Smith & Nephew plc (NYSE:SNN)
Q2 2011 Earnings Call
August 05, 2011 4:00 am ET
Olivier Bohuon - Chief Executive officer, Director and Chairman of Disclosures Committee
Adrian Hennah - Chief Financial Officer, Executive Director, Member of Disclosures Committee and Member of Risk Committee
Martin Wales - UBS Investment Bank
Navid Malik - Matrix Group Limited
Thomas Jones - Berenberg Bank
Justin Smith - MF Global UK Limited
Ingeborg Øie - Jefferies & Company, Inc.
David Adlington - JP Morgan Chase & Co
Unknown Analyst -
Okay, good morning. So I'm Olivier Bohuon. I'm the Chief Executive Officer of Smith & Nephew and I welcome you to our presentation of the second quarter results 2011. I will speak about our achievements for the second quarter and then to Adrian for the Q2 numbers. When Adrian is finished, I will come back and discuss my observations in finance about Smith & Nephew, our industry for my first months here. So I'll then talk about the changes I intend to make to better focus our resources to deliver value for our customers and for our shareholders. As usual, we'll take questions at the end of the formal presentation.
So despite the difficult environment, we've had another strong quarter of revenue growth. Overall, our revenues were up and underlying 5% to just over $1 billion. It's another good performance as our market conditions remain soft. Once again, Orthopaedic Reconstruction generative revenue growth at above the market rate. The highlight remains our U.S. franchise, which grew 10%, compared to the U.S. market gross of minus 3%. Stromile [ph] is now consistently delivering the good growth going forward. We'll now be challenging the team to beat it from here. Endoscopy grew 5%.
In the U.S., our gross rate was higher than for some quarters. Within Europe, we're now seeing the impact of austerity measures more clearly in our numbers. Despite the difficult environment in Europe, Advanced Wound Management was our fastest-growing business. Our growth continues at above the market trade in the large part due to our negative pressure when therapy product range, which will continue to expand. The trade profit margin was 21.9%, and Adrian will talk to you through the details behind this, including some nonrecurring factors.
Adjusted earnings per share were $0.181, an increase of 6% benefiting from the weak U.S. dollar. We're declaring an interim dividend of $0.066, which is an increase of 10% and in line with our long-standing policy. Our cash generation continues to be strong, and we have now net debt of $346 million. As I would explain later in the presentation, we are reorganizing our internal structure. For the moment, we'll continue reporting our segment figures as we have had in the past.
Turning to look at performance of each business in turn. First, the Orthopaedic business. Again, revenues in the quarter were up 4% on Q2 last year and we achieved growth in all our geographic regions. Market conditions in orthopaedic were consistent with those we saw in the first quarter. Volumes remain subdued due to pressures from macroeconomic background. Against this market background, our trading performance is good. And Adrian will give you more specific details on the impact of price and mix.
Orthopaedic Reconstruction continues to grow at above market rates driven by our global knee franchise which grew at 7%. In particular, we grew knees by 10% in the U.S. Here, our portfolio of VERILAST VNA [ph] surface, VISIONAIRE knee calling [ph] blocks, and our long-established LEGION primary knee system is proving to be a winning combination with surgeons. We continue to reinforce this message with patients who target direct-to-consumer advertising in the U.S. For instance, we have been running TV adverts between [indiscernible] with our Smith & Nephew spokesperson. She had a successful double knee replacement last year.
Globally, sales were flat. The mid-level headwinds remain and it's holding back sales at our BIRMINGHAM HIP system. Excluding this, our traditional hips continue to grow at above the market rate. We had another good performance from the R3 cap system. In Europe we're experiencing new interest in sales of our product with [indiscernible] hip system. Finally, we have now extended the very last brand that we have been discussing marketing our knee range to our hip diagnostics [ph].
It was a good quarter. We believe our Trauma business has now established consistent traffic chord and which we can do further. We extended our SURESHOT range by adding femural [ph] nails to the existing TDO [ph] system. In clinical therapy, we grew 6% where [indiscernible] again achieved a double digit-growth rate.
Turning to the Endoscopy business. Sales in this business grew by 5%. Beyond, this was an improved performance from our U.S. sales team in a weaker Europe. We have now launched the products we highlighted Q1 and are receiving positive feedback from surgeons. For example, we launched a BIORAPTOR care of suture [ph] for shoulder instability and a range of blades designed to provide secure reception and sharpness [indiscernible] dynamics. These contributed to a solid Arthroscopy performance with continued high growth in Sports Medicine repair.
Shoulder and Hip sales again led with very strong growth, and we expect to increase some new knee products later this year, which will naturally benefit from this franchise. [indiscernible] down as we continue our strategy of focusing on the special items, most closely tied to our Sports Medicine business. In June, we acquired Tenet Medical Engineering [ph] for an initial payment of $35 million. Tenet [ph] market's leading-edge patient positioning systems. Smith & Nephew has been long-standing distributor of Tenet [ph] and this system complementary to our Sports Medicine business.
So turning to Advanced Wound Management. The Advanced Wound Management business grew revenue by 8% in the quarter much above the market rate of 3%. The market continued to be tough, particularly in Europe, where we had a strong market share. This is most noticeable in key elements of Advanced Wound care such as formal dressing. We are also seeing hospital reducing their use of products, which combat inflation, such as silver to help mitigate short-term budgetary constraints.
To meet these austerity pressures, we are making a series of target marketing investment. We launched several new products in the quarter, including ALLEVYN Gentle Border multi-site. Against background, we deliver a redeeming performance supported by with strong growth in the Negative Pressure Wound Therapy. The high point of the period for me was the launch of the new generation of Negative Pressure Wound Therapy, PICO [ph]. I attended -- this was the old one, this is the new one, you see? Very good one. I will show it later. I attended the European launch in May and I will talk to you about my sightings later on today. So with that, I will hand over to Adrian and will come back later to talk to you about the strategy.
