Smith & Nephew Plc (NYSE:SNN)
Q4 2010 Earnings Conference Call
February 10, 2011 05:00 AM ET
John Buchanan – Chairman
Dave Illingworth – CEO
Adrian Hennah – CFO
Asthak Malik – Matrix
Matt Miksic – Piper Jaffray
Julien Dormois – Exane
Ilan Chaitowitz – Redburn Partners
Florian Gaiser – Kepler Capital Markets
Well, good morning and welcome, everybody. Before Dave and Adrian take you through the full year results, I thought, in the light of the other announcement this morning that I should say a few words. You’ve seen the announcement of the succession, CEO succession at Smith & Nephew and the announcement of Dave’s retirement. The board is very sorry to see Dave go.
Some evidence, I could go much beyond this. And that might come out with many questions you have. But this is what’s been happening under Dave’s tenure as CEO just to highlight one point, earnings per share 13% compound over the four years and we all recall this is probably the most difficult business environment and ever so been through. This is a stunning achievement and not at the expense of growth.
What Dave leaves behind, platforms from growth as for the business level, and a wider geographical footprint. Dave’s nine years at Smith & Nephew have been characterized by a customer oriented approach, and of course, aimed at creating shareholder value. You can see from those numbers the compounding of value under his tenure has been excellent. But Dave has also evolved the culture of the company, deepening the innovative skills that are so essential, and you’ll have more of that later, but also to focus on efficiency. Efficiency, not as a program but as a deeply embedded process in order to fund future growth opportunities. So, we thank Dave very much and we’ll have lots of time for celebration and wish him well for the future.
But looking to the future of Smith & Nephew, of course, we’re delighted to recruit an excellent successor from the healthcare segment, Oliver Bohuon, who has worked with GSK and more recently with Abbott in the States for a number of years, running their pharmaceutical business is an impressive health care professional. His leadership skills together with the team that Dave has created, the foundations for growth that have been established we’re very excited about.
The underlying foundations of this industry and the segments were an of course, enormously powerful, as demographic trend now expanded to the emerging markets. That, without skills set the leadership team that’s been developed and the products coming through make us really excited. So, we look forward to introducing you to Olivia in due course.
With those few remarks, let me pass it over to Dave and Adrian. Thank you.
Well thank you. I did have a little bit of a nightmare last night. I kind of woke up in the middle of night thinking that I had arrived here this morning, it was just me and the sound guy, no one else was here. So, I’m glad to – I’m glad to see that you all made it in.
First of all, you know, we’ll, obviously make a couple of comments later on, but I do want to focus on the significant achievements of this company in the last quarter and the momentum that we have going in to 2011.
I’ll go ahead and run through those and we’re going to go through the normal process and then I’m going to hand it over to Adrian to take you through the numbers and then I’ll come back and talk about our industry, our strategy and give you some details about how we’re planning on delivering on our strategy in 2011.
So, starting out with the financial –with the highlights for 2010 and Q4, 2010 was a very, very good year for us. We gained momentum in the second half of the year as we had forecasted and expected and ended with a very strong finish having generated revenues just shy of US$4 billion and that represented 4% growth for the year. Our focus on our customers and on innovation paid off leading to our out performance of the market.
Now, the fourth quarter was particularly strong for us, pretty much across the board with revenues of over $1 billion and 5% average daily sales growth. I’m going to talk a little bit about average daily sales throughout the presentation and it’s because we uniquely had a significant fewer number of sales days in the fourth quarter than we had in the previous year.
We have delivered on our commitment to strengthen our margins across our businesses as all of you are aware and we’ve done this in the toughest market conditions that we’ve experienced from many years and we’ve done it while increasing our revenues with the majority of our businesses outperforming their respective markets. And the same time we’ve made major investments in our businesses. We achieved this by developing a culture capable of using efficiency to free-up resources which then allows us, the management team, to make high quality decisions and investments for a sustainable growth.
As a result we generated a margin of 26% in the quarter and 24.5% for the year giving us the flexibility to make choices that optimize investment with return and growth. Our adjusted earnings per share were 73.6 cents, an increase of 12% and we’re proposing a final dividend of 9.82 cents which is in line with our longstanding policy, an increase of 10%. We generated of over $500 million of free cash in the year reducing our debt to just under $0.5 billion and we reorganized our banking facilities at the end of the year.
Now, let me move on to look at the business highlights for the year and starting with Orthopedics. Our knee business end of the year with phenomenal momentum, for the year our knee business outperformed the market and saw revenues grow by 5% and had an extremely strong fourth quarter with 9% growth in the U.S. and 4% globally. Our trauma business continues its steady performance and has improved consistently throughout the year.
In Endoscopy, we maintained our strong momentum while we reshaped our U.S. sales force. Emerging markets was again a very bright spot in this business, it is notable that sports medicine repair had double digit growth for the year as well.
In Advanced Wound Management we have consistently grown revenues above market and have seen our ongoing investment in negative pressure wound therapy pay-off as that business has developed momentum and made a substantial contribution to our overall growth.
In emerging markets, this is a growth engine for us. It’s seen excellent growth and we continue to invest in several high potential geographies. Overall, this year we’ve seen the benefits of having a balanced business, balanced geographically and balanced across a number of market segments. Our developing businesses are complimented by established ones giving us the ability to make choices about where to invest and this year we had a substantial program for that growth, all-in-all a real good finish to the year.
All right. Well, let me take a look at each of the businesses in turn and at this time I’m going to start with Advanced Wound Management usually starts somewhere else and we’ll start with Advanced Wound Management. This business has clearly been transformed in the last four years and continues to deliver significant value to the group.
