So just on the guidance and some of the moving pieces, right? We do expect positive impacts as we go into 2024 from revenue leverage. We started to see that come through in Q3, and we're going to build on that in Q4, and we expect that to continue in 2024. Pricing, there's, of course, the inflation offset, but some of the more strategic work we're doing at pricing we'll expect to start to pay dividends as we go into 2024. Ongoing productivity gains under the 12-point plan will be a factor as we head into 2024. Then I mentioned, of course, the VBP and Sports Medicine that will act as a headwind, as Anne-Francoise talked about. Previously, we had guided to around 1% to 1.5% of group sales being impacted by VBP based on the expanded scope that we see. We think it will be more like 1.5% to 2%. So that will have an impact that offsets some of the factors that I mentioned. In terms of transactional FX, it had been a headwind in 2023, but we don't expect that in 2024. We also don't expect the same scale of headwind in terms of input cost inflation in 2024. The bridge that we provided at H1 gives some good indication as to the major factors that we see influencing a margin step-up as we go into next year and beyond, including materials and staff cost inflation offset or unwind rather, COGS, manufacturing optimization, and the cost reduction programs having a full-year effect in 2024 in terms of what we started in 2023. And of course, as I said, the growth leverage. So as I indicated, I feel good about leaving our guidance for 2025 unchanged. In terms of the shape of the trajectory from 2023 levels, as I said, we don't expect it to be linear and more of it will come in 2025 than we do in 2024, but we also don't expect it to be a hockey stick. Hopefully, that gives you a bit of color. I think I made the comment around FX already. So hopefully, that addresses your first question. Your second question around VBP, I think I incorporated that into my response. In terms of the factors that we believe will offset the more expanded scope, it really comes down to the factors I enumerated earlier. It's growth leverage from other parts of the portfolio, cost reductions, probably the full-year effect, our productivity initiatives, the unwind in terms of input cost inflation. So those are some of the factors. Also, to keep in mind that in China, not all aspects of Sports Medicine are covered by REGENETEN. We expect to launch in China, which we expect to be a growth driver. Of course, the AET part is included in the VBP guidance. So we expect that to be a growth driver as well. So hopefully, those pieces all make sense, Veronika.

No, that's very clear, Deepak. Maybe just quickly, if I can squeeze a quick follow-up. I think you alluded to this in the press release that you're starting to make progress on some of the manufacturing footprint optimization.

Yeah.

When can we expect to hear more from you on how this is underpinning the 2025 margin target? And anything you can share at a high level about how that's going at this stage?

Sure. I mean, you should expect more at our full-year results, Veronika. But as I shared, our network optimization efforts continue. We've announced that we're going to be closing two of our smaller factories within our network that represent about a 20% reduction in footprint in manufacturing. We've also reduced headcount as part of this process as well. We'll give you an update specifically on the numbers in full-year. So the combination of those factors we expect will contribute towards our gross margin improvement efforts.

Just to add to this, Veronika, I think two elements, one is the efforts of the network optimization will be more visible in orthopedics. I mean, there are actions across the whole network in terms of continuous improvement. But clearly, orthopedics will benefit the most. As you look at the segmental analysis, you'll see the margin improve. One of the driver will, of course, be revenue leverage for the other is also the action around the network and the manufacturing costs. I think the second as well, it's important to understand, it doesn't flow immediately through the P&L. As you know, there's a phasing impact of cost of goods inflation, etc. Deepak talked about the shape of the guidance part of that. The savings from manufacturing take longer to flow through as you build into your inventory and the savings on you flow through as you release the inventory that will be produced at a lower cost, so that will take some time.

Great. Well, I look forward to hearing more about that in a bit. Thanks guys.

Sure thing.

We now turn to Lisa Clive with Bernstein. Your line is open.