Thank you, Olivier, and good morning, ladies and gentlemen. If you can turn firstly to Slide -- I think it's 9. Yes, 9, and the income statement. Revenue in the quarter was $1.077 billion. As Olivier mentioned, this represents 5% underlying sales growth after adjusting for exchange rates on quarter 2 last year. We had one fewer sales to end quarter 2 this year. And last year, growth in average daily sales was therefore about 1% higher.
Trading profit in the quarter was $236 million, an underlying reduction of 3%. Reported trading margin of 21.9% was 160 basis points lower than quarter 2 last year. This margin was slightly lower than we had expected. The main drivers of this reduction were in cost of sales, to principally to a somewhat higher growth in lower margin sales than we had expected and to the normal quarter-by-quarter variation in SG&A spend with a small bunch in the regular greater expenditures.
This quarterly falling margin does not impact our intention to deliver a broadly constant margin in medium term at around 24%. You'll hear from Olivier in a few moments about the sharpening of our focus both on growth areas and on achieving significant available efficiencies to fuel that growth. Interest costs are down on last year, mainly reflecting our lower debt.
Moving to the next slide, Slide 10, and moving further down the income statement. The tax rate for quarter 2 is 30.8%. The rate we continue to expect for the full year is 60 basis points lower than quarter 2 last year. EPSA in quarter 2 were $0.181, an increase of 5.8%. This is higher than the trading profit growth, principally due to the weaker dollar.
Turning to the next slide, Slide 11, and an analysis of revenue by business segment. The impact of currency was quite material in the quarter. In quarter 2, the value of the U.S. dollar was 7% weaker year-on-year against the average of the currencies in which we operate. The effect in our Wound business was slightly larger due to its higher proportion of non-dollar, especially euro sales. If current exchange rates would remain the same until the end of the year, we estimate that this will increase reported full year sales and trading profit growth by 5%.
Turning to the next slide, Slide 12, and an analysis of revenue growth rates by business and by geography. Market conditions have, as we expected, remained challenging. Across our businesses, we saw price pressure increase slightly in the quarter. In our Orthopaedic business, we saw a like-for-like price reduction of around 2%. This was again substantially offset by mix gains. In our Wound business, we saw similar price pressure. In our Endo business, we saw slightly less price pressure. At the top line, we were able to offset much of the price pressure with mix gains.
In the United States we saw a slight increase in price pressure and a continued strong performance from sales mix with VERILAST, VISIONAIRE, and our NPWT range continuing to perform very strongly. In Europe, we saw some further tightening to market conditions across all of our businesses and across most of the continent. In the rest of the world, we saw similar market pressures for the last 3 quarters in the more developed economies. Our rest of the world region includes, as you know, Japan, Australasia and Canada, as well as the emerging markets. Emerging markets continue to grow strongly especially again in China and India.
Within Endoscopy, Olivier mentioned the small Tenet acquisition. This is a Canadian company, which makes patient positioning systems, which we have sold on a near-exclusive basis for some years. As we have been selling almost all of their output, there'll be no material increase in sales as a result of the acquisition. There will be a small increase in profit commensurate with the purchase price. In addition to the $35 million upfront payments, there are further payments. A first payment of $2.5 million deferred for 18 months and then up to $14.5 million dependent on future revenue milestones.
In our Wound business, sales grew by 8% in the quarter, again well above the market rate. The sales growth in the United States of 14% was increased slightly by wholesale inventory sales -- excuse me, wholesale inventory level fluctuation but reflects mainly excellent growth in Negative Pressure Wound Therapy sales. Wound growth in the rest of the world of 14% was increased slightly by a change to our distribution arrangements in Canada. Worldwide NPT sales again grew strongly in the quarter and contributed half or 4% of the total Wound growth of 8%.
Turning to the next slide, Slide 13. This shows the usual analysis of trading profit by business segment. As mentioned earlier, trading margin in the quarter decreased by 160 basis points, a little below our expectation. While margin actually increased in Wound by 160 basis points as we continue to drive efficiency, and as NPWT sales continue to grow strongly. Margin decreased in Ortho by 260 basis points and it ended by 230 basis points.
In Ortho, in contrast to sales where mix was strong, gross margin has been decreased by mix pressures. More of our growth than we expected has been driven by products or geographies where we currently achieve lower margins. Emerging market sales including in Eastern Europe grew strongly. And within U.S.A., although sales of premium products specially VERILAST and VISIONAIRE are driving top line growth. They are slightly dilutive to group margin. SG&A spend was also a little higher than we had planned due to a number of small issues, including a loss in Greek bonds which we'll describe more fully in a moment and some of above plan costs on the program to improve the productivity of our inventory and instrument deployment.
In Endoscopy, margin was impacted by the planned investment in R&D capabilities focused on the many opportunities in minimally invasive joint pet surgery. Expenditure in quarter 1 in this area was a little lower than we expected and in quarter 2, a little higher. And in quarter 2, this was accentuated by the weakness in Endo European sales. We've added a column on the right which deducts for the half year the $25 million BlueSky credit from last year's Wound and Group margin. As you can see from this adjustment, the reported trading margin for the group was down 70 basis points in the half on half 1 last year.
Turning next to Slide 14 and the cash flow statement. We had another good quarter of cash generation with $136 million of free cash flow in the quarter. Our trading cash conversion rate was strong at 103%. We continue to make steady progress in improving efficiency with which we used our inventory and instruments. Cash also benefited by $20 million from the sale of some Greek bonds. We had received these bonds from effectively mandatory conversions of trade receivables. We have a further $22 million of Greek debt, some of which the government has stated it will convert into bonds. We have a 28% average provision against this remaining Greek debt, and we incurred a loss of $4 million in the period on this Greek debt.