Four years ago, this business was an issue for us, through revenues reflected it’s product range and it’s approached the customer service and its margins reflected a lack of focus on value and efficiency.
So, we made some changes, we made some management changes, we invested some money, and we focused the business on efficiency, innovation and outperforming the market.
And the management team responded brilliantly, by rejuvenating product lines, introducing new products such as Allevyn Ag and Gentle Border, entering the Negative Pressure Wound Therapy market and establishing a market presence, so that in a very short period of time, we have over 5% market share with a continued strong growth trajectory.
The investment in Negative Pressure Wound Therapy has involved the development of products, sales channels, logistics, manufacturing, legal, regulatory work. This is a major effort and a highly successful one.
We also turned our attention with the establishment of global operations, our global operations team to production efficiencies. As part of this, we closed the factory, our wound care factory in Florida and opened up our new factory in Suzhou, gaining substantial margin benefits in the process. We think that the team has done a great job and I congratulate all those involved.
So let’s look at wound care in a little bit more detail in 2010. We grow our revenues by 7% in the year nearly double our estimate of the global market growth rate, of somewhere around 4%.
In the fourth quarter, our advanced wound care business performed well, very much holding its own in tougher conditions, and when combined with the Negative Pressure Wound Therapy business grew revenues by 7% in the quarter, well above the market rate.
Negative Pressure Would Therapy had another fantastic quarter driving revenue growth in all geographies and now has a revenue run rate of over $100 million U.S and that’s from nothing, zero in 2006.
Margin performance for the quarter, and the year was substantial. And we are pleased with the margin for the year as a whole. Again, before I move on to Orthopedics, I’d just like to thank all the people on the Advanced Wound Management business who have created this great success, my thank you and my congratulations.
So, moving on to Orthopedics. In Orthopedics market conditions were pretty much as we expected and I think pretty much as all of you expected, a bit softer throughout the year, in the medium term, we do know, we do believe that demographics will continue to drive this market that we believe also that the number of patients that are waiting for procedures is still present. And we also are seeing volumes grow and strengthen.
I believe we have managed within these market conditions pretty well. We have innovated with products like VERILAST, our knee with an FDA cleared 30 year wear claim that has clear clinical evidence demonstrating its longevity and consequently patient and healthcare systems benefit.
Also VISIONAIRE, which speeds up surgery, provide better patient outcomes, takes costs out the procedure, innovation such as these have generated mixed benefits for us which have broadly offset the pricing pressure of 1% to 2%.
In the last quarter however, we saw significant volume growth in knees and also in traditional hips. While our hip business overall continued to be impacted by lower BHR volumes, our traditional hip range has continued to outperform the market.
The performance of our knee business this year has been truly great. We’ve outperformed the market in Q4 and for the year. We have some great new products, VERILAST, as I mentioned earlier, and VISIONAIRE are patient specific cutting blocks. We’ve now completed by the way over 10,000 procedures using VISIONAIRE. These two products have driven our U.S knee revenues up 7% in a year and 15% average daily sales growth in the quarter.
Against the backdrop of competitive products being withdrawn from the market and our continuing debate over medal on medal, the recent Australian data clearly shows the great long-term performance of OXINIUM. And this combined with the excellent clinical data for BHR gives us continued confidence for our hip business going forward.
And trauma, trauma has grown every quarter this year and ended the year with 10% growth in the quarter and 3% for the year. A good performance as the improved quality and tenure of the sales force delivers positive results and we approach market growth rate in that business. It’s great to see the positive results, now being consistently achieved quarter-after-quarter by the management team.
We continue to provide focus to the way we manage our inventory and instrument sets in the field, this is a longer term program and its value to the business is critical. We’ve made some good progress and we have a lot more to do, we expect to see the continued benefit of this over the next few years. As a final note Orthopedics increased its trading margin by 130 basis points in the quarter and 60 basis points for the year as it benefited from manufacturing improvements and expense controls.
Now, I’m going to go ahead and move on to Endoscopy. Our Arthroscopy segment grew by 9% in the full year and 8% average daily sales in the quarter. Capital equipment revenues have reduced to 13% of Endoscopy revenues as we continue to align our capital products with the segments that we actually are serving most aggressively in Arthroscopy.
Emerging markets has historically been a very strong performer in the Endoscopy business, and this year was no different as our investments have paid off and we finished with a particularly strong Q4, growing revenues outside the U.S. and Europe by 14 %. It was great for me personally to be at the Global Sales Meeting in Florida recently, just last month and to see the sales rep from Beijing win the Global Sales Person of the Year award for 2010. This is a clear sign of the energy and the traction that we are now getting in our emerging markets. While knee and shoulder products such as FAST-FIX and OSTEORAPTOR, fair business, double-digit growth, DYONICS RF drove resection to mid-single-digit revenue growth for the year.
Hip arthroscopy is a market that we have created, we’ve developed it and we are leading the way. We have a clear market leadership position in this segment, our revenues continue to grow strongly from a small base and are an increasing importantly of Endoscopy’s revenues. Endoscopy’s margins were 60 basis points lower for the year, a reflection of our investment in new products in our sales channels.
So, moving on how do we see 2010 as a whole, in summary against the backdrop of challenging market conditions we delivered overall revenue of growth 4% and at the same time strengthened our margins and made some pretty big investments in the year, a balance that we are quite proud of. We’ve achieved much in our revenue growth in 2010.
Advanced Wound Management has outperformed that market and negative pressure wound therapy is gaining real momentum. Reconstructive orthopedics has used innovation and clinical data to dramatically off set pricing pressure and drive real revenue growth in this business.
Trauma has grown its revenues every quarter of the year and our sports medicine business grew at 9% for the year. We’ve improved our working capital, we’ve improved our cash management. The efficiency improvements that we committed to four years ago has not only been achieved, but we’ve also made the necessary culture changes to sustain this and invest for the future.
