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Executives

Dave Illingworth - Chief Executive

Adrian Hennah - CFO

Analysts

David Adlington - JPMorgan Cazenove

Justin Smith - MF Global

Seb Jantet - Investec

Smith & Nephew plc (SNN) Q2 2010 Earnings Call August 5, 2010 4:00 PM ET

Dave Illingworth

Well, good morning, everyone. Welcome to our second quarter 2010 results presentation. I’m going to break the ice this morning and then hand it over to Adrian to take you through the numbers and then I’ll come back and wrap up and then Adrian and I will take questions.

Let me start with the highlights for the quarter. We’ve made good progress this quarter as we’ve continued our high level of investment in the business for the future and have stayed focused on driving out efficiencies. The long-term growth drivers of our business, demographics, emerging markets and patient demand for an active life are unchanged.

Group revenues rose by 4% in the quarter, as Advanced Wound Management outperformed its market and Endoscopy grew by 9%, while a number of issues continue to impact our high performance products in reconstructive Orthopaedics. In Orthopaedics, revenues increased by 1% overall, and trauma revenue strengthened and grew by 2%. In reconstruction, our European team grew their revenues by 3%, as their actions resulted in growth at around the market rate for the second quarter.

Revenues in Endoscopy grew by 9%, as a strong performance outside the US drove this business to near double-digit revenue growth. And in our Advanced Wound Management business, we grew revenues at above market rate with the strongest growth outside of Europe. So let me move on and talk about the margins for a second.

Trading profit was up 7% at $226 million. We increased our trading margin by 60 basis points this quarter with improvements in all of our businesses. We have an ongoing focus on improving our working capital management to strengthen our cash generation and this quarter we converted 89% of our trading profits to cash. We’ve increased our dividend in line with the policy, our long-standing policy by 10% to $0.06 per share.

And now if I move on to the individual businesses in turn, I’ll start with Orthopaedics. Our Orthopaedics business is experiencing a couple of headwinds currently. First, our higher specification products are being impacted by the economy as the effect we expected from the recession becomes more apparent.

Second, the discussions in the media and in the Orthopaedic profession about metal-on-metal implants unfortunately impacted BHR. As the gold standard for resurfacing, BHR has a long-documented history of clinical efficacy, with over 100,000 procedures done and registry data that shows superior outcomes. We know that with the proper patient selection, BHR’s results are outstanding and these views are supported by the scientific data.

So as a result of the headwinds, global revenues grew by 1% in the second quarter, with strong performance in the emerging markets. In Reconstruction in the US, our knee revenues were up 2% as GENESIS and LEGION gained from some trading down from higher specification products. VISIONAIRE has had a positive impact and we see an excellent stream of opportunities from this product. Our US Hip revenues fell by 3%.

We currently have, and continue to expect, at or above market growth in our traditional Reconstruction product lines. Our US customer service initiative is targeted to increase both the efficiency and effectiveness of our sales force and to improve customer service in line with our customer focus strategy. This project continues to progress.

In Europe, despite the tougher market conditions, the actions that our management team outlined last November for many of you are gaining traction and Reconstruction revenues grew by 3%, which is around market growth rates.

In Trauma, we’re very pleased to see our revenues grow by 2%, which is an indicator that our actions in the US are starting to deliver benefits. Our SURESHOT targeting system continues to be very well received and has driven up related revenues. Our nail sales are strong, as SURESHOT is helping us to get into a competitive accounts.

The new Foot & Ankle range, which we introduced earlier in the year, has also had a positive impact on revenues for the business. Margin in Orthopaedics was up 20 basis points in the quarter, a good performance given that we continue to make significant investments in this business while experiencing some tougher market conditions.

The next slide, and there similar slides for each of our businesses by the way, it takes a look at how our strategy is driving future growth. We’re focused on innovation, on customer service, in investments for growth and improving our efficiency. And here are some examples.

We recently appointed a Chief Operating Officer in the Orthopaedics business with a clear role to manage the day-to-day business of Orthopaedics, freeing up a very substantial amount of time for the President to spend on customer-facing activities. The recent FDA approval for our 30 year wear claim for VERILAST, which is OXINIUM with crosslinked polyethylene, is proving to be a product combination that has great appeal for our customers. We’ll also be supporting our sales force with an increase in media, direct-to-consumer advertising and sales support in the second half.

In resurfacing, we’re building a specialist team to focus on surgeon support for BHR. We appointed a national executive for China this past quarter, as part of our customer service focus and to support the development of our Chinese business. Kelvin Johnson is a member of the Executive Committee and has been responsible for our rapid growth in emerging markets. His appointment has significantly increased our management capacity in this rapidly growing market.

We’re also expanding our training programs in China to increase the levels of customer service. There’s a lot of exciting things going on in Orthopaedics, as we build momentum in this business. We do intend to continue our strategy of excelling in the high-performing product segment of our markets, where underlying demographics are expected to support long-term demand.