Lastly, in this part of the presentation, turning to Slide 15, and the outlook. Our revenue outlook for the full year is unchanged from last quarter and indeed from when we presented our full year numbers in February. Our medium-term margin outlook also remains unchanged. We'll hear from Olivier in a moment more detail around our priorities for the coming quarters and years. We see significant opportunities for organic growth and we will invest to take these opportunities. We also see significant opportunities for efficiency improvement, and we will take us opportunities too. And we expect to continue to need to deal with the modest price pressures for a while.
Netting these our broadly constant margin of around 24% of over the medium term remains our intent. In 2011, we expect our planned investments, including some modest costs associated with the organizational changes, and the slightly adverse gross margin mixed trend in Ortho to exceed slightly our efficiency improvements.
Finally, a couple of more technical comments on future segmental reporting in the light of the changes in the organizational arrangements that we will be making. Firstly, we do not plan to make any changes in reporting until next year. Secondly, we will continue to provide the same level of visibility on Endo and Ortho top line, as we do now, as well as an increased focus on emerging markets. And thirdly, we plan to provide with our Q4 numbers historic material to allow you to re-base your own analyses.
And on that rather technical note, I'll hand back to Olivier for a rather broader picture.
Okay. Well, Adrian, thank you. I would now like to talk to you as to my observations and findings about Smith & Nephew and our industry. Whenever a company gets a new CEO, there's a lot of speculations about what is going to change, what does he want to do, what could change the strategy. I do believe, I do not believe in change for change's sake. When I make changes is because we see our anticipated changes in our environment, customer, markets, competitions and we need to address this to be successful.
However, I come here as a fresh pair of eyes. As people keep pointing out of me, I am the first non-internal CEO appointed in Smith & Nephew, in Smith & Nephew's 150 years of history. And certainly the first French one. No doubt a challenge. That means I can bring all my experience to this great company without any preconceived ideas. Much were still the same, the values, performance, innovation, trust, the customer focus, the need for innovation, importance of quality people. But what is clear is that we are operating in an increasingly changing environment and we have accepted this, and we are adapting to it. Over the next few slides, I'm going to take you to all those things and what I've seen at Smith & Nephew and [indiscernible] the challenges we face and the ambitious agenda I setting to Smith & Nephew's future direction.
So as confirmed in my first month at Smith & Nephew, well, the IR visit time. As you may expect, I've been in visiting all the largest site in the U.K., in the U.S., in Europe, in Asia. And I've met all the senior management team and many of the employees around the globe to discuss the markets, to discuss the plans. I've met with many of the customers to hear their needs, and I've seen the R&D teams to understand our innovation pipeline. I've asked a lot of questions. I've challenged the answers.
Smith & Nephew is a great company. I tell you, I've been very impressed. The last 4 years have been tough. I mean, the economic climate has been difficult, and Smith & Nephew has weathered it well. It is consistently growing revenues, often outperforming its market segment. We have significantly improved the operating margin and it has transformed its [indiscernible] management business as you have seen earlier today.
The business is very healthy, something clearly demonstrated by the strong cash generation. It has maintained investment in R&D. Innovations continues to bear results, which operate as our VERILAST, VISIONAIRE, Negative Pressure Wound Therapy, to name a few. The pressure is a strong one. In many organizations, customer service is just a label rather than a behavior. It is not the case at Smith & Nephew. But the businesses are focused on the individual customer needs and have deep relationship.
Finally, the group is well diversified. By this, I mean, it has a broad range of businesses providing plenty of growth opportunities. It is geographically diversified with strong positions in established market of U.S., Europe, Japan and so on, and Smith & Nephew has some presence in the largest emerging markets of China and, to a much lesser extent, to India. It also has a balance of franchises which contribute to the consistency of the overall financial results.
In summary, there's plenty to be proud of and plenty to be a bit optimistic about. But we have challenges. The market dynamic are evolving. Over the last 10 years, there have been trend to market consolidation. We are now competing with larger peers with higher share of voice across multiple product lines. Some of the recent changes in the market, I'm convinced, are cyclical in nature. For example, the low volume growth for hip and knee procedure in the U.S. or the lower use of antimicrobial head dressings in Europe, these are cyclical and they're not structural. However, some are however structural.
Price pressure is here to stay. It's just simple economics. Health Care providers have less resources to deliver the ever increasing demands from patients. The outcomes of products, the actual outcomes over long term across multiple studies are becoming even more important not just clinical outcome but cost saving as well. And I'm not sure that this industry has worked a lot on than these.
Finally, by and large, growth in the mature established big markets will become harder. It's not impossible to grow. I mean, the Knee 10% growth that you have seen today in the U.S. shows it. But it's harder. Whereas once growth was simply a matter of growing with the market. Growth now has to come from taking market share and this is done through innovation, customer service intensity and additional sales force efficiency.
On the other hand, the emerging market economies are becoming even more attractive, and the strategic priorities will change to reflect these realities. So what are my conclusions? Well, the first thing that is certain in my mind, that nothing is fundamentally wrong at Smith & Nephew. We are well prepared to meet the challenges. However, for Smith & Nephew to deliver strong results for the shareholders and benefit from its wide stakeholders, I'm starting an ambitious but I believe achievable agenda for growth.
Let me expand on a strategic priorities on this slide. We'll drive greater focus in our established markets by optimizing our sales and service regionally, delivering efficiencies for greater scale and best practice sharing. And this is absolutely critical. I mean we need to have the management focused on the geographies and on common themes of the geographies. Someone taking care of the issues or opportunities of the established market. Someone taking care of the growth potential of the emerging markets. Someone taking care of the distribution market and having a refocus and not doing everything.
We'll drive greater focus in our established market by optimizing the sales force, I said that to you. In emerging market, we'll look at greater resources. We're going to allocate greater resources in the emerging markets and focus to capture the growth.
Innovation remains core. We'll increase our investment and ensure it is focused in the areas, which offer greatest growth and value. We are simply finding the operating model. By streamlining our processes and functions, we can liberate resources to redirect them to highest growth areas. We'll also become more agile and faster in the [indiscernible]. This simplification includes uniting our Orthopaedic and Endoscopy business unit under one single management, which I will talk about more in a few slides.