As I change places at the podium with Adrian, I will leave you a bit of an eye chart as a backdrop with a few of our achievements in 2010.
Well, thank you Dave, and good morning ladies and gentlemen. You can turn firstly to slide 15 and the income statement. As you can see, revenue in the quarter was just over $1 billion. This represents flat underlying sales after adjusting for exchange rates on quarter four last year. There were of course four fewer sales days in quarter four this year. We estimate that average daily sales were about 5% higher than in the corresponding period.
Trading profit in the quarter was $278 million, an underlying growth of 9%. The reported trading margin of 26% was 220 basis points higher than quarter four last year. For the full year, underlying sales grew at 4% and underlying trading profit grew at 11%. Full year trading margin was 24.5%. This benefited as you know from a $25 million accounting gain in respect to the purchase of BlueSky. Adjusting for this, the full year margin was 23.9%, a 120 basis points increase. Interest costs are down on last year reflecting both the lower debt and the lower interest rate.
Turning to the next slide, slide 16, and moving further down the income statement, the tax charge for quarter four was 28.6%, giving a rate of 30.8% for the full year. The tax charge in quarter four last year was reduced to 25% and for the full year to 27.9 as a result of the favorable settlement of some tax disputes. Adjusted earnings per share in quarter four were 21.6 cents, an increase of 6% slightly lower than trading profit growth principally due to the lower tax charge last year. Adjusted earnings per share for the full year were 12% higher than in 2009.
Turning to the next slide, slide 17, and 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. As there was an unusually large difference in the number of business days year-on-year quarter in four, we’ve also shown our estimate of the growth in average daily sales in the column headed ADS on this slide. The adjustment is relatively straight forward and we also an end of businesses as fewer business days translate recently directly in the fewer procedures and fewer sales. We estimate the four fewer sales days equates to about 6% sales growth. In wound where we saw most of the wholesalers, the translation is less direct. We estimate the business growth an effective 7%, 3% higher than the reported growth.
As we mentioned in previous quarters, the Orthopedic growth rate was also reduced by 1% by the discontinuation of the spine activities. In quarter four, the value of the US dollar was similar year-on-year against the average of the currencies in which we operate.
Turning then to the next slide18, and analysis of revenue growth rates by business and by geography, as well as the numbers on this slide we will also refer to the growth rates of our main product types which are included as usual in an appendix. These numbers are not adjusted for the number of sales days and are specifically stated.
Market conditions across our businesses continued in line with our broad expectations for this stage of the cycle. We saw no major change from earlier in the year in the United States, with continued modest price pressures offset by mix and reporting the amount solid.
In Europe we experienced tightening market conditions with an increase in the impact of governmental austerity measures across the Continent. In the rest of the world we saw similar pressures earlier in the year in the more developed economies and continued buoyant demand in emerging markets.
At constant currency sales in our Orthopedics business in the quarter were down 1% on quarter four last year before the ADS adjustment. Knee sales grew at 4%, hips were 5% lower, Trauma Fixation grew at 4% and Clinical Therapies declined by 12%. Across Orthopedics, we saw price pressure in line with the previous quarter, like-for-like price reductions were steady at about 2%. We again achieved positive mix offsetting the price reductions. Adjustment for sales days, we believe this was market leading growth in knees, slightly above market growth in Trauma and market growth in hips.
We saw demand for our knees strengthen during quarter three, especially VISIONAIRE’s knee cutting blocks and VERILAST total knees in the United States. This continued through quarter four and strengthened our reconstructive growth.
Sales of our traditional hips grew at above the market rate with another strong performance from all three. But as discussed in previous quarters our total hip growth was held back by continued headwinds for our BHR products, of course by the broader discussion around metal-on-metal implants. BHR sales accounted for around 15% of our Hip sales worldwide. BHR sales continued to be strong in the larger, more specialized, higher volume hospitals and we remained very confident in our strong future for the product. Continued focus operational delivery allowed us share further study improvement in trauma.
In clinical therapies, EXOGEN continued to perform well with positive trial data driving sales in several countries. SUPARTZ continues to be under pressure.
In United States, overall Ortho sales were 1% lower an excellent performance. US reconstructive sales were up 2%. Growth in our US knee business was strong at 9% and US hip sales were 6% lower. Trauma Fixation sales in the United States were down 1%. And CT sales in the United States were down 10%, a decline of 6% excluding the impact of the small spine disposal.
In Europe, Orthopedic sales were 4% lower. We saw a solid performance in a weak European market offset by some weakness in the BHR. The exit from the spine business reduced European growth also by about 1%. In the rest of the world, Orthopedic sales grew by 3%. The positive underlying trends in the emerging markets continue and the economic compressors continue to be evident in Japan and Australia.
Sales in our Endoscopy business were flat before the ADS adjustment. arthroscopy sales, which include both repair and resection, grew strongly again at 2%. Visualization and related sales were 12% lower. This reduction is in line with our strategy to focus on capital sales more closely on equipment related to our arthroscopy activities. Visualization sales accounted in 2010 for about 13% of global Endo sales.
Sales in Endoscopy in Europe were 3% lower before the ADS adjustment. This represents a weakening from early in the year and was due to the increased economic pressures. Endo sales and the rest of the world were again strong with good growth in emerging markets.
Wound sales grew by 4% in the quarter again before ADS adjustment. We continue to see clear signs of good progress with NPWT. Total Wound sales grew 7% including ADS adjustment. And obvious, NPWT sales contributed 5%. We saw week non NPWT sales growth in Europe again due to economic pressures. In United States sales growth of 17% was boosted by an increased in the level inventory in the wholesale chain, but still represented the study underlying improvement that again by further strong NPWT growth.