Now turning to Endoscopy, Endoscopy turned in another strong performance this quarter, as our arthroscopy revenues grew by 11%, an excellent performance with continued growth potential. We had overall double-digit growth in Europe of 10%. The US grew by 2% and the rest of the world grew by 22% as we benefited from strong revenues in Japan and emerging markets.

In arthroscopy, we saw the results of new product launches. We had six this quarter, including TWINFIX Ultra Suture Anchor for shoulder repair. In resection, our radio frequency blade continues to reenergize from a small base our resection segment. Our hip arthroscopy business is growing fast, as this market develops and has clear long-term benefits for us.

We see continued scope for investment in this business and recent short-term investments have resulted in good returns. We will continue to balance margin improvements with opportunities to drive top-line revenues through accelerated product development. And on top of a strong revenue performance, the Endoscopy business improved its margins by 20 basis points.

Let me show you a few of the things we’re doing in a little bit more detail in Endoscopy. First we have a new approach for the development of innovative new products, our fast-track development program. This program has already delivered products such as FOOTPRINT Ultra PK in the first half of the year and is building an excellent pipeline for this business.

Our fellows program, where surgeons share experience and ideas, very well received by our customers and the spring program was no exception and was extremely well attended. I attended the official opening of the new Surgical Skill Centre in York last month and met with surgeons training there. It is really great to have a world-class facility in Europe as well as in the US. The centre is fully booked for the rest of the year.

The hiring of a new senior vice president for research and development is a significant step in support of our new product investment plans as we develop a much faster cycle for innovation to meet the needs of our customers and our patients. Sales force training is a key part of our business and we’ve designed and delivered courses locally throughout the first half to better meet the needs of our sales force.

And in the US we’ve been executing a structured program to realign our sales, our sales force to strengthen our management and development of our customer-facing teams. We have now achieved our internal milestone of having two-thirds of our US sales force as direct employees, from 100% of distributors two years ago. And we expect to see the benefits of this as we go forward. The level of innovation in this segment is higher now than it’s been for some time and gives us a very strong position to continue on its growth path.

Now let me turn to Advanced Wound Management. Advanced Wound Management grew its revenues by 5% this quarter, the ninth quarter on a row that this business has performed at or above the market. In the US, we saw revenues grow by 7%, driven by Negative Pressure Wound Therapy. And as we benefited from our initiatives to develop this business, in Europe we grew the revenues by 4%, a good performance despite the impact of the timing of the German price increases. In the rest of the world, revenues grew by 7% as demand continues to grow in the developing markets. And also Negative Pressure Wound Therapy grew very well in the quarter, although litigation continues on a number of fronts.

Advanced Wound Management had several new product introductions this quarter, including DURAFIBER, which is a new product for cavity wounds. Infection management continues to be a strong area of growth in the business and our silver products are very well positioned in the segment. Margin increased in wound care by 230 basis points this quarter as the actions that we’ve taken in the past are producing very good results.

So moving on to the second half of the year, in Wound Management, we expect growth from a number of our VAT activities, some of which are already complete. In the US we’re increasing our resources in the longer-term care segment as part of our drive to increase our penetration and develop that segment of the market. Negative Pressure Wound Therapy has undoubted enormous long-term potential for us as a business despite the continued legal action.

We continue to invest in new products and distribution channels to realize the significant potential in this segment. We have a series of new products on the way to expand our range, including dressing extensions. The emerging markets offer significant opportunities for the Advanced Wound Management business. We’re focused in our efforts and are making significant investments in these marketplaces.

To improve efficiency, we’re moving the conversion process of our silver-based dressings from Canada to Hull as part of our global operation strategy to improve margins. We’re also seeing the benefits of the additional production in China as we supply more product globally from this facility.

Now I’m going pause for a minute and turn it over to Adrian, who will take you through the numbers.

Adrian Hennah

Well thank you, Dave, and good morning, ladies and gentlemen. Turning firstly to slide 12 and the income statement, revenue in the quarter as you’ve seen was $959 million, representing underlying growth of 4% after adjusting for exchange rates on quarter two of last year. There was one more sales day in quarter two this year than quarter two last year, increasing growth by about 1%. Growth rates referred to in this presentation are before adjusting for that extra sales day unless we specifically mentioned to the contrary.

Trading profit in the quarter was $226 million, giving underlying growth of 7%. Reported trading margin was 60 basis points higher than quarter two last year. Interest costs are down on last year, reflecting both lower debt and a lower interest rate.

Moving to slide 13 and moving further down the income statement, the tax charge for quarter two is 31.4%, our estimate for the full year rate. Adjusted attributable profit for quarter two was $152 million. Adjusted earnings per share were $17.01, which is 11% higher than quarter two last year. This is slightly higher than the trading profit growth due principally to the lower interest charge.