Hi, there. First question on CORI. Can you just comment on what the current commercial strategy is for CORI and where some of your bigger competitors are placing robots for free? So what proportion of your CORI installations are sold, leased, placed, etc., and how should we think about that evolution going forward? And then second, just on utilization of CORI increasing, can you just comment on why the total US knee business was down this quarter? And how we should think about the timelines of that recovering? That would be helpful to hear a little bit more on that.

Sure thing. With CORI, our interest is not just placements, but it's placements plus utilization. So that's what we're looking for, which is why I reported on the utilization number. The mix of business models in terms of cash sales and rentals and lease models do vary across geography and actually within geographies as well, and that does vary from quarter to quarter. I'd say we're competitive and do our best to address the needs of customers, and some customers prefer cash sales, others in these models and are responsive to the needs of our customers. In the end, the strategy we're running though is not to place robots indiscriminately, but rather to place them where we expect to see utilization. That combination is important for us. We're also looking at where we place them and we're encouraged by the uptake we've gotten not only in academic medical centers, where historically we've had a weaker presence, and we're starting to see and gain traction in that, but also in the ASCs, which I know is a growing segment, and CORI is very well positioned within that segment as well, and we're pleased with the uptake we're seeing there. In terms of the US knee business, the primary factor in Q3 really was around some product supply challenges. Although LIFR overall has improved in orthopedics, the product availability overall has improved in orthopedics. The particular SKUs in the US, our US business tends to be heavy on the JOURNEY OXINIUM. Some of those SKUs continue to experience challenges in Q3, and that impacted not only replenishment of implants but also our ability to place complete sets that can be utilized in procedures. As I mentioned, when we look within the quarter, September was where we saw significant recovery of that and we continued that improvement into the first month of this quarter as well. So we're pleased with the movement there, and we expect now in Q4 to recover in the US. So hopefully, that addresses both of your questions.

Great. And just one last follow-up, just on cementless knees, what proportion of that 25% done with CORI or done with cementless? Just trying to understand whether there's a mix improvement opportunity if cementless is still not used very widely. Thanks.

Yeah. We don't break out cementless versus other. What we're really looking at is constructs. Cementless is not what's driving CORI. For us, it's about selling the portfolio we've got. We're very pleased with how our portfolio is positioned relative to our competitors. We're actually really looking at constructs, not just a single product line.

Our next question comes from Jack Reynolds-Clark with RBC. Your line is open.

Hi, there. Thank you for taking the questions. Two for me, please. The first is on pricing. I think you touched on it earlier, but I was wondering if you could give a bit of color around kind of the contribution of pricing to your growth in the quarter. I guess that has two parts to it. Obviously, the first is the kind of development of price erosion or lack thereof through the quarter, then also kind of the initiatives that you're implementing as part of the 12-point plan. And then the second question just was on CORI replacement. Obviously, appreciating that your focus is on kind of penetration and utilization, which obviously seems to be trending quite nicely. But I was wondering if you could give some color on kind of where you are on that 300 placement target for the year and then also how that's split between kind of ASCs and hospitals.

So Jack, in terms of pricing, it's an important element of the 12-point plan. It's part of one of the initiatives, as you mentioned yourself. It's also important to try to offset some of the inflationary pressure we're all seeing. We've continued to make good progress in updating and standardizing our pricing controls across the portfolio. So we have continued to see positive pricing like we did at the end of last year, and that's continued into a low single-digit positive through the third quarter. So we're pretty pleased with the progress we're making here. It's a great collaboration between all the teams here from commercial to selling organization to finance. Now looking further out, there is more strategic work to do on pricing. When we launch new products, how we are pricing it, etc., but we do not depend on pricing as a standalone mechanism for guidance.

On CORI, I will update you in terms of numbers of placements at full year. We're making progress towards the goal that you mentioned, Jack. In terms of ASC, we've got better than overall share in ASCs. In other words, we're pleased with the kind of traction we're getting at the ASC, which is a big growth driver. We'll come back to you with specific numbers, but we just don't want to get into quarterly updates on numbers for CORI.

Yeah. No, understood completely. And then if I just squeeze in another one around AETOS. Just wondering what your thoughts were if you had any kind of further developments around introducing that on CORI, I guess following the launch.