Turning to the next slide, slide 19 and these shows the usual announces of trading profit by business segment. As we have already noted, the reported trading margin for the group was up 220 basis points in the quarter and by an effective BlueSky adjusted 120 basis points in the full year.
In Orthopedics margin increased by 130 basis points compared to quarter four last year and by 60 basis points in the full year and very importantly focused work is continuing to capture the significant opportunities available to improve further the efficiency of our field processes. As signaled in previous quarters, the Endo margin decreased by 190 basis points in the quarter and by 60 basis points in the full year. We have been investing in the substantial opportunities in our Endo business. And we planned to continue to do so in 2011.
In Wound, we again saw a significant 830 basis points increased in the margin. We continue to benefiting in particular from the lower costs in our China factory. And in this quarter the year on the increase also reflect heavy NPWT investment in the comparative period. For the year as a whole, the reported wound margin is increased by 280 basis points by that BlueSky adjustment which will of course not be repeated next year. Investment in NPWT, including legal costs, continued to impact the Wound margin.
Turning to the next slide, slide 20, and the cash flow statement, we had another good quarter of cash generation, with $150 million of free cash flow in the quarter. We continue to make study progress and improving the efficiency to use our inventory and instruments. Restructuring spends continued in line with guidance and now are small, as we come to end of the programs announced four years ago. We include as usual analysis of the total spend on the restructuring programs in an appendix. Net debt decreased to below $500 million in the quarter as a result of the free cash flow generation.
And then turning to next slide, slide 21 and the last slide of this part of the presentation, the outlook for the next 12 months. As you know, it is our policy not to give numerical guidance on the outlook, but to focus on revenue trends compared to the market and on efficiency and investment plans. In the Orthopedic area reconstructive and trauma together we believe that underlying global market growth was the same in quarter four as in quarter three at 2%. Within Orthopedic Reconstruction we expect to continue strong commencing in our own sales, driven by recently launched products, especially VERILAST and VISIONAIRE and by continued focus on operational performance.
We expect to go faster in the market over the next 12 months. Within Orthopedic trauma we made substantial improvements in 2010 and we are committed to sustaining this performance. Within Orthopedic Clinical Therapies we expect competitive pressures to continue. The discontinuation our spine activities reduced total Orthopedics sales growth by 1% in the quarter. We expect a similar impact in quarter one before this annualizes in quarter two of this year. Within Endo, we continue to expect to grow ahead of the market in Arthroscopy. Within Wound we continue to expect good focus with NPWT to push growth ahead of the market.
With regard to margin as already I mentioned we continue to see significant efficiency improvements especially, in especially our field based activities in our Orthopedic business. We also continue to see significant opportunities to invest the growth in new geographies and in new products and intend to take these opportunities. We also continue to see modest price pressures through this stage of the cycle as western governments deal with their large deficits and borrowing.
In the short to medium-term we expect our efficiency improvements including the impact of that modest price pressure will broadly match our additional investment. We do of course continue to expect some variation in margin quarter-on-quarter depending in particularly on the timing of investment.
I’m pleased again driven with by that 25 million credit from our Wound business rising from the acquisition of BlueSky equivalent to 60 basis points of margin will not be repeated this year. We expect amortization of acquisition intangibles to continue at about $9 million a quarter. We expect net interest cost to continue to fall as net debt declines though our new borrowing facility has a slightly higher cost than the one it replaced. We include a summary of the new facility in an appendix.
We expect other finance costs to continue at about $2 million to $3 million per quarter. We expect the tax rate for 2011 similar to 2010 at around 31% and we have as usual included in the appendices a table setting out the number of business days in each quarter and if focusing on our next quarter, please do remember that the BlueSky credit fell in quarter one last year.
And with that brief look at the outlook, I will hand back to Dave.
Okay. Thanks, Adrian. In the last few minutes before we go to Q&A, I’ll talk about our ongoing strategy and our plans for the year. In 2010, our strategy clearly drove market out-performance, improvement of our margins and helped us increase our generation of cash. At the same time, we made substantial investments as I talked about earlier including China and Negative Pressure Wound Therapy.
We now have a strong base from which to move into the next phase of growth and our consistent strategy supports that. For example, last month in Fort Lauderdale we held our Annual Leadership Conference where we bring our top 100 leaders together to talk about strategic issues for our business and we worked for two days to challenge our approach to innovation in line with our strategy in 2011.
I left that conference very excited about our people, the high level of energy in the business and our plans for 2011. I’d like to share with you just a few of the plans on the investment agenda for 2011. And I’ll start with Orthopedics, first, we are leveraging our strengths across the company, one of the examples is we’re linking our SUPARTZ marketing with the Rediscover Your Go campaign in reconstructive orthopedics giving us a broader and deeper presence in the market for knee repair.
We formed a serious of cross functional tiger teams in the business to work on new product development. And we already have a new cross-linked polyethylene product in limited launch as a result of that effort.
Our VISIONAIRE and VERILAST will continue to be the core of our efforts in the knee market as we look at options to extend some of the benefits of those technologies into our hip products as well.
Our continued focus on margin includes the rollout of lean manufacturing principles to 100% of our factories from Memphis, to Aarau, to Beijing and we have nearly finished Orthopedics head office, our brand new Orthopedics head office within Memphis to improve the services, specifically that we offer to our customers.
In Endoscopy, we have an in-house new product incubator process called InVentures and this is intended to drive a very quick process of turning customer feedback into new products, literally within 24 hours.