Turning to the next slide, slide 14, and an analysis of revenue by business segment, you’ve heard from Dave on the progress of each business. This schedule gives the growth rates in the quarter to which Dave referred. In quarter two, the value of the US dollar was broadly unchanged year on year against the average of the currencies in which we operate strength against the euro and sterling offset by weakness against the yen and a number of smaller currencies.

As noted already, the extra business day increased reported growth by 1%. Conversely and as signaled in prior quarters, the timing of price changes in Germany reduced reported wound growth by about 1% and the sale of a small USA spine business and the end of a spine distributorship in Germany reduced reported Ortho growth by about 1%.

Turning to the next slide, slide 15, and an analysis of revenue growth rates by business and by geography, as well as the numbers on this slide, we’ll also refer to the growth rates of our main product types which are included as usual in the appendix. At constant currency, sales in our Orthopaedics business in the quarter grew 1% on quarter two last year. Hip sales were flat. Knees grew at 3%. Trauma Fixation grew at 2% and Clinical Therapies declined by 6%.

Across Orthopaedics, we saw a slight increase in price pressure. Like-for-like price reductions were 2%. Mix continues slightly positive, but materially lower than the trend over the last few years. Dave highlighted the headwinds for our BHR product. BHR sales account for over 15% of our hip sales worldwide and over 20% in the United States. We have seen sales remaining strong in the larger, more specialized, higher volume hospitals, which together with excellent clinical data confirms our confidence in the future of the product. This move in customer mix to higher volume hospitals has, however, led to a weakening in average price achieved.

In United States, overall Ortho sales were 1% lower. US reconstructive sales were flat. Growth in our knee business was 2% and US hip sales were 3% lower. Trauma Fixation sales in the United States were down 1%. CT sales in the United States were 2% lower, which was a growth of 2% excluding the impact of the small spine disposal. EXOGEN continued to grow strongly, SUPARTZ continues to be under pressure.

In Europe, Orthopaedic sales grew by 1%. We saw encouraging performance in our traditional products in the face of a weak European market. In the rest of the world, Orthopaedic sales grew by 5%. The positive underlying trends in the emerging markets continue. Growth in Japan was reduced by the biannual reimbursement price reductions, which took effect from April.

Endoscopy sales grew by 9%. Arthroscopy sales, which include both repair and resection, grew strongly again at 11%. Visualization and related sales were 2% lower. Visualization sales accounted in 2009 for about 15% of global Endoscopy sales.

Endo sales in the USA grew by 2%, in Europe, at 10%, and in the rest of the world, at 22%. Wound sales grew by 5% in the quarter. Total Wound sales grew by 7% in the United States, grew by 4% in Europe, and by 7% in the rest of the world. We continue to see clear signs of good progress with NPWT. NPWT sales contributed 3.5% to total Wound growth. We signaled last quarter that Wound sales were boosted in quarter one by the timing of price increases in Germany and will be correspondingly reduced this quarter. This was indeed the case.

And with regard to the USA, we also signaled some reduction of Wound sales from consolidation of our wholesalers. There was indeed a reduction but the impact was offset by other fluctuation in wholesaler inventory levels in the quarter. End-customer sales growth in United States excluding NPWT is improving, but has not yet reached the levels we are targeting.

Turning to the next slide, slide 16, this shows the usual analysis of trading profit by business segment. As we have already noted, the reported trading margin for the group was up 60 basis points in the quarter. In Orthopedics, we saw a 20-basis points margin increase in the quarter. We continue to see significant further opportunities to improve the efficiency of our processes in Orthopedics.

We are committed to achieving these improvements in order to put us in a position to invest in the many opportunities we see for growth and to help deal with the price pressures as Western governments deal with their substantial deficits. The Endoscopy margin also increased by 20 basis points in the quarter. As previously signaled, we see particularly substantial opportunities to invest in our Endoscopy business and as a consequence we continue to expect some modest reduction in margin for the full year.

In Wound, we again saw a significant underlying increase in the margin. We are benefiting in particular from the lower costs in our China factory. Investment in NPWT, including in legal costs, continued to impact the Wound margin and we expect it to for some time.

We are facing two particular headwinds on margin at present, firstly, pricing. We’ve already mentioned the slight weakening in pricing in Orthopaedics. We are seeing similar pressures in Wound. The 7.5% reduction in reimbursement levels in Spain was perhaps the clearest example in the quarter.

Secondly currency, we have, as you know, a quite good natural hedge against transactional currency exposure, but with some exposure to dollar strength in Ortho and Endo and for sterling strength in Wound through the location of our largest factories. The recent strength of both the dollar and sterling against the euro will, if sustained, put some pressure on gross margin as the lag from our inventory holding cycle passes.

Turning to the next slide, slide 17, and the cash flow statement, we had another good quarter of cash generation, with $119 million of free cash flow in the quarter. You’ve heard from Dave on the continued steady progress we are making improving the efficiency of our field based operations. This includes the efficiency with which we use our inventory and instruments. And you can see this reflected in these numbers. Restructuring spends continued in line with guidance. We include as usual an analysis of the total spend on the restructuring programs in an appendix. Net debt decreased to $720 million in the quarter, principally as a result of the good free cash flow generation.