Yeah. So as you know, shoulders is a growth market within orthopedics. Our entry into that is an important segment with AETOS. We're pleased with the initial results primarily so far. The activity has been around design surgeons that we've also taken it beyond that initial group. Overall, good traction that we've gotten. As I indicated, I think on the H1 call, maybe it was a Q1 call, I forget now, but we see the potential of CORI in shoulder. The form factor of CORI is very well-suited for the shoulder application. It is in our pipeline and we look forward to updating you on that at the right time. But I'll leave it as very excited about the potential for CORI in shoulder.

We now turn to David Adlington with JPMorgan. Your line is open.

Hey, guys. Thanks for the questions. Firstly, again, back on CORI. I just wondered if you could give us some comments on what you're doing differently to drive that big step up in growth and how sustainable you thought that was. And then secondly, just on the GLP-1 impact maybe I'm going to touch on it. So maybe not so much on ortho, but I just wanted to get your thoughts in terms of wound care given the importance of diabetic and venous leg ulcers for that business? Thank you.

Sure, David. In terms of CORI, CORI is not something we're driving in isolation. At the end of the day, what matters to us is selling the portfolio that we have. We're very excited about the differentiation that we have within orthopedics, but certainly within the knee. The focus is on selling the portfolio, CORI, together with JOURNEY and LEGION. That's the combination. So we're executing with that in mind, taking into account our differentiation and where we think we can win. Our results should be viewed in the context of the broader commercial execution improvements that we're making on the back of investments in innovation. So in terms of constructs, JOURNEY II is obviously exciting in terms of the true next-gen knee construct that we have. We have some great differentiators of our own. CORI's the only robotics platform to have a revision indication; it also has the knee tensioner that we released recently on CORI, enabling surgeons to do soft tissue balancing before making cuts. CORI is the only platform that doesn't require imaging. Now with added functionality on CORI, the ability to do cutting saw-based solutions on top of milling. All of these things combined for us create an attractive value proposition for our customers in selling the whole portfolio. Regarding GLP-1s and wound, just narrowing in on diabetic foot ulcers, they comprise about 20% of the wound market. Patients who have diabetes with diabetic foot ulcers can take 10 to 15 years for these ulcers to manifest. GLP-1s have been available for some time now already for this group, and these issues arise due to glycemic control, not obesity per se. Therefore, the data you're seeing on GLP-1 and obesity doesn't directly apply to diabetic foot ulcers. So we do not expect a significant impact on our wound business due to GLP-1s or some of the new data coming from GLP-1s.

We now turn to Graham Doyle with UBS. Your line is open.

Morning guys. Thank you for taking the questions. Just firstly, one on the short-term margin, maybe I'll ask a follow-up on 2025. From what you're saying, it sounds like you changed the guidance from at least 17.5% to around 17.5%. It kind of implies something like a 20 to 30 basis points lowering in that target, seemingly driven by China and some issues over a short period of months. So could you contextualize that because annualizing that would be worrying when we think about next year? So maybe just contextualize what's actually happened there? And then how much is attributable to it? I'll just follow up with the 2025 question after if that's okay.

I'll take the question on the margin. As we've mentioned, there are many moving parts. The dynamics we've seen so far in the second half have been as we described with our H1 results, driving productivity and operating leverage. What we're seeing now is the additional headwind from China to consider. When we gave the guidance, we did include some pre-VBP impact. But there are more moving parts at this point in time. While we're working to offset the impacts of China, there's only so much that can be done within one quarter of the year remaining, and that's why we adjusted to around 17.5%. Clearly, we are still seeing the seasonality and the seasonally higher margin, the unwind of one-time commercial costs, and the planned cost reductions coming through. We should not forget that our Q4 is always the highest sales quarter, as Deepak mentioned before. So clearly, we are working through, and it's just one quarter that we cannot offset.