Finally, we'll supplement and accelerate our organic growth with appropriate acquisitions, as well as significantly increasing our focus and our ability to capture new growth opportunities, this strategic priorities will liberate the resources to fund these opportunities.
As I said, this is just our framework. Over the next few slides, I will give you a greater sense of direction of these priorities. Key to our success in established markets will be our ability to take market share, that's pretty obvious. Not only sales efficiency but by continuing to develop end market innovation products. I think the example of VERILAST, VISIONAIRE, the NPWT, are good example of why we do better because we bring the good innovations on the market.
The great example of this is this one. So this one is the hospital NPWT. This is pretty heavy, believe me. This one is the Home Care NPWT, which is better, still big. And this one is a new one. As you see, there's no canister and we see just like it, a device very small, which is amazing. And this is re-innovation.
We enter this market 4 years ago, and I've learned a lot. We are always focused on what the consumer wants, shows, ease of use, efficacy and costs. This focus as an increase our revenue more than 3-folds over the last 3 years. And this is just the start. In May, the European Wound Management Association conference, we unveiled the PICO [ph] as I've shown to you.
So as I said to you, there is no canister, it's easy-to-use. It delivers the efficacy and attractive price points [indiscernible]. For patient it is effective, comfortable and discreet. For providers, it is simple to apply, clinically proven and cost-effective. PICO [ph] is a fantastic product and the feedback has been very, very positive. But it's also early days. Our customer will take time to become familiar with this novel extension of negative pressure and is only the latest addition to our broader NPWT portfolio. This just one example. There many more. Our strong Q2 result are showing this.
It has always seemed obvious to me that the potential of the emerging market economies for the [indiscernible] therapy is big. You'll be as aware as I am of the growing upper middle class in these countries and the increase of EBITDA per capita in all these geographies. [indiscernible] Smith & Nephew has also held this view. We saw very strong priority and focus in China. These efforts have been successful. Smith & Nephew revenue from the usual definition of emerging market countries have grown consistently at over 20% per annum and now is a [ph] 9% of the group sales. But I think China is clearly too narrow to focus. We need to secure a position and we need to capture the growth in the highest potential markets.
So what are we changing? We are changing the nature of the approach. The management focus, as I mentioned to you. I want someone focusing on the 4 biggest market that we have and market opportunities for groups. I don't want to have someone focusing on the complete word and looking at all the different opportunities not in the right order. So someone will now take care of Brazil, Russia, India, and China. This is what I call the management focus. And we are going to target also the level of resources.
We are going to split the set the emerging market in 2 organizations. One is called the Emerging Market, the BRIC, okay? And this is due to the stability of this market, to the potential growth, to the demographic, the growth potential and so on. The second is International Markets. It's a large number of countries going from Argentina to Thailand or to some North Africa countries. I think there is one thing in common. They are usually distribution countries and we are here to work through a very specific system. The management in our focus emerging markets in terms of markets team will now determine the appropriate product portfolio, sales, structure and infrastructure. They will be responsible for marketing Smith & Nephew entire portfolio of product in these countries, which means that we're not going to enter in India through the end of business. We are going to enter as a big Smith & Nephew promoting all the ranges of product of Smith & Nephew.
Decisions will be taken in Chennai and Mumbai and not pushed from Memphis, Andover and Helle like in the past. There would be additional resources such as protected R&D spend without those wear [ph] expectations. For the 4 focused emerging markets, where in 2010 the revenue were less than $100 million, we aspire to do more than $500 million in the next 5 years.
Smith & Nephew has a good R&D reputation. Over the years, we have invented and developed a wide range of technologies such as OXINIUM, various hip and knee system, trauma nails, numerous sports medicine repair and inception [ph] products and extensive coloring [ph] from dressing range. We are now going to build on this and invest further.
During 2010, we invested around 4% of the revenue in R&D. It's $151 million. Over the next 5 years, we'll invest well over an extra $300 million in R&D in total. So we're going to reinject $300 million in this R&D in the next 5 years. We'll be more disciplined about how we spent our R&D dollars, be more rigorous in ensuring the targeting of innovation to support our key markets and geographies.
So where are we going to focus this investment? I've said more resources will be put forward to develop the product portfolio for the emerging market. Secondly, we are already starting investing more in the newly [indiscernible] Sports Medicine area in particular, this year in the biomaterials, such as scapforth [ph] of cartilage, bio-absorber anchors and injected [ph] suture. In the reconstruction, we believe maxes [ph] from patient products will be a fruitful area. While in Advanced Wound Management, NPWT as I highlighted, has good prospects. Innovation is and innovation remains more than ever a big part of our business.
So what does our group would like to deliver these priorities while we have simplified the operating model? When I simplify I think -- it's difficult to explain. So you would maybe, if I did, keep complicated. But it is simple, believe me. It's very difficult to explain, actually. I've always spoken about how we redefine our approach to better emerging markets countries. As the right-hand side of the slide shows, by trading an organization whose management will just focus on China, India, Brazil and Russia. And another one was management was focused entirely on other international markets. You see this on the slide.
On the left hand side of the slide, the established market of U.S., Canada, Europe, Japan, Australia and New Zealand would be addressed by 2 divisions. The first, advanced clinical devices, have been created by uniting our Orthopaedic and Endoscopy business under one management team and the second is our [indiscernible].
So in short, what does that mean? You have 4 managers reporting to me. One is in charge of a division, Advanced Surgical Devices, one in charge of Advanced Wound Management, one in charge of Emerging Markets, and one International Market. The first one, the 2 divisions, a business focused on established market. But on a top of this, they serve for R&D purpose and global marketing purpose further-ward, okay? According to demand coming from the emerging market or international market. And the other guys, the Emerging Market, International Market, this is the scope of their business and they decide their strategy, they decide their portfolio, they decide their marketing, and we finance, which was not possible in the past, some R&D money for these geographies.