Turning lastly in this financial part of the presentation to slide 18 and the outlook, in the Orthopaedic area, reconstructive and trauma, we believe that underlying global market growth decreased quarter on quarter from 7% in quarter one to 5% in quarter two. We expect to improve our growth relative to the market progressively through recently launched products, especially SURESHOT and VISIONAIRE, through strong clinical data, especially for BHR and VERILAST, and by continued focus on operational performance.

Within Orthopaedic clinical therapies, we expect competitive pressure to continue. The sale of our outpatient pain management business, together with the termination of a small spine distributorship in Germany, reduced Clinical Therapy sales by about $6 million in the quarter and profit by about $1 million. We expect a similar impact until this annualizes.

Within Endo, we continue to expect to grow ahead of the market in Arthroscopy. Within Wound, we continue to expect good progress with NPWT sales to push growth ahead of the market. We have, as usual, included in the appendices a table setting out the number of business days in each quarter. There will, I would remind you, be four less days in quarter four.

With regard to margin, we continue to see significant opportunities to improve the efficiency of our business. We also continue to see significant opportunities for new investment and some headwind from price.

And with that brief update on the outlook on 2010, I’ll hand back to Dave.

Dave Illingworth

Thank you. I find it a little bit interesting this morning over a coffee, I had three people come up and say, are you pleased with the results? And I guess that’s the analyst version of the open-ended probe. And I think I finally figured it out. But I am pleased. I’m quite pleased with the results. I think despite some challenges that we’ve had over the last couple years, we have not wavered from our core strategy in this business.

We’ve energized the Endoscopy business. We’ve turned around the Advanced Wound Management business and are beginning to leverage its number one position globally. We do excel in the younger, more active patient segment of Orthopaedics. We made very solid investments in our key emerging markets and we are significantly improving the efficiency of our overall business.

So let me just go through this last slide and then we’ll open it up for some Q&A, a little bit of color to Adrian’s comments. In Orthopaedics despite the headwinds, we’re positive about the outlook for reconstruction. We continue to see this business performing well. Our strategy of working in the younger, more active patient segment is unchanged as I just said. We have new products. We have more in the pipeline to strengthen our performance in the medium-term and the actions that we’ve taken in trauma have returned this business to growth. And there is more to come over time.

Our Endoscopy business is outperforming the market in arthroscopy. We are pleased with the good momentum and expect continued benefits from its position as the global market leader in arthroscopy.

For Advanced Wound Management, we delivered above market growth for some time and although the global wound care market is becoming somewhat tougher, we see that our Negative Pressure Wound Therapy business has very substantial long-term potential and we’re happy to compete in this segment and also to provide a clear choice for our customers and our patients.

As far as margins are concerned, the actions we are taking now to improve our efficiency are giving us the ability to invest more freely in the business for the long-term. I think we’re going to take some Q&A and we are on a little bit of a tight schedule today. I want to warn you in advance. So we’re going to do our best to get as much Q&A as we possibly can, but we do apologize if we have to cut it off at some abrupt point in order for us to keep our schedule for the day. So we’ll take the usual, do the usual format. We’ll take some from the lines and some from here.

Michael.

Question-and-Answer Session

Unidentified Analyst

Great. Thank you. I have three questions. Firstly on pricing, can you split the pricing of minus 2 between recon and trauma? If you can’t give us precise numbers, just the trend in those two divisions? Secondly, what is the constant currency growth rate for your recon business if you exclude BHR? And the last question is on outlook. You highlight that you expect a material improvement in 2010 over 2009. Does that include the write-back of the provisions in wound care?

Dave Illingworth

Adrian, this is right up your alley, my friend.

Adrian Hennah

Okay. Sure, okay. You rattled them off a little rate, Mike. You have to remind me of the third one in a minute. On pricing, we’re not going to split it precisely for you, but what we can say is that historically, of course, as in the last few years anyway, trauma has been showing higher like for like growth than recon. We’ve seen them both come down but we’re not going to split for you the change in the two. But they’ve both come down.

Unidentified Analyst

But is one worse than the other in Q2, the change?

Adrian Hennah

The change is broadly similar i.e. the change in the rate of change if you’re with me, as opposed to the absolute change numbers. You’re right there. In terms of the constant currency recon growth excluding BHR, again, we’re not going to give you an exact number, but Dave did mention in his presentation that if you look at the traditional products, i.e., they’re not ones that are particularly oriented to the more high specification, and we have exceeded market growth. So that gives you a sense that BHR is a significant drag for us. That’s what we meant to signal by that, but we’re not going to give you any more precise numbers.

Remind me of the third question, Michael. I didn’t scribble it down fast enough?