And in particular, we didn't signal 20 or 30 basis points. We just said around 17.5% to be clear, Graham. As I mentioned, the VBP is something that we had anticipated. We called out kind of the 1.5% to 2% group sales. The added impact of the anticorruption campaign, we don't necessarily think will persist for an indefinite time frame. It's difficult to tell how long that will last. So VBP, of course, is more permanent, but the impact of the anticorruption campaign, we don't expect to be the case indefinitely. But we didn't signal 20 to 30 basis points just to be clear.

I appreciate that. I suppose I just mean that above 17.5% and around 17.5% are different. I'm kind of picking that point. Just on 2025, so I'm just thinking of the things that have changed from when you set that guidance at the start of the year. Obviously, VBP itself is new. It sounds to me based on the original guidance, the margin base for the end of this year is going to be lower versus where you were originally.

It indicated that when you put guidance out, there is you try to have some amount of contingencies built into account for things for moving pieces. As I indicated in Q1, but really at H1 when the question came out based on what we knew at that point in time around VBP, which is the only real big factor that's changed since we set out guidance. We believe that we could buffer through that and offset the expected headwinds from VBP. Even with the expanded scope that we see now, we expect to be able to offset that in the guidance and still achieve what we set out in the midterm. That's the fundamental kind of assertion that we're making. There are other positive factors as well. So as I mentioned, the 12-point plan, we continue to make progress on. In some areas, we are ahead. In other areas, we're just according to plan, but we are according to plan, but there are actually green shoots there as well. We're pleased with the traction we're getting with the 12-point plan. You've seen that translate into revenue growth. Q3 is further evidence of that. I believe we'll continue to drive growth, and that should translate into operating leverage. In terms of inflation, anyone's guess as to how resistant that's going to be. Anne-Francoise mentioned the fact that there is latency, so there's about a year gap between when you see inflation start to recede from a macroeconomic perspective and how that enters into our P&L. So that's another delta. We've assumed a certain level of persistent inflation actually into 2024 in terms of how our guidance is built. As I said, so far in 2023, you could probably surmise from our comments that inflation isn't worse than we modeled in terms of P&L impact. Those are some of the moving pieces that hopefully give you a bit of color.

That's really helpful. Yeah. Probably fact isn't a word to use right now with GLP-1s with that. Thank you very much.

Our next question comes from Hassan Al-Wakeel with Barclays. Your line is open.

Hi, good morning. Thank you for taking my questions. I have a couple, please. Firstly, on VBP. You mentioned the scope is wider now, impacting 1.5% to 2% of sales versus 1% to 1.5% previously. Can you explain what is incremental here? Can you also talk about the extent to which you are seeing destocking in the channel; maybe help us by telling us what China joint repair was down by in the quarter? And then secondly, on growth, how do you think about the current procedural landscape in the U.S. and when this pent-up demand in the market may receive? Do you think that current market expectations for 5% organic growth at 120 basis points of margin expansion next year are achievable? I guess, particularly on margin given the extra headwinds that you are talking about incrementally today. Thank you.

In terms of VBP, just to ground us and reiterate what Anne-Francoise said, China cost us about three points of growth in joint repair in Sports in this quarter. Let me talk about the impact on AET, which isn't related to VBP but rather to the overall slowdown in the healthcare market, in part because of the anticorruption campaign. In terms of the expanded scope, it's still very much an ongoing thing; we expect another communication here, I think, in mid-November, that will spell out the categories. It's still within joint repair, but it's just particular product categories within joint repairs, so it's not that AET is now in the mix where it was previously not. It’s really more product categories within joint repair that accounts for why it's bigger than we originally thought. Just to ground us, it cost us about three points in Q3. Regarding how much destocking we see in the channel, there are a couple of facts. First of all, as we've indicated, we do see that we've experienced how ortho went to calibrate, how to manage this with our distributors this time around. So what I can say is similar type of activities as we saw when orthopedics went at this point in the development of VBP. It's hard to unpick that from what's going on in the market. There are some indications that as it pertains to sports, in particular, patients are waiting to have their procedures done post VBP because the out-of-pocket pay would be lower. There is some effect around that. Of course, I mentioned the overall healthcare market slowdown that's impacted not just us orthopedics or sports but just generally enhanced healthcare. It can be difficult to unpick how much of this is VBP and how much of it is sports-related. Procedure slowdown in anticipation of VBP among patients and the overall healthcare market. Those are the different pieces to that.