By narrowing the focus in established market, these divisions will lead a renewed and target approach for our customer. They will streamline the processes function to liberate resources for the investment as I've highlighted in the earlier slide. In particular, the Advanced Clinical Devices and Advance Wound Management division will support the Emerging Market, International Market through our R&D model. This will also provide marketing and regulatory support. We will also accelerate the speed and focus of the global process improvements by bringing several global functions under one single management. This function will include manufacturing, where we have a lot of work to do. Distribution, we have a lot of work to do and IT systems and quality and regulatory.
This is much more than just a management reorg. It marks a fundamental change in how we interact with our customers and with one another. Before I turn to next slide, I just want to reiterate how we are going to pay for this additional investments in emerging markets and R&D. I guess, it's a question that you have. Well, in addition to efficiency gains from our simplified [indiscernible], which are significant, we have identified further opportunities for us to reduce our cost of goods and lower our SG&As. We'll continue to improve our manufacturing efficiencies and as you know, we have many programs to improve our field base logistic. We will also increase the productivity of the R&D and improve our return on investment. And last, but not the least, there are many opportunities to increase the productivity of the sales force.
Organic growth on its own will not satisfy our determination to build significant value for the stakeholders. I believe, we have a strong platform from which to make acquisitions. We have the required management strength and capabilities. We also have the financial strength with our own net debt at $346 million. A very causative [ph] business. We have a very strong balance sheet also. We have had a couple of successful small bolt-on during the last year and [indiscernible] in Advanced Wound Management and more recently Tenet [indiscernible] That Adrian was mentioning in Endoscopy.
So to preempt your question, what are we looking for? Firstly, we are adding small pieces of technology to our portfolio or moving parts of our distribution channel from indirect to direct. This will continue. Tenet is a good example of what I mean by supplementing the existing portfolio. Secondly, we are looking for appropriate acquisition to supplement our organic growth strategies. This could be in fast growing [indiscernible] segments such our entry into Negative Pressure Wound Therapy, through our BlueSky acquisition or it could be acquisition which allow us to increase our sales geographically. Our focus as in the emerging market while where we certainly need to acquire platforms, companies to support the growth, the organic growth of these geographies.
Then we have last but not least, a strong appetite for more substantial acquisitions and, in particular, in 2 fields, as you can imagine. One is the Advanced Wound Management and the other one is the Minimally Invasive Surgery. We are actively looking for opportunities, which meet both the strategic and financial criteria but it's totally difficult to predict once such opportunity arise. We'll not forget our focus on organic growth and cost improvement. But I believe acquisitions will also be a significant additional growth driver for Smith & Nephew.
So to summarize, we have great foundation at Smith & Nephew, but we can do better. We are going to do this by focusing our business to a greater extent than in the past, focus in management, focus in geography, focus in resources, focus on efficiency and focus on the growth areas, which will truly make a difference to our company.
This is just a start. This is just a framework of what we aspire to do. Where do we want to end up? Well, it's about better financials, faster growth, liberating resources to invest further and generate greater returns. And let me reinforce what Adrian said about margin outlook. It is our fervent intention over the medium term to fund these additional investments by diverting resources from our business. It is also about truly being a single Smith & Nephew organization. On the whole, I think we currently fail to take full advantage of our skill and breadth of relationship. Over the coming quarters, I will share with you detail of what we are doing and the result of our actions.
Smith & Nephew achieved a huge amount over the last 4 years through a lot of hard work, has good products, great people, healthy margin, strong balance sheet as it steps into emerging market. On the back of this foundation, I have truly laid out the agenda to do better and build credit value for the stakeholders.
So thank you, and that ends the formal presentation. And I'm going to open the room for questions.
Ingeborg Øie - Jefferies & Company, Inc.
Ingeborg Øie, Jefferies. First of all, you're setting an aggressive agenda for growth. Could you share with us what sort of market growth you see in the medium term and also what opportunities Smith & Nephew has to outgrow it? If you could share some numbers or some -- to actually have a sense of what you're thinking. Secondly, who are the managers you're putting in place in the International segments and in the Emerging Markets? Are these internal people? Do you already -- have you already identified who they are. And secondly, how do you assess Smith & Nephew's position in those markets, particularly in the BRIC countries relative to your competitors? In the BRIC countries.
Well, let me start first with growth. Again, there's no one market. There's one word, the street markets. You have the established markets and that common scenes you find in the established market our price pressure, government issue, strong economic issues and the market. I can summarize it. It's in the low single digits. And will remain this way. I don't foresee any big bump on these markets. And here, the name of the game is not to surf on the market because there's no market. So the name of the game, as you have seen here is to bring innovation, be more efficient and gain market share. That's what we are doing actually. And that's what we're going to focus on. And that's what I want the management to focus on. Second type of markets, here you can start from the growth. At the same time, you'll also have to capture share and these are the emerging markets. They are BRIC market, plus maybe Mexico, South Korea, Turkey, whatever. But again, we have decided to focus on 4 geographies and not on 8 or 9 just to be sure that we have enough resources to invest there. And we are not diluting our efforts. So here, it's I think a question of surfing plus getting share and being strong and find the right investment. And I think innovations also, but the right innovation and the right portfolio. Because again, if you want to be strong in the emerging market, it's not just be strong by launching high-tech at the low price and deteriorate the margin. It is having the right cost of good, the right price and then make a profitable growth in the emerging market, which is what we want to do. And see, you have a bunch of markets in the world with pretty high growth but in a tiny market. There was no visibility of the future or pretty big risk of political risk or economic risk. I mean it's a patchwork. So here, the common thing on this they are distribution markets. So we are focusing on improving the way we are in this market. For example, avoiding to have 3 different distributors when we come one for Smith & Nephew. And so this is what we do. Your second question on the management. Well, I'm not going to answer this question. We are looking for the management now which is not done, especially for the one which is the Emerging Markets and International Markets, we have an interim solution at this moment. Okay, and your last question, Smith & Nephew in the BRIC market. I told you $120 million of sales, so we are pretty good in China, I think, because that has been the focus. We are having a significant growth. We have pretty big ambition in China, but we do not exist in the rest of the big countries. Brazil, well, most Euro. India we do play well but we have a small business there, about $0.25 million. In Russia, we're not big either. So I think it's really a place where we can start to mix things.