Unidentified Analyst

Yes. The third question was, you highlighted that the margin expansion will be materially higher in 2010 over 2009. Does it include the write-back of the wound care provisions?

Adrian Hennah

Well, we’re not expecting any write-back of wound care provisions in half two.

Unidentified Analyst

Well, but for the first half it’s quite significant, so therefore it does have a positive impact for your full margins?

Adrian Hennah

It does for the full year.

Unidentified Analyst

Yes.

Adrian Hennah

But you just quoted half two, didn’t you?

Unidentified Analyst

I mean for the full year. So your guidance, I think, in the presentation was for margin improvements to be materially higher in 2010 over 2009. Does that guidance include -?

Adrian Hennah

Clean. Cleanly.

Unidentified Analyst

It’s clean?

Adrian Hennah

Yes.

Unidentified Analyst

Okay.

Unidentified Analyst

I have three questions. The first question is on VISIONAIRE. It’s quite astonishing to see how many procedures you’ve actually done with that device. Can you give us a sense of what percentage penetration that is of your knee business and what sort of margin should we think that product would contribute? The second question is on the hip business. Clearly given the concerns about metal-on-metal, that’s having a negative impact on BHR. And we do understand that BHR does have outstanding data. Can you give us some sense of what you’re doing there to re-educate surgeons and what your expectation is for that entire category, whether you would be able to maintain that category and what your position would be within that category? And the third question is clearly on the austerity measures that have been announced, have you seen any impact on your business now and what are your expectations of that going forward?

Dave Illingworth

Okay. Well, let’s split this up. Let me take the metal-on-metal and the BHR to begin with. I think, [Edan], we are being swept up a little bit in this debate in the Orthopaedic profession and also with some of the products being taken off the market with our competitors and some of the controversy that’s been swirling around. And I think we need to get back on the front foot, quite frankly, with BHR. That’s why we’re putting a team of specialists in place who are able to handle not only the effective use of the data, but also really know inside and out the product and its applications and the surgical techniques, et cetera.

We’re also going to be doing some advertising. We’re going to try to distance ourselves and differentiate ourselves from that general broad metal-on-metal controversy. We have terrific clinical data. We have over 100,000 procedures being done. We’re in conversation with the Australian registry to try to differentiate us in terms of how they actually, so we’re not lumped into broad categories. So there’s a lot of work going on and I think we will be effective.

It’s a great product. We’re very bullish on it. We’re very happy with it. We’re not happy with the fact that it’s been under some pressure, I think, a little bit from the controversy on metal-on-metal, and also a little bit from the fact there’s been a general deferral of procedures in that younger, more active patient. And there is possibly even some trading down of product and there is also some potential loss of market share as a result of, I mean, think about it for a second.

For all intents and purposes, we’re the one company that has metal, has BHR, has resurfacing in the US. So we are able to get into a lot of competitive accounts if they want to do resurfacing. So if for some reason, they decide not to do resurfacing, it wouldn’t be unusual for us to lose that competitive position with an individual surgeon. I’m not saying that happens all the time, but I think it’s a mixture of those things. But all in all we’re pretty bullish on it.

Do you want to try another one?

Adrian Hennah

Austerity measures? Do you want to do that one?

Dave Illingworth

Austerity? What was the question around austerity measures?

Adrian Hennah

What impact are we seeing? Sure, I’ll do it.

Dave Illingworth

Yes, go ahead. Since I forgot the question. I should give shorter answers, I guess.

Adrian Hennah

So what in fact have we seen in austerity measures. well, Edan, I think we have consistently said that the period after recession, we thought was going to be, was going to have headwinds from big government deficits playing and I guess what we expected is now happening. We can see it not just for us, for our competitors.

And yes, we do see it bit by bit. You see it in the behavior of hospitals, who are reacting indirectly to the actions of governments and you see it in some cases, as in Spain, directly to the actions of government. So, yes, we are seeing it bit by bit. We are seeing the headwinds we expected. A gradual impact, small impact on prices everyone has signaled. We’re feeling much the same as everyone else who’s spoken about it in their results. And we expect that to be around for some time. We still do not expect a quantum change in the model, which is also the position we’ve taken now for some time. So what we’re seeing is consistent with a sustained period of some pressure, which I don’t think is surprising to really any observer of what’s going on in the marketplace.

Dave Illingworth

What was the third one?

Adrian Hennah

I think, well the first one was VISIONAIRE, where I’m sure we’re not going to give the level of detail Edan wants for this question.

Dave Illingworth

We aren’t going to give you the answer to that. We’re very pleasantly, I shouldn’t say surprised, but I guess we are pleasantly surprised for the take-up of that product. The growth rate’s been strong. The people that use it like it. We’ve been able to, because we have that technology in-house, we’re now thinking about how we can apply that same type of technology to other products in our product line.