The other question was regarding margin, correct?

Yeah. It was around the current procedural landscape in the US and when this pent-up demand might be released. Do you think that current market expectations for 5% organic growth at 120 basis points of margin expansion next year are achievable?

So procedure-wise, I think Q3 was another robust quarter, but not nearly to the same level as Q1 and Q2. In terms of pent-up demand, for us, our growth is going to come primarily from improved commercial execution. A tailwind in the market will help, but in the end, given where we are and our performance in the recent past in orthopedics, what we're counting on is our ability to execute better commercially within an existing market. This will be the bigger driver for us. In terms of the margin number you indicated, we're not going to be talking about 2024 guidance yet. We'll do that in February.

Okay. I guess if I can just follow-up again on margins and maybe ask in a different way. What's your current base case on when China anticorruption impact abates? What is the current margin effect, if at all? To what extent could it impact your ability to hit 2025? I asked because you're talking about further headwinds today and at H1 results, your confidence around midterm margins was abundantly clear.

Yeah. To be clear, VBP as we envisioned it, even with the broader scope that's reflected in your question, would have us leading our midterm guidance where it is. The impact of the anticorruption campaign is a bit hard to tell. We're not counting on that being a persistent effect. In other words, VBP price reductions happen, and you're not expecting them to be set, right? The added headwind for the year is the impact around capital sales and to some extent, procedures based on the anticorruption campaign. I was in China just about a week ago. The indications are that there is some improvement in procedures in September, and the expectation is that it would get better in Q4, but it's hard to tell. It really is hard to anticipate how that's going to play out. For what it's worth, we don't expect that to be a persistent effect going into Q4 and beyond, therefore, the impact on midterm margins to be negligible.

We now turn to Sezgi Oezner with HSBC. Your line is open.

Hello. Thanks for taking my questions. I will have two, please. First of all, in terms of the CORI expansion that we're seeing, how much do you feel as the bigger driver, the larger indication of CORI or the lower pricing associated with CORI? How do you see the client base responding to that, whether the peers free offering of CORI is a decision-maker or whether the volume growth is more impactful at that? And second, if we circle back to the potential costs associated with the program, how confident are you that they will remain within the realm that you had announced so far and that we won't see any additional costs coming, particularly any one-off costs coming from the program within the remainder of the year 2024 and 2025? Thank you.

In terms of CORI, as I mentioned, CORI is not being driven in isolation. At the end of the day, what matters is selling the portfolio that we have. We're excited about the differentiation within orthopedics, but certainly in the knee segment. The focus is not just on CORI, but on selling CORI, combined with the best-in-class implant portfolio, JOURNEY II, and the revision capabilities we have. Instead of talking about any single thing, the power is in that combination. So as mentioned, we're making great progress through the 12-point plan and have confidence in those lines to bolster our margins and deliver growth. Regarding restructuring costs, we feel good about the number we put out, and we're tracking well to that. We're keeping a close eye on that, report it to our Board, and obviously monitoring that carefully. We feel positive about where we're positioned relative to the envelope that we indicated.

This concludes our Q&A. I'll now hand back to Deepak Nath, CEO, for closing remarks.

Great. Thank you very much. As I said, I'm pleased with what was another strong quarter for us. We're making great progress in our 12-point plan. We're starting to see the results of that come through in the financials. We've got a lot to be excited about. And as I said, in addition to fixing our operations, we're very excited about the investments and innovations that we've made are starting to deliver. I'm very excited to be able to talk about that at our Meet the Management session on November 29th, which I hope you will all attend. So thank you very much for your questions.