Earnings Call Transcript - SNN Q4 2022

Deepak Nath, CEO

So good morning, and welcome to the Smith & Nephew Full Year 2022 Results Presentation. I'm Deepak Nath, Chief Executive Officer. And joining me is Anne-Francoise Nesmes, who is the CFO of the company. So I'm pleased to report a good finish to 2022. Underlying growth rate accelerated versus the first nine months with all of our franchises contributing. We've continued to outperform in sports and wound management, which generate together 60% of group sales. We're still early in our work to fix orthopaedics. And although growth improved there, too, it will take some time for us to get to where we want to be. The company is well positioned going into 2023, and we're transforming the way we're operating Smith & Nephew through our 12-point plan, driving greater rigor and execution as we deliver our strategy for growth. Delivery of the 12-point plan is progressing, and our KPIs are already moving in the right direction, and I'll share some of that data with you later. But with improving operations and a good exit to 2022, we expect both faster growth and margin expansion in the coming year. We're also updating our midterm targets. On growth, we feel very good about the outlook. We're continuing to execute well in our outperforming businesses. And the fix of orthopaedics is underway, and we're delivering a high cadence of innovation. For the margin, the macro environment has been more challenging than me or anyone else expected back in 2021. Inflation has been higher, and global supply chains have stayed disrupted for longer. And our midterm goals reflect offsetting most of that additional pressure through a range of cost actions. However, it's also and moving the date of our margin target back by a year. Shortly, I'll cover how we'll deliver the targets of consistent 5% growth or above and at least a 20% trading margin by 2025. I see the delivery and more importantly, the fundamental improvements we're making required to achieve them as the first step and our ambition to transform Smith & Nephew. But first, I'll begin with the highlights of our full year numbers. So revenue was at $5.2 billion, and that's 4.7% growth on an underlying basis with one less trading day in 2021. Reported growth was at 0.1%. Trading profit was $901 million, which is a 17.3% trading margin. And we generated $444 million in trading cash flow, which is a 49% conversion. Adjusted earnings per share grew 1.1% to $0.818. We're proposing an unchanged dividend of $0.375 for 2022. I'll now pass you to Anne-Francoise to go through the detail of today's results before back to discuss our outlook in more detail.

Anne-Francoise Nesmes, CFO

Thank you, Deepak, and good morning, everyone. I always wonder why nobody sits in the first row. So hopefully, you can see me behind the lectern here. So I'll start by covering the fourth quarter revenue, which was $1.4 billion, which represents a 6.8% underlying growth. As Deepak said, all three franchises contributed to the strong finish. And the factors behind that included reduced VBP headwind in the quarter and the contribution of new products. We've also made progress with product availability, which has limited our growth in recent quarters. Our internal supply chain performance is starting to improve, and while there are still challenges in the availability of external inputs like semiconductor, resin, sterilization capacity, we're seeing some easing. Looking by geography, the performance was broad-based. The U.S. grew by 4.8%. Other established markets grew 7.3%, and emerging markets grew 12.1%. We acceleration in emerging markets reflects largely a return to growth in China, which represents 6% of our group sales. And while VBP was still a headwind in Q4, there was also an easier prior year comparator due to the inventory adjustments and the provision that we took back in Q4 2021. The renewed COVID waves in China as the country changed its approach to new outbreaks and an initial limited impact in Q4 to increase as we move into January 2023. So we do expect a more noticeable headwind in Q1. I'll now go into the detail of each franchise, and I'll start with Orthopaedics, which grew 4.1% underlying. Now this is the part of our business which is the most impacted by VBP. Without China, growth in the quarter would have been one percentage point higher in Knees, two percentage points higher in Hips and 0.4 points higher in Trauma and Extremities. That aside, innovation across the portfolio is a key part of our picture and our performance. Recent launches are already contributing to the growth. And together with our robust pipeline are improving our growth outlook for the coming years. In Hips and Knees, we've advanced with our plan to improve our performance, including new product launches. First, our cementless total knee, LEGION CONCELOC, continued to ramp up with strong sequential growth. With this as an auction, we have an impressive new portfolio. We have done kinematic knee. We have the OXINIUM surface technology. We have cemented and cementless options, and the robotics platform uniquely covering all of Total, Uni and Revision knee surgery. Our implant availability also improved over the previous quarter. Overall growth is not there yet where we aim it to be, but we're in a better position here than we were when we initiated the 12-point plan, and we expect further improvement in the coming quarters.