We’re starting the development of new products for China and other emerging markets to fuel growth in these regions. And last year we appointed a Head of Healthcare Systems, he’s now built a team that is winning contracts for all our businesses across the U.S. Our customers loved this service and we will continue to work on expanding this program in the current year.
In Advanced Wound Management, negative pressure wound therapy will be a continued area of investment for 2011 particularly as we know that less than 5% of acute wounds are treated using NPWT technology.
We are now poised to capitalize on our success in this segment and we are working on new products to meet the ongoing market demand for not only growth, but for choice.
We strengthened the emerging markets management team and we did this specifically for wound care in 2010 and this is going to help drive our growth in 2011 as well as our additional investments in Europe.
The outlook for the business is certainly strong, in terms of the market we know that healthcare systems are under pressure and in the short-term we expect market conditions to be much the same as they were in 2010. We are certainly not immune to the market factors, but we do have the products and the people to help us to continue to outperform as we did in 2010. And at the same time, we expect that demographics will continue to drive underlying demand for the foreseeable future.
The sales momentum that we generated in the second half of 2010 gives us great confidence that we will continue to grow in 2011 and beyond. Although austerity measures may affect us in some of the developed markets, this will in contrast to stronger emerging markets where we see significant growth prospects.
We do believe our continuing work with customers to identify and then meet their needs better, faster and more economically than before differentiates us and is helping us win in markets around the world.
I’m also sure that we have the right disciplines in place. And more importantly, the right people in place to deliver on our strategy. The investments that we have made in the last few quarters are paying off now. And our improvement in margin is giving us the ability to invest for the longer term. We certainly have more challenges than we expected in 2010, but the real momentum that we have and the many investment opportunities that we plan to execute on 2011 gives us confidence in our business moving forward. Our target four years ago was to create a company with a culture of efficiency, market our performance and investment for growth. I think we’ve achieved this. And I’m very excited about the opportunities and the ability Smith & Nephew now has to increase investment and growth for the future. With that John, Adrian and I will now take any questions that you have.
Asthak Malik – Matrix
Asthak Malik from Matrix. Just on the emerging markets in China growth, could you give us a favor of some of the trends that you’re saying on those volume growth, the margin to expect around that and the strategic options you have, because obviously within (inaudible) you’ve made some great decisions in getting into China, but how does that impact strategy on Endoscopy and Orthopedics in wake of this market grow to.
That’s a great question. I think you have to understand what our strategy, again I’ll remind you, you have to understand what our strategy is in China; the first, it’s a multi-phase strategy. The first phase is getting our presence with a significant enough critical mass that we start learning the capabilities, that we get people on the ground, that we start understanding what the market forces are. Because it’s not good enough, and it’s sustainable to take products that are built in Boston and Memphis and Hall and ship them to India or China or any other market in the world and expect those products to be relevant. It just isn’t going to happen. So the first step of our strategy was to use manufacturing, use our desire to get lower cost of goods. We didn’t go to the lowest manufacturing cost site in the world, we went to a lower cost site in China.
We have two factories now in China. The wound care business is producing tens of millions of products a year, and they are all being exported out of China. It’s not a market penetration strategy. Today it’s purely a way for us to lower our cost of goods. But with some factory in China comes, you then have to hire people to run that factory. Then all of a sudden you start hiring the engineers and then sustaining engineers. And then before you know you start making relationships with the local officials. And then you get involved with the folks who are setting policy for expansion of healthcare in these many cities around China. And the next phase that we are in right now is how do we start developing the right kind of localized products for sale into China. And then we’ll have the critical mass in the organization to really capitalize on it. It’s very, and it’s, I think it’s a very sustainable strategy.
We’re doing the same exact thing in Orthopedics. We have a factory in Beijing. And we will start by making some lower cost instrument sets, some lower cost of goods products that we’ll be shipping all over the world, there will be a factory just like any other factory we have in our system, and then we’ll quickly move on to making sure that we have the people on the ground waking up every day reading the Asian Wall Street Journal, not the New York Wall Street Journal or the London Wall Street Journal or their Financial Times, but reading the local newspapers and being involved with the local issues so that we can capitalize on that market. I know that’s a very long answer, but it’s a very, very important strategy. And I think it really truly differentiates us from what the competitors do. The competitors go over and try to figure out how can they sell – most companies go to these countries and figure out how can they most affectively sell what they already are selling somewhere else in a developed part of the world. And the needs are completely different. So that’s our strategy. And I think it’s going to work brilliantly. Yes, Michael?
I have two questions, one is for the Chairman, one is for Adrian. For the Chairman, can you talk a little bit about the selection process that you went through for the new CO, when did it start, are you looking more for a strategic or for an operational person. And also what importance does the background of this year have being in Pharma rather than medical devices. That would be the question for you. And then for Adrian, in terms of your margin outlook, when you say that some of the investment opportunities maybe offset by further efficiencies, should we be thinking about the margins in 2011 being sort of similar to 2010, or should we still expect some sort of margin improvement?
Well, Michael, let me start the process of selection over a period of months defining as you correctly point out the need. And of course, it’s an end and end approach the wish list, walking on water is an optional extra. But you don’t always get that. But we wanted the global plan of stature in healthcare industry, someone who’d achieved, not just a good salesman, someone of who demonstrated in various parts of the world. And like Dave Liviai (ph) has performed in Maryland, here in the States and significant achievements in the developing parts of the world. A healthcare professional, the leadership means rational skills as important as a secret knowledge, we believe.
So the Pharma, who were probably leading us in terms of the environment we are finding ourselves in day-to-day increasing regulations et cetera, et cetera, I think will be good to Smith & Nephew. At the next level of course for Tine Davis for instance absolutely infused in medical devices technology. That’s right in the genes. So you want someone who can pull that leadership team together, someone who can operate at the strategic level, and also bring other things – marketing, operations and so on. So we were very fortunate, and not only really names of course, to have had an excellent short list. And Liviai (Ph) stood out even above the others. So, I hope that answers your question.