We think its going to be the way of the future. It makes a lot of sense. It’s going to go; we believe the progression’s going to go from custom cutting blocks that essentially take the place of a computer-assisted type of a surgery, all the way to custom implants and just-in-time inventories. I mean if we look five years out into the future or 10 years out into the future, there’s the possibility, because a lot of these, most of these surgeries are planned. The vast majority of these surgeries are planned well in advance that we might be able to make custom implants with custom instruments, reduce our inventory, increase our customer service levels, have better clinical outcomes and potentially lower the cost to the end-user. So it’s a very, very exciting technology for us and we’re going to continue to push it.

One more?

Adrian Hennah

Okay. David? Do you want to this one?

David Adlington - JPMorgan Cazenove

Thanks, hi. David Adlington from JPMorgan Cazenove. Just really to pick up in your outlook statement, which it really seems to have changed slightly from the last quarter. Just wondered if you could give us some further color on your thinking there.

Dave Illingworth

You’re the outlook guy.

Adrian Hennah

Well, I would say it’s broadly the same, but reflecting the realities of the quarter. It’s not meant to be anything more than that. I mean clearly, we remain very pleased with Wound and very pleased with Endoscopy. And clearly there are developments in the quarter in the Orthopaedics space, which you need to be sensible about in reflecting the outlook. It’s no more than that. That’s what we’re saying.

David Adlington - JPMorgan Cazenove

So it’s more of revenues, rather than bottom line impact within recon?

Adrian Hennah

Yes. I’d say it’s reflecting the realities of the quarter, yes.

David Adlington - JPMorgan Cazenove

Thank you.

Dave Illingworth

Yes, Bill. Okay. We’ll go back here to the floor. Yes?

Unidentified Analyst

Thank you. Just a quick follow-up, first of all on wound care. Adrian, the wholesale adjustment in the US, to what extent do you think that it’s sort of finishing? I mean is it ongoing? Are we going to see it for a couple more quarters, or effectively do you think we’re done with that? And then also to change tack slightly, this week we had the first proposals for the changes in the FDA approval process for new products in the US, the discussion of the 510-K process. I’d be very grateful if you could give a thought on those proposals and how you believe they might affect your business?

Adrian Hennah

Sure. On the first one, yes, I think you can say it’s done now. There is a little bit more to come in terms of the actual changes we’re making on the ground in the wholesalers, but frankly the impact of that on sales is within the normal cycle we get quarter-by-quarter on wholesale inventory. So I don’t think you need worry about that in your numbers as you think forward on that one.

Dave Illingworth

Well, I think on the second one, I’ll give you a broad answer. Our going-in assumption is that the clinical, the regulatory and the compliance hurdles are going up significantly going forward. And that’s the assumption we’re making and we’re preparing ourselves to be able to deal with that. We’re going to be dealing with the same issues that everybody else deals with and we believe that it’s going to come under more scrutiny in the future and we’re preparing ourself for that.

Unidentified Analyst

I mean you don’t feel in terms of process that there seems to be a commitment to simplify the process perhaps lower your paper work as well?

Dave Illingworth

We believe that the hurdle’s going to be raised. In the round, we believe the hurdle’s going to be raised going forward. The clinical data needed the regulatory guidelines, the compliance guidelines and everything that we’re doing in our business is meant to try to address that proactively.

Unidentified Analyst

Right.

Dave Illingworth

Yes, back here. We’ll get you a mic here I think, so everybody on the air waves can hear you.

Justin Smith - MF Global

Thanks. It’s Justin Smith from MF Global. Just rewinding three years to Plus and let’s ignore Greece. No one’s got crystal ball, but I mean clearly the parent environment’s changed significantly in Europe in the last three years. Can you just talk a bit again about the volume opportunity that’s still there in continental Europe and the benefits that will still come from Plus ex Greece?

Dave Illingworth

Well, that’s an interesting frame to the question. Let me talk about Europe. It’s kind of hard to talk about Plus because we don’t think of Plus anymore. I mean those products and the business and the people and the facilities and the development plans, they’re all basically fully integrated into our business.

We did pick up a significant amount of market share as a result of making the Plus acquisition. We obviously, as you know, lost a significant amount of top line business when we exited Greece for a period of time. But we’re happy with the market share gains. It’s moved us into a leadership position in some very key markets like Germany, and now we’re actually on to much more the next phase, which is how do we take what we do in Europe and the centers of excellence that we have in Europe and integrate those into a global product development process.

And the next phase really is looking at emerging markets and what are we doing in the China and how do we bridge Asia to Europe, Europe to the Americas and do it very effectively so that we can continue to leverage our strengths. So it’s really hard to answer that question on a company-specific basis like Plus. Yes.

Seb Jantet - Investec

Thanks, hi. Seb Jantet with Investec, just a quick question on margins. You haven’t mentioned that you went ahead with the EIP program. I’m wondering how we should be thinking of that in terms of kind of progressions in 2010 and beyond. And as a follow-on from that, is there any IP2 waiting in the wings? What should we be thinking about the margin progression beyond that?