Deepak Nath, CEO

Moving to Sports Medicine and ENT franchise, which grew by 9.2% despite a challenged supply chain. Joint Repair grew 11.5% with double-digit growth in both shoulder and knee. And REGENETEN has been a multiyear driver of growth. We've continued to invest in new medication in new regions and evidence, and we are now seeing growth reaccelerate. There's also significant further potential for REGENETEN as we launch in Japan, in China and India in 2023. AET grew 4.2%, driven by both the core AET and WEREWOLF FASTSEAL and a softer prior year comparator. And ENT grew 1.7% as the post-COVID recovery in tonsil and adenoid procedure volumes continued. As I said earlier, this is in the context of headwinds from semiconductor and resin shortages, sterilization capacity constraints, so a very strong performance. Finally, in advanced wound management grew 8% underlying, and the recent pattern of balanced performance in the quarter across all regions and all categories continued. In Advanced Wound Care, Europe and Asia Pacific showed particularly strong growth as with our skin substitutes business in bioactive. Advanced Wound Devices grew 14.9% with double-digit growth from our single-use negative pressure product PICO. And our traditional platform, RENASYS is another product that was limited earlier in the year by component availability. The situation improved in Q4, and RENASYS returned to more significant growth as a result. And we also reached a significant milestone as we obtain 510(k) clearance from FDA for RENASYS Edge in the U.S. Now I'll move on to the detail of the full year financials.

Anne-Francoise Nesmes, CFO

Revenue for the full year was $5.2 billion, up 4.7% on an underlying basis compared to 2021. Revenue was flat at 0.1% reported revenue due to foreign exchange headwinds of 460 basis points given the strength of the U.S. dollar compared to other major currencies. As you see on the chart here, Sports Medicine and wound shown 6.7% growth and 6.4% growth, respectively, and orthopaedics grew 1.9%. This full year growth rate also reflects one fewer trading day than in 2021, as Deepak mentioned earlier. Now having covered revenue in detail for Q4 and the full year, I'll now move to the summary of our P&L before expanding on some of the key elements of the P&L. The underlying gross profit was $3.7 billion, resulting in a gross margin of 71%, which is a decrease of 10 basis points.

Deepak Nath, CEO

And you have to understand there were significant moving parts behind that. For this year, the headwind of raw materials inflation that we've talked about, our gross margin level was offset by price increases and other movements in inventory valuation. The SG&A line here in the P&L reflects higher inflation in freight and logistics as well as sales and marketing expenditure levels returning to normal after COVID. Trading profit was $901 million, with the trade pressure increased as the year progressed and ultimately came to 210 basis points for the full year. And we worked hard to offset the headwinds. Notably, we were able to drive price increases, improving margin by 80 basis points.

Anne-Francoise Nesmes, CFO

And then we had a lot of activities on the slide here maybe is too much of a summary, but there's a lot of moving part behind the net pricing and the net cost savings you see here of 130 basis points. In particular, the 130 basis points reflect the benefits of significant cost reductions and operating leverage offsetting labor inflation. Now looking further down the P&L, adjusted earnings per share grew by 1% to $0.811, and that's primarily driven by lower net financial expenses and a lower tax rate due to adjustments in respect of prior years.

Deepak Nath, CEO

Looking at our cash flow, we generated trading cash flow of $444 million in the period, with trading cash conversion at 49%, which is disappointing and lower than our typical level. We do expect our trading cash conversion to return to more normal historical levels in 2023, however. The change in 2022 was mainly due to a higher inventory, which you can see in the capital outflow of $477 million. And we wanted to illustrate and explain the change in the inventory and what drove the inventory growth. The largest single contributor of inventory growth was strategic raw material buying as part of managing through the unpredictable availability of some materials.

Anne-Francoise Nesmes, CFO

You can also see here the impact on inflation on the average value of our inventory. In addition to some increases that we made to support growth, would it be building inventory ahead of new product launches, increasing safety stocks or building stock in market, where we expect the growth to accelerate for existing products. Clearly, we recognize that the starting point at the end of 2021 was already too high and particularly in orthopaedics.