Unknown Analyst -
I have 3 questions. Firstly on the new strategic framework, I'm just curious why you think it's necessary to make some changes. Smith & Nephew's done well in Orthopaedic. You are outgrowing the market, you're doing well in Endoscopy and also in Wound Care. So why the need to make changes today? I'm concerned about what happened when previous management changes were made with Orthopaedic recon and trauma. There were changes. And even after 4 to 5 years only then were some of these things corrected. I would say they probably failed initially so why make these changes? Question #2 is for Adrian. On the EBIT margin guidance for 2011. Based on the simple math. You sort of need a meaningful improvement in the second half. Why is the second half better than the first half when you're highlighting increased pressure in Europe from austerity, pricing pressure and so forth? And then the third question is for the year again on the longer-term EBIT margin thoughts. You've made some comments about making more investments and some changes. Is it fair to say that you think margins will be flat longer term or do you think longer term margins can go up at Smith & Nephew with all these changes that you're proposing?
Well, let the third be the first one then [indiscernible] will come back on the EBIT question. Why do we change? That's a good question. We change because we are in peace, okay? That's means that, first one, it's the right time to change. I mean there is no -- nothing wrong. We do well, as you're mentioning. We have the right management and we also believe that the market is changing totally. And what I've seen coming here is not enough focus and started to use more where focus or that's exactly what I found. So people were going a little bit everywhere. And I wanted to have the top managers responsible and accountable for some specific markets. So that's why we have addressed the Wound and New Surgical Devices division in the established market and create something else, to avoid dispersion. I think it's important to talk about the why did we unite Ortho and Endo? Well, you're right, they do well, they do well. But what you don't see from mix and rewards is the duplication of efforts, duplication of processes, the fact that we are very often common customers and we are seen by 2 different people who do not talk to each other. So this is something which is not something you can see when you are not inside. And I tell you, this is very, very obvious. And making these guys together will definitely help to save a lot, to be more efficient, to be more productive, and to certainly divert some resources to do something else.
Yes, the first question, Michael, why do we expect margins to be stronger in the second half than the first half. I think the answer is three-fold. One is seasonality. If you look -- absent last year when we had the BlueSky adjustments in the first half which will not repeat this year, which of course is the second reason. And then thirdly, there was some bunching of irregular costs which we highlighted. Small but meaningful in quality which we don't expect to get one for the rest of the year. Those are the 3 reasons.
Unknown Analyst -
And the medium-term margin?
Well, yes, I'd love to improve it. But I think if we keep it flat this will be a good achievement, which is what we want to do and what we want to fund with the price erosion we have in the market. With the issue facing the market. So we're driving for some of these [indiscernible]. We have a number of things to see, to do as you have seen. I mean, R&D investment. I mean, this year again, we invest a lot in the R&D business. I mean, I told you I want to inject $300 million in R&D in the next 5 years. This year, we are making new investments in the bio materials, very significant. We have all these emerging market investments to realize. So you know what? I think it's pretty good use of the money to prepare the future and invest in these businesses.
Navid Malik - Matrix Group Limited
Nav Malik from Matrix. Just a couple of quick questions. On the R&D spend, the ortho industry has remained so stubbornly around 4%, 5% sales in terms of R&D. Absolute spend compared to, say, pharma [ph] is more in the 15% range and pharma [ph] has obviously not necessarily had those productivity gains. But with the spend going up, one of the things you said I think at the full year results was that you were looking to try and get products to the market through the R&D engine, which would reduce complexities or cost at the operating theater level for example and improve clinical outcomes. So you make the reason to use the approximately [ph] competitive in an environment more compelling. How can you sort of elaborate on that to us for us to try and understand why that R&D investment is really justified? Because at the end of the day all the orthopaedic plays have the same option. They can all increase their R&D spend likewise. And on PECO [ph], which looks like a pretty good product, it seems to me that if you're trying to get the aspirations into the BRIC economy with some of your product lines, PECO [ph] might be well-suited given presumably the better margins, the simpler cost and distribution, the lower level of support you need. And if you look at some of the countries like India and the [indiscernible] region, Diabetes is pretty much barreling. So it must be a market you should be addressing.
Second part of it, yes, you're right. I mean this is definitely a big market for Wound and certainly opportunities for PECO [ph]. I do agree with you. Coming back on your first question on the R&D, well actually, yes, you're right. It's more 5%, 6% R&D on sales in India to our business. By the way, we are spending 3.8% R&D on the service with this $151 million. So we are not exactly at the level we want to be. We have additional investment to do. We have to refill some money for some money for this Emerging Market portfolio. We have to inject in the very materials and some new opportunities. So I do believe we need to put more money in R&D. And you know, again, let's be serious on this one. I mean, the growth is coming from where? It's not just coming from -- take the Wound, the Wound portfolio. The wound portfolio is not the gross driver of the company. Advanced Wound Management, because of the innovation is just driving this gross to 8%. So if you do not bring this innovations and adapt it...
So what was your question again?
Navid Malik - Matrix Group Limited
[indiscernible] R&D spend. This when we show the obviously [indiscernible] full year results. I think you talked about really trying to target innovation through reducing operating procedural times and getting better clinical outcomes, or that's the way you get market share. So in terms of the R&D spend, how do you sort of develop, deliver on that ambition? And what type of products would come through and where would the pressure points be in terms of the margins as well in the medium term?