That was one ridiculous, the margins Michael. As you know we don’t give numerical guidance and you are not the one that with us – the reason Michael. The elements to the guidance, I shall repeat, we do see and that each element is important. We do see significant further improvements, potential for efficiency improvements is that they know end it well, we are very committed to getting those. We also see significant opportunities for investment, we are also very committed to taking them – we broadly think that’ll be equal. Therefore, we’ll be flat broadly.
Great. We’ll take two questions from the phone lines then.
Thank you, sir. Our first question is from Matt Miksic from Piper Jaffray. Please go ahead.
Matt Miksic – Piper Jaffray
Hi, good morning. Thanks for taking my questions.
Matt Miksic – Piper Jaffray
One, follow up Dave on pricing. That seems like some of your peers in Orthopedics has charted out sequentially softening price environment in Q4, something that – it’s how that you are seeing something more stable, is just to be clear as (inaudible) 2% independent of mix like-for-like or why is it that you think that you might be saying it’s something that’s maybe better than some of your competitors?
Well, we can’t speak to the competitors, but just to clarify what we said, yes, we said in the Orthopedics space we’ve seen broadly comes from pricing pressure if you take it together on the world, around minus 2%, and we’ve seen this pretty much offset by mix.
Matt Miksic – Piper Jaffray
So 2% or roughly a similar kind of number for mix?
Matt Miksic – Piper Jaffray
Okay. And then, a follow up on these very lines, wondering if you could talk about maybe what some of the impact of the direct consumer was in the fourth quarter, if you inspire that again, and then just in general, understanding there it’s a differentiate technology, face a little bit of a higher, it’s a little bit of a higher cost technology. How they could just be, I guess, in these available part of business could that be?
Good question. Let me try to take a shot at it. Let me first comment on the director to consumer because I can’t give you an absolutely definitive answer, because we don’t know what the answer is. We’re making some – we’re drawing some conclusions based upon the results that we’re seeing. Clearly we believe that their direct to consumer campaign is paying off for us in these. But I also remind you Michael, that we’ve been interrupting in direct to consumer for quite a while kind of off and on and we’ve been somewhat skeptical about how much impact that would actually have. I think the difference this time, at least the assumption we’re making and the conclusion that we’re drawing is that the difference this time is that, it’s not just direct to consumer advertising for the sake of getting our name out, but it really, truly is a product and a feature and a benefit to the customers that’s meaningful.
I mean, this FDA wear claim of 30 years is creating a real buzz in the marketplace, people are talking about it, clearly, I think the younger more active patient who is could not enough decision making is getting their attention and we can’t quantify for you, we just can’t, we don’t have, we just don’t have the visibility, actually what’s driving what here. But, we’re drawing some conclusions and we think that given the clear differentiation in the products that the direct to consumers is probably having an accelerator effect on our success.
So, we’re going to continue to test that theory and we’ll continue to have some very focused marketing campaigns with direct to consumer advertising both with VERILAST and some of the potentially other highly differentiated products that Smith & Nephew has.
I think the custom to spoke implants and instruments sets are the way the future, I mean, if you think about what we, what we are struggling with right now is a company in terms of how we run our business. We have lots of inventory out there in the field in order to support lots of different types of surgery and lots of different models and types of implants and if you saw a surgical sweep, if you are fortune enough to be able to witness what’s goes on in the surgical theater and surgical sweep, you have seen multiple instrument sets that are worth hundreds or thousands of dollars. You would see multiple implants because the surgeon doesn’t really quite know exactly what they’re going to need at any given time.
And we consign all of that, all of that inventory, whether it would be the implants or the instruments sets and the entire industry has set that, set that as a way of working. If we could get to the point where we can take an image for a joint replacement for instance and we can send out an instrument set and implant that is going to fit perfect. I think it could dramatically improve the efficiency of how we deliver these products to our customers.
So, I’m pretty excited about it, and I think that real need will drive the adoption of this in the future and you’re seeing it now with something as simple as cutting box with VISIONAIRE.
Thanks for your color on VISIONAIRE is actually looking healthy, maybe VERILAST could be, I’m sorry.
Unidentified Company Representative
I mean VERILAST could be. Well, I think it’s still a, I think it still has to be a plug in the right place at the right time. I mean it is a more expensive technology. Clearly, there is some cost benefit tradeoffs that people have to be considered it out and I think that is happening in today’s healthcare world. So, it’s not going to completely take over our sales in these. But, I believe that if you’re a high demand younger more active patient, it’s going to be pretty meaningful for you to consider this technology.
Matt Miksic – Piper Jaffray
Thanks so much.
John Buchanan There you bet Mike, one more question from the phones?
Thank you. We’re moving to Julien Dormois from Exane. Please go ahead.
Julien Dormois – Exane
Hi, good morning guys. Two quick questions if I may, the first one would be on the SG&A cost in Q4 that were released low in terms of percentage of sales. So how did you plan to evolve around that in the next two years? And the second one is about the US cash will be virtually debt to – cash positive somewhere in 2011. What are your plans for using the substantial cash generation you are forecasting for next two years?
afraid I didn’t understand that first question.
The first was the SG&A cost in Q4 as a percent of sales, do you have anything to comment on?