Deepak Nath, CEO

This is why inventory is one of the key focus area in the 12-point plan, and we expect to reduce inventory buyback. The effect of that is the leverage ratio finished at 2.2x adjusted EBITDA, which is similar to recent level and in line with our target of 2x to 2.5x. And now I'll move to the outlook for 2023.

Anne-Francoise Nesmes, CFO

You will have seen this morning that we're guiding for underlying revenue growth of 5% to 6%. Within that, we expect continuation of the above-market growth in Sports Medicine and Advanced Wound Management, and we also expect further improvement in orthopaedics. This will be driven by better commercial execution and growth from new products as we continue to implement the 12-point plan. There will be phasing effects through the year. We're seeing the renewed COVID waves in China impacting surgical volumes.

Deepak Nath, CEO

And therefore, we also still have another quarter before we fully lap VBP during Q2. So that means that Q1 will be slower with acceleration as the year progresses and the China headwinds subside. On trading margin, we expect the 2023 trading margin to be above 2022 level and at least at 17.5%. Clearly, there's a lot of moving parts behind the margin. And as you can see on the chart on the right, there are several components building that margin.

Anne-Francoise Nesmes, CFO

We'll continue to see margin headwinds from the macro environment, which remains uncertain. However, we more than expect to offset those headwinds. That will come from a combination of positive operating leverage and productivity improvements under the 12-point plan, including specific cost actions that we're setting out today. Looking at the detail on the chart on the right, you can see that transactional FX will be a headwind of around 100 basis points from the dollar strength in 2022.

Deepak Nath, CEO

There's also continued raw material cost inflation, and some of that is a delayed impact as we work through inventory that's based on higher purchase prices. We partially offset this through pricing actions and product improvement in COGS and manufacturing.

Anne-Francoise Nesmes, CFO

Higher-than-usual staff costs from wage adjustments in the second half of '22 and the usual merit increase in '23 will largely be offset by commercial and G&A savings, and revenue leverage will provide the remaining offset. So taking all these variables into account, we expect trading margin expansion year-on-year. We've also updated today our midterm guidance. And I'll hand you back to Deepak to cover that.

Deepak Nath, CEO

Thank you, Anne-Francoise. So as you know, we issued the midterm guidance last about a little over a year ago. And since then, a lot has changed. The macro environment has been more challenging for everyone with higher inflation and longer disruption, as I said earlier, to our supply chains, and that continued all the way through 2022. We've also made progress. We started the implementation of our 12-point plan that's fundamentally transformed how we operate as a company. Our new midterm goals reflect both the changes in the macro environment over the last year and also the actions we are taking to offset the pressures and drive higher top line growth. On revenue, we're now targeting underlying growth consistently at 5% or higher. That's above historic levels. And in a moment, I'll show you the building blocks of how we are making that change. We're also targeting trading margin in excess of 20% in 2025 and beyond. Clearly, the margin guidance implies a nonlinear path over the next three years. Thus, due to the higher inflation headwinds, as assumed in 2023 and productivity gains from operations coming more towards the end of the period, particularly around manufacturing, we do still expect to make year-on-year improvements throughout this period, and that's only the first step. From beyond 2025, we'll be in a fundamentally changed position. We'll have a choice of how much we want to reinvest on more growth opportunities and how much we allow to flow into further margin expansion. We'll probably go into the detail of how we do that. I just want to anchor and remind you of our fundamental competitive position. I have no doubt that we have the right to win in all three franchises. In Orthopaedics, that comes from a full product portfolio and technology. We have highly differentiated implants, particularly in knees and also with OXINIUM, as Anne-Francoise mentioned. We've got platform technologies, robotics with unique indications and assets on our CORI platform. In sports, we have a full offering with leading positions across joint repair, enabling technologies and biologics. There are also clear synergies between orthopaedics and ENT, for example, in the ASC channel. And in Wound, which is the heritage of Smith & Nephew, we've got the broadest portfolio across all segments with biologics, devices, films, and dressings. We've got a leading position and negative pressure. We also have strong clinical evidence for our portfolio that sets us apart from the value segment of wound.