I think that one of the things I've discovered here is that despite the fact we have a number of re-innovation, I was not very impressed by the process of selecting the innovations. So obviously, we have great innovations but, you know, I do think and I think Adrian shares that, but there is a way to look at the portfolio and choose the right investment in terms of NPV. Here it was more I have a good product that something's nice. But then how do we prioritize that? While -- actually, we are working now with the NPVs. We look at the model. We work with risk adjustment, we look at the fixed sales, we look at the risk we have in the price reimbursement and we find the least of 10 priorities, which for us are the best for the corporation. So this is the way we are going to work now. More priorities, more focus, more productivity or so. And again, [indiscernible] of R&D money for the innovation market, which was not at this stage established. And again, why not? it was not because people were not willing to go there. It was because the focus was more on the big markets. Nobody was asking for it. And that's why having someone focusing on the emerging market, telling this is what winning in the emerging market. This is what you are going to deliver within this referenced environment will change the game.
Unknown Analyst -
Several questions, if I can. One, on the Endo-Ortho combination. Can you talk a little bit about how the roles of the sales reps will change going forward? Will they cross out, will they not? How are you thinking about getting better efficiency out of them that you've been talking about, at least in concept? The second about emerging markets, and again thinking about the sales force. Since you're not separating the business necessarily by business line, will every rep sell every product? Or how are you thinking about organizing that business? And lastly, the R&D approaching [indiscernible] investment. A lot of your competitors, a lot of your peers, when they go into emerging markets the approach they take is instead bringing out some of the older product portfolios to get that cost of manufacturing advantage that you discussed. So how is your approach going to be different and what really are you thinking about when we say developing products specifically for emerging markets?
Okay, going back to the last point, which is the Emerging Market portfolio. You have two ways of dealing with that. You have to either acquire a local manufacturer of products in the specific market and potentially export them actually in other places, which is, one, at low cost but good quality, [indiscernible] Smith & Nephew, which is something that's absolutely critical. It is not because it's not the high end of the Tech that you do not want to have quality. I think that's very important. And second one is to work with our own engineers on developing specific products for these emerging markets. But then, the problem, the cost of manufacturing is that we cannot do that in very high cost places. That we have to be localized potentially to make them at low-cost and then the right pricing in the market. Sales force, second point in the emerging market. If I've mentioned the focus of the management, I've never said that sales force will be the same. It will not be the same. Potentially it can be the same Ortho-Endo because the target, they're after the same customers. But on the [indiscernible] different. One, you have some nurses, you have some pharmacies, it's not all the same product nor is in distribution channel. So sales force is something that we're going to address locally according to the market specificity, because they are different in India, in China, in Brazil. So we're going to work on this. The efficiency -- you are terrible, Veronika, because you asked me the question before the meeting, and my answer was, "I don't know." I mean, putting together under one management, the Ortho and Endo, yes we will have in many places, common customers and some reps can call the same surgeon. That's fine. But it's not general, and so it will be again a case-per-case work that we have to do depending on the country, depending on the type of customers we have, depending on the system and so on and so forth. So I cannot answer to you now. But that's something we're going to look at very specifically. But that comes back again to my point on sales force efficiency and productivity. Adrian, you want to add something?
No, I think that's right. This is not about putting sales forces [indiscernible]. That's a complete misunderstanding of this reorganization, if that's in your mind.
David Adlington - JP Morgan Chase & Co
Dave Adlington from JPMorgan. A couple of questions. Firstly, one of the headwinds you faced in the quarter on the margins at least has been from mix. I was wondering if your could give us some greater color on that and the expectations going forward, giving the sources of your growth would appear to be having the same sort of mixed headwinds. I mean the greater growth coming from potentially lower margin areas? And second, for Adrian, the reporting lines going forward, are we going to get 4 sets of sales numbers and 4 sets of trending profit numbers? And it would seem to me that that's going to be very concentrated in the Advanced Surgical Systems. Can you comment to that?
Yes, okay. In terms of the headwinds on margins, where are they coming from and will they continue, yes, essentially, we had faster growth in -- some products were slightly lower. Gross margin for VERILAST and VISIONAIRE in particular and in similar geographies. Will they continue? Yes, they probably will. What does that mean? It means efficiencies need to match it, so that's the way it is, David. It's a good news problem, frankly, the high growth. So absolutely, we accept that. Absolutely, that's taken into account as we have our forward-looking views on our margin. In terms of the reporting lines going forward, we haven't finally settled on what it will look like, David, frankly. Although I repeat what I said in the prepared presentation. That we won't change anything until next year. We will maintain.
attention to maintain visibility on the top line. So we won't stop distinguishing minimal invasive or Endo sales from -- Trauma sales from Reconstructive sales. As you go down the P&L, that will be more challenging, frankly, because part of the purpose of this is to manage them jointly. So exactly what the content of it is, don't know. We will develop that over the next couple of quarters. And I'll share it with you on the [indiscernible]. Just how many segments we'll report is also -- we'll just have to wait and see because [indiscernible] quite small. So exactly what that will look like, we'll work out over the next couple of quarters.
Martin Wales - UBS Investment Bank
Martin Wales UBS. Firstly, given this pressure to emerging markets, what do you need to beef up your compliance organization to make sure that you're compliant with U.S. regulations for operating international markets given how important that market is to you still? Secondly, given that you've had a look at Negative Pressure Wound Therapy, you'd like to put some sort of long-term potential enrollment that Adrian's been somewhat reluctant over the years. And finally, how can you advance with management organization in the U.S.? Clearly, Negative Pressure Wound Therapy is being more successful excluding that. The U.S. still looks like an outlier in terms of performance. And how do you improve the broader advance would management in the U.S. in particular?
Okay, let start with the Q1 and the compliance in emerging markets. Again, we have one way of operating in the world. It's not 2 or 3 ways, we operate in the similar in the U.S., in Europe in the emerging markets. Compliance is absolutely critical. We have 17 compliance officers in the company working on this. We're setting with the development of the American market increases [indiscernible] of compliance officers in the business. But I tell you, there is no 2 ways of looking at compliance there is one way, which is being compliant. That's pretty simple.