No there was nothing unusual in that, it was perfectly straightforward in evaluation from previous quarters and that was no unusual releases or extra cuts in SG&A in quarter four. In terms of the use of cash, yeah, I think the important consideration as the Blue considers borrowing and the use of cash is that. We are fundamentally in a growth industry and we believe that a strong balance sheet is an important thing for a successful player to have in this industry. And so we wish that we have a strong balance sheet, we still got half a billion borrowing which is more borrowing in most of peers. So, as at the moment, our use of cash is very much focused on paying that debt down. And clearly if we get to the point when we have significant net cash flow, we will look it again at the moment. Our focus is on paying that debt down and make sure we have a strong balance sheet so that we can – over the next medium term period of time use that cash sensibly for shareholders.
Julien Dormois – Exane
Okay, thank you.
Okay, you there?
Thank you very much, I have two questions, the first question on the customized technologies that you are rolling out, can you comment on how that would change the barriers to entry to your Orthopedic markets? And then secondly in terms of your, the new products that you are going to launch, you usually have a slide showing what your key product launches will be in the coming year, can you comment on, what are the key things we should be focusing on for you there? Thank you.
Okay, well a couple of good, but tough questions, let me take the second one first. The reason why we haven’t put that slide in there is because next week is the AAOS most of you would be at the large Orthopedics convention in San Diego would be my guess and we will be show casing new products at that meeting. So, we typically at this final year we don’t talk too much about new products because we will be doing it 24 hours a day starting on Monday. In terms of the, it’s an interesting questions about barriers to entry I’m not sure that I can give you a really good answer but I would invite Adrian to supplement my comments here. I think it’s probably is going to be about the same, I think there is pretty hard barriers to entry today and the industries that we are in and that’s one of the reasons why you see almost 95% of the market is with the top 5 companies in the space, it’s quite concentrated it has very high cost associated with it and the cost are not just the inventory cost than of having instruments out the field. But it’s also of having the high touch service levels, that we have with our customers and I think that those high touch levels are going to continue for the foreseeable future. You could make an argument that if the custom implants works extremely well, that you might not need some of that high touch in the operating period and I think we are just going to have to wait and see how that evolves. But my – if I was going to take, if I was going to place it that right now I would bet that the barriers to entry is going to remain pretty high for the foreseeable future.
Yeah maybe there is one thing Dave, as we discussed this in the company most of the aspects industry do not change fundamentally because of direct to patient. The one area is potentially slightly different is how capital intensive it is because a large amount of the capital is deployed in the field and if you need less capitalized potentially a reduction of barrier that we see the use of capital is being a very small element of total barrier to entry, however it might shift the balance between smaller players and bigger players which is something we would look favorably upon the cause.
I think the other thing we have to consider is that just because we have custom implants I don’t think that there are going to be fundamentally, there are not going to be – not every implants could be unique, there is a strong consideration for quality and longevity and ware and all of these things that go into any kind of customizations are going to impact that and I believe that the Healthcare Community certainly our surgeons and the patients are going to and want to make sure that there is an assurance that we can be predictive about the quality and how well these implants are going to actually perform and where. I’m just giving Hennah a word out there, just opposite into the room.
Thank you very much (inaudible) continue distress the dramatic driver for demand, yeah with these low volumes, do this mean that there is huge inventory of the patients for knees and hips and is it rising and what are the trends there?
I think so, I think that I mean, we have been saying this for some time now, I don’t think that because of an economic recession that, an economic recession cure for arthritis, I just don’t believe it. I think that if you had osteoarthritis before the recession you probably have it now. And I think what happens is that the earlier stage that you have the issue and maybe the younger that you are, you might make choices about delaying the procedure. And I think that’s what going on, and I think it is linked to consumer confidence. I believe we’re starting to see some of that rebound, I don’t think it’s in a huge way at, I think we’re still are working through this, but I think those volumes are out there Peter, I do believe that.
Yes, that was three. I am sorry.
Thank you. First of all, Dave congratulations and wish you all the best. Just two quick questions back in one for Adrian on NPWT and wound specific, wound in general. Can you give us a sense in terms of the significant margin that improvement that we’ve seen in the fourth quarter? How much has come from manufacturing versus other parts of the business whether it’s the legal cost declining or you’re getting better efficiencies out of your sales force. And then for you Dave just one final time pricing in Europe austerity that a bit of a change from your part, how are you thinking about 2011 and what about your discussions with governments and experiences has been in Europe so far this year. Thank you.
I mean, clearly it was a very substantial increase in margin and wound in the quarter, both were significant and manufacturing has been consistent throughout the year, you’ve got the sense of that on the move, ongoing stuff if you look through the whole year. There was a bump from the fact that we had very significant NPWT investment in quarter for last year.
I think on pricing look, it’s no secret the pricing in Europe has been tough. It’s been under quite a bit of pressure. The thing that we had going forward that we worked very hard to achieve is not because we’re just lucky, is this balance, is this geographic balance and the balance within our businesses. I mean we have, we’re seeing some real mix up left with some very unique products that’s getting us some price in some areas and in markets like Europe we’re seeing continued price pressure. We’re seeing very good success and high growth rates in areas like China and India, and other developing parts of the world. So, we worked hard at having a balance business and balance portfolio businesses and geographies and it’s working out for us. I think we’re going to continue to see pressure in Europe on pricing and I think it’s going to work itself out in the next quarter. I think we’ll continue to deal with it, but we’ve been managing it pretty well.
Okay. We’ll go back to the phones. We have –
Thank you. We’re moving to the Ilan Chaitowitz from Redburn Partners. Please go ahead.
Ilan Chaitowitz – Redburn Partners
Good morning. Thanks for taking the questions. It’s Ilan Chaitowitz from Redburn Partners. Just a couple of housekeeping questions I guess, could you maybe go back to last question. Could you give us a split out of the legal costs that you incurred in Q4 and 2010 for the full year just to give us some sort of idea what the impact of that was and how you might see that playing out in 2011? Second question relates to BHR and what the quarter-on-quarter trajectory is in the US, just trying to get a feel for how the pressure is playing out on metal-on-metal and if you are seeing that consistent or improving or worsening versus Q3? And the final question is just on the receivables could you just talk about why those ticked up in Q4 if there is any particular reason for that?