Dave Illingworth

Well, you haven’t heard about it because it’s been by design. We’re trying to wean our presentations off talking about EIP specifically, because the EIP program truth be told was a way for us to get not only the communication to the outside world that we were going to make a commitment to improve our margin and the efficiency in the business over a period of time, but also to put some endpoints in place so that our internal folks in the business understood that this was a real program and that we’re going to have real commitments and that we were going to have to have to real investments in our business to reengineer ourselves.

And we’ve been working on this for a three and half years and we’ve met all the commitments along the way. We’ve been progressively improving our margins every quarter, and for the first two years, everybody said, you’re never going to do it. We know you’re never going to do it. When’s it going to end? You’re going to fail. And now actually, everybody’s saying, hey, this is terrific. It looks like you’re going to succeed. And you’re doing a great job and now it’s really become a part of the fabric of the company.

Do we believe that there is a greater, first of all, there won’t be an EIP-2, but there will be greater scope for efficiency gains in our business as we go forward? And now one of things that we have to do is to figure out how to balance that. How do we balance taking efficiencies that we know we can get from the business going forward and balancing that with investments in the business for top line growth? So we’d like to have that flexibility to determine that.

Do we see more scope for efficiency improvements? Yes, we do. Are we going to commit to actual margin targets in 2011 and 2012? No, we’re not. But you should know that we are not stopping our efficiency programs and looking at improving our earnings on a consistent basis going forward, because there is continued scope to do that. We haven’t signaled yet as to what balance we’re going to take in terms of top line investment.

Does that sound right? I have to make sure Adrian doesn’t yell at me after this. Yes.

Unidentified Analyst

Thanks. Firstly, the rest of the world seems to have been the strongest growth, particularly in Endoscopy. Maybe you could talk a little bit about what’s driving, or which countries, are driving those growth rates. And seeing as you mentioned China, maybe you could update us on where you are in China. And then one for Adrian, your cash flow generation looked increasingly impressive. I would guess you’re going to pay down your debt by the end of next year. What are going to do with all this cash?

Dave Illingworth

I’ll let Adrian take the second one after I handle the Endoscopy one. And maybe a little bit about China. It’s actually a little bit opposite dynamic in our Endoscopy business versus our other businesses. We’re getting more accelerated growth outside the US in the Endoscopy business and I think it purely is just the maturity of the clinical uptake and the maturity in that business, where there’s more growth to be had outside the US.

And it just happened in the US first. It became a very established clinical procedure to do arthroscopy and a lot of repair procedures in the US market and we’re seeing very, very good growth. It’s really across the board, Martin. We’re seeing very strong growth in the emerging markets within the Endoscopy business, in the 20% type range. And we’re seeing strong growth in the European markets.

Unidentified Analyst

Do you have any sense how long this sort of very strong growth in the rest of the world could continue?

Dave Illingworth

I’ll tell you it’s going to be quite a long time in China because it’s growing from an extremely low base in China and India, for instance. Yes, we’re growing really fast in China, but it’s a very, very low small base, there’s only a handful of sports medicine surgeons in China today. I mean Orthopaedics in China today is defined by trauma products. Its plates and screws and things, I mean when somebody has a problem, they go in and they put a plate and a screw in place and they fix the leg. They fix the broken bones. There’s a lot of sophistication to be had in that marketplace as it develops. So a long, long time, a long period of growth ahead of us in the emerging markets.

China itself, we’re putting a lot of effort, lot of resource and a lot of investment. We now have two manufacturing facilities there. Our wound care facility, we’ve talked about. It’s producing about 45% of our global foam products and it’s just cranking them out, millions, millions of dressings and it’s doing extremely well and it’s integrated on a global scale.

The Orthopaedic business factory is just getting started and we have to go through a phase where we have to get our products approved in the US and certified by the SFDA in China for Orthopaedics, because they’ve made some law changes over the last 12 months that we have to recertify products if we move the factory. So we’re going through that process now. So that will pay off in the next couple of years.

We took one of our top guys, who’s been responsible for the growth in the emerging markets, Kelvin Johnson, and we asked him to move to Shanghai and he’s picking up his family and moving to Shanghai. And he’ll retain his title as the President of the emerging markets, but he’s now going to be the National Executive of China. And what that means is he’ll have overarching responsibility for all of our businesses in China to give us a bigger footprint, to give us some scale to allow us better to negotiate with local officials and also to help brand ourselves in that marketplace. So lots of investments, we have an internal Board of Directors that we’ve established. I’m chairing it personally and that shows you the level of commitment that we have and, so very exciting things going on in China.

Adrian Hennah

On cash flow, Martin, yes, cash flow is good, and it is a reflection of the dealing with inventory in instruments in the field, which we’ve been talking around for some time. We do think a strong balance sheet is a good thing in this industry and so therefore, we are focused on using the cash, for now at any rate, to pay down debt. We’ll address the nice question of what we need to do when we get to net cash when we get there.

Dave Illingworth

Okay, I’m getting hand wave pretty furiously on the phone lines. I think we need to be, in a sense of fairness here, we need to take a question or two.

Unidentified Analyst

Did I understand your comments correctly to say that you’re still confident that your (inaudible)?

Dave Illingworth

Yes and that is correct.

Unidentified Analyst

And so that’s excluding BHR. I wasn’t sure if you gave a growth rate that you would sort of measure yourself against there.

Dave Illingworth

Well, no we did not give a growth rate. We did not split it up, but if you take the high performance products out of the mix, then we are growing above market growth rate in our core products.

Unidentified Analyst

I guess that market growth rate that you would say is what, 3, 4% or -

Adrian Hennah

Wasn’t in the US.

Unidentified Analyst

(inaudible) this quarter?

Dave Illingworth

Hang on a minute.

Adrian Hennah

What are you talking about, hips or knees?

Unidentified Analyst

I guess the comment I heard was sort of across your Orthopaedic products in general.

Adrian Hennah

Well, we see the Orthopaedic, if you include trauma as well, globally going at about five, in the US at about 5, if you include trauma and recon, slightly less just for recon.

Unidentified Analyst

Okay. That’s helpful. One follow-up on the 510-K process, I understand it’s been a long time coming (inaudible) and I guess on the one hand, looking at the way you launch products, and implants particular, these are long cycle launches and not really something [Technical Difficulty]

Dave Illingworth

From the lines and from, I have to be fair to Michael, so a question here.

Peter Cartwright - Fiske

Peter Cartwright at Fiske. The renewed emphasis on top line, are you signaling any change there in particular, I mean any drive for more acquisitions or is it just more products, more reps, more?

Dave Illingworth

No, we’re not signaling anything on the acquisition side at all. What we are signaling is that we’re looking to find the right balance of making investments in our business to drive the top line. We have a long history of being able to drive the top line and outperform the markets. We have been on a pathway to really focus ourselves on getting fit, more efficient, improving our margins, fixing some of the system issues that we had, getting processes and systems more institutionalized and re-engineered in our business and that’s taken a lot of management focus over the last couple of years, as we’ve talked about. I do believe we’re entering into a phase where we have to think carefully about what that right balance is.

Okay, we have time for one more question. Unfortunately, we’re little short on time today. Yes.

Unidentified Analyst

Hi. It’s Tom Jones from Berenberg Bank. Thanks for taking the last question. I just wondered if you could quickly circle back to the Endo business, and particularly US That’s obviously the weak spot within the Endo business. I just wondered if you wanted to add a little bit of color on what’s going well there, what’s going badly and what you might do better going forward.

And then secondly, just talking about the FDA’s regulation changes, is there any potential for this to actually end up being an advantage to the larger players such as yourself and the Strykers and the Zumas of this world if the regulations are going to hurt everybody. Is there some opportunity for you in it that’s going to keep some of the smaller players in the Ortho and trauma world, give them more of a headache than it will for you.

Dave Illingworth

Well, to the second question, hopefully it will. We’ll have to see. I’m not wishing any headaches on anyone from a regulatory point of view, but clearly we’re trying to make sure we’re as prepared as we possible can be. A couple of comments on Endoscopy in the US. We haven’t bee shy in signaling over the last few years that we were reducing some of our exposure and focus on the capital side of the business. So that’s been a bit of a shift for us in the US over the last few years.

The second thing is that half, about half of our business comes from resection, which is a pretty slow growth marketplace. So when we talk about what’s going on in the US. market on a blended point of view, some of our competitors are just in repair and that’s growing very, very quickly. There’s a large private competitor that is in repair only that we compete against. So we try to be fair and not selective about how we look at the marketplace.

But I think that’s part of it, is that about half of our business comes and a significant amount of our profit comes from a part of the market that’s growing kind of slowly. You add that to the maturity of the market and then you add it also to the fact that we’re trying to refocus ourself more on repair and less on the capital side of the business and I think that’s what it adds up to in terms of a growth rate. No alarm bells for us. We’re happy with what we’re doing.

We’ve also made some internal changes. I don’t want to suggest that it’s impacting our top line, but we’ve had some things that we’ve had to balance along the way, like changing out some of the distributors in our sales force. We think long term, it’s going to be very valuable for us to have as employees our own sales force. And now we have about two-thirds of our sales force that are direct employees, where two years ago, it was 100% distributors. So those are things that we haven’t talked about but you deal with along the way. So I think those are dynamics in general.

Dave Illingworth

Okay. Well, thank you very, very much. I apologize for us cutting it a little bit shorter than we normally do, but I’m sure we’ll be able to talk to most of you over the next few weeks. And I appreciate your attendance. Thank you very much.

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Source: Smith & Nephew plc Q2 2010 Earnings Call Transcript
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