How you want to take, you want to split it up?
Well, let me take the BHR first, I think we are certainly working through the weakness in the BHR product, I think it’s been multi-factorial and its genesis in nature, I think, clearly there has been some pricing pressure. The fact that we are, I won’t say we are the only resurfacing competitor in the US, we are the one with the most credible position and we have the vast majority of the market share. And I have always said and I think I have said to this group that I wish we had more competitors for this product because we are sitting here with 12% market share and yes so that means 88% of the market is trying to discredit our BHR product because we are quite unique. But the fact of the matter and it has been exacerbated by the fact that a couple of our competitors, very large competitors and credible competitors have withdrawn their metal-on-metal offerings from the market place. And it’s created this swirl of controversy around metal ions in particular, this issue about metal ions in the production of metal ions is really nothing new. What is clear is that unless you have the right product design and the right metallurgy, then you potentially could have issues. We have had this product on the market for a very long period of time, over a decade with over 100,000 procedures being done. We have well documented registry data that shows the survivability of this product. And right now what we are doing in BHR is re-educating and remarketing these products to make sure that the facts get out that metal-on-metal does not equate to the BHR and the resurfacing product that Smith & Nephew has. But, these issues are product specific, not technology specific. And that we feel very, very strong about it and that has been a little bit of an uphill climb for us, and it has not been an easy thing to do, but we are committed to it. We think it is a great technology, and we will continue to stand by it. So, I think we’re working through most of those issues as we speak. So with that, I’ll let you talk about the link for clause receivable.
We’re not going to give a figure for the legal cost for a whole variety of reasons and they have been substantial, there’s no question about that. And as for what they’ll be going forward, I guess you could probably ask KCI (ph) that question, but you can ask us since we tend to be the defensive side of most of that legal cost, not the offensive side. But, clearly has been a lesson intensity about legal action, but essentially it’s driven by them, not by us.
And all the receivables – Yes, you’re quite right, quarter four did see a little bit of a tick up from the video of two components. One of them is just is open left, you do get quarterly variation. But, that is an underlying slight pickup, not un-associated within the European pressure, because most of the pickup is across Europe. And not alarming from our point of view in a sense of recoverability, but it’s another manifestation of European governments being under pressure.
Thank you. Can I just push back on the BHR trend macho? My question was more about what was going on in Q4 versus Q3?
Yeah. I’ll just yes – more numerically on quarter four that clearly was around the time of AOS last year, when the metal-on-metal debate took us to a job was a catalyst for a lot of metal-on-metal products have a bit of a hit so – and our product, our BHR was an exception there. So, we’re all getting on to be a year away from that. So, you might expect some sort of lessening of the decline.
That’s certainly consistently with what we see. But it wasn’t just an AOS. It was a more protracted impact than that. So you shouldn’t expect a keen annualization, but you should expect some – because of our confidence in our product, which is firmly based on what we see in the marketplace, you should translate that gradually into numbers.
Right, has demands of BHR improved in Q4 2010 versus Q3 2010?
We’re not going to go into quarter-on-quarter changes in that granular way.
Okay. Thank you.
How we’re doing Phil. One more question? Okay, there’s likely one.
Ladies and gentlemen Florian Gaiser of Kepler Capital Markets.
Florian Gaiser – Kepler Capital Markets
Thank you for taking my question. It was a good question that’s been asked previously, the question is in hips. You make a lot of progress in these with good clinical data and good product. What do you think it takes in hips to have a signal revival and also from R&D strategy point of view? And secondly, you mentioned, adjacent technology has grown stratus going forward, if you could comment on that, please?
Well, I think actually we’re seeing it in hips. I mean, we’re growing our hip business, overall hip business at market growth rates with still a bit of a drag from the metal-on-metal controversy that’s impacting our BHR. If you look at our core hips, we’re outgrowing in the market. So we feel pretty damn good about it. So, I think you’re seeing it now and as we work through some of those other controversy on BHR, I think it will have an uplift effect on it. So we’re claiming victory in that regard. In terms of the adjacencies – I’m not sure pretty, I understood –
I’m not sure I understand the question. Can you help me understand the adjacencies?
Florian Gaiser – Kepler Capital Markets
You mentioned that the investing for growth in slide 23 adjacent technologies. What did you mean by that?
Well, I think that what we were referring to there is a for instance, in our Endoscopy business – we’re taking the technology that we have and investing in the gynecology market for instance. And that market has, that business has grown about 40% for us in 2010. Now from a very small base, but we really see some great opportunities. Hip arthroscopy is another area, I mean, that’s a joint that was never addressed in terms of our arthroscopic repair because it was so hard to access. And we worked with surgeons in the field and essentially created devices that allowed us to get better access that we could do these arthroscopic procedures and that adjacent space that anatomical adjacency is beginning to take off. We also look at other technology adjacencies along the way, but we’re not ready to really talk about those, some of the more, the more common adjacencies might be spine, like the dental things that have technology similarities across the businesses that we might be able to leverage as we go forward. So, that’s what we are referring to.
Okay, well look, I think that’s all we have time for and we’re on an extremely short schedule. I would like to thank all of you for being so kind. This has been without doubt, the most fun phase in my life working for this company and a big piece of that is because of all the relationships, the folks in this room and that are on the telephone lines. So, I thank you very much for that, it’s been terrific and this company has got a great future and be around for few more months and I look forward to talking with all of you.
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