We're as one on this. It's clearly going to be big, but we're absolutely not putting a number out. It's going fantastically.
You can make easy calculation by the way. If you take the gross and what has been announced in the past, it's pretty easy...
Martin doesn't just want the sales now. He wants the sales going forward. They're going to be big, Martin.
You can extrapolate also. No. I'd say it's a big part of the business and it definitely the growth of this that we do not want to forecast on this [indiscernible] forecast.
Martin, you're right. The growth in the U.S. of our Wound business by NPWT. The growth excluding that has been for a significant period and still is pretty modest. I mean, pretty much flat. And that is a disappointment for us. It's been a disappointment for some time. Frankly, the focus on getting NPWT to grow has been the right place to focus in the recent past because the potential. Because you just got us to agree is or say is very substantial. As that gets significantly bigger and significantly better established, yes, we would expect to see the rest of the Wound business come back into something. It was a growing organization. But just at the moment the priority is quite likely on reaping the benefits of that NPWT investment.
Thomas Jones - Berenberg Bank
Tom Jones from Berenberg. Two questions. Firstly on European austerity pressure, this is really the first quarter we've seen it wash over into your Arthroscopy business. I was just wondering how you are feeling that manifesting itself? And the Ortho business, it's been a fairly level mix of price mix and volume and Wound seems to be mainly price in the less-advanced parts of your Advanced Wound Management business. So I just wondered how that splits falls out in Arthroscopy, particularly in Europe. And the second question, a more general one. I just wondered if the events of the last few weeks have caused you to reassess your thoughts about how much and when you might be deploying some capital? I suppose, if I'm being cheeky, I'm asking about the buyback.
Buyback, there's no plan to buy back. I think that's a pretty simple answer.
Thomas Jones - Berenberg Bank
In which the follow-up question is, why not? Your stock's cheaper that it ever has been. Your balance sheet is as unlevered as it has been. Debt for you is still reasonably cheap. Why isn't it a serious consideration?
Yes. I mean the answer is, you heard Olivier talking about the role of inorganic as well as organic growth. We believe having a strong balance sheet at the moment is right thing to do for shareholders. You see opportunities, both smaller technology-oriented ones, smaller geographic ones and potentially slightly bigger ones in the Wound and Minimally Invasive joint area. And that's the reason. It's as simple as that, Tom. Clearly, in 2 years time, it's proved that there haven't been opportunities that make sense for shareholders then clearly, we're going to looking again. But just at the moment, that really...
Thomas Jones - Berenberg Bank
You got the best part of $1 billion of available liquidity. You're throwing off free cash to a couple of $100 million a quarter. Are you trying to tell us that you can see $1 billion plus, plus the cash flow of acquisition opportunities out there? Or you're just being super conservative given what's going on in the wider market?
We can see significant -- we have a significant number of opportunities. We firmly believe that a strong balance sheet is the right thing to have for now. Again, if it turns out, the big opportunities turn out not to crystallize and not be there, then we [indiscernible] it. But just for the moment, that seems to us the right place and the right thing to be doing for shareholders.
Thomas Jones - Berenberg Bank
And on the austerity?
On the first question, yes, you're quite right. This is the first quarter where we've seen in our Endoscopy business significant impact in Europe from the austerity measures. It is mainly not price, it is mainly mix and volume waiting this type stuff around Europe. And mix -- and a willingness to trade up and some degree of trading down. We're not seeing any fact that applies to all our businesses. [indiscernible] but the it is the case that we're not seeing significant changes in the like-for-like pricing pressure. I mean it's there but it remains modest.
It's there and will remain. It doesn't change.
Justin Smith - MF Global UK Limited
Justin Smith, MF Global. Just to go back to the buyback question again, sorry to have to go back to it. Buying back stock is obviously a good investment so couldn't you share, gentlemen, both of your thoughts with regards to the acquisitions criteria that you've both got, how those might change going forward, just so we can understand why returns on acquisitions are going to be better than buying back the shares?
Sure. I mean, fundamentally 2 criteria. One is strategic fit, one is financial. And the strategic fit, you've heard a bit about and maybe Olivier would like to expand on that in a second. In terms of financial criteria, discipline is absolutely important to us. We haven't done that many acquisitions, but those that we have done and have looked at, we apply a range of financial criteria. The single most important to us is return on capital in year 3, cash-on-cash return on capital. Dilution accretion, we're going to play all sorts of games in that when you got interest rates as they are now. So that our pre-criteria. It's not the only measure but it's the single most important financial measure, I would say.
Coming back on, I think that's consistent with we discussed also. I mean exactly this criteria is absolutely clear. Regarding the strategic intent, which is I also believe the important -- I believe in size in the Wound Management, so I think that in Advanced Wound can be bigger, much bigger, will help. I believe the potential in the Minimally Invasive surgery is huge. And I do believe it's definitely an area of focus for us. And so those 2 fields are keeping us busy. Yes, sir?
Unknown Analyst -
Thank you very much. I was going a variation on the same theme as the last 2 questions, really. When you describe the business as you saw it, you mentioned consolidation in industry #2 sort of quite high priority. Yet when you gave the list of things you were going to do. You then mentioned more M&A, and that was almost the last night. So you've sort of described a dash of growth on the one hand. Yet do you really believe you have the critical mass in a consolidating industry to do it? And shouldn't M&A be higher on the list? And is it really higher on the list one way or another?
Well, coming back on my first point which was the consolidation in the industry. I was referring at the consequence of this for us in terms of share voice. We are fighting against bigger players investing more money in that sort of terms in specific area. And so it means for us that it's a stretch. So which means that we, I guess, we invest more SG&A and that's so we can do [indiscernible] and be more conductive with resources. We inject the money where it should be or be more efficient. And also being bigger, which is [indiscernible] part of the game, which is why I'm mentioning consolidation as a key strategic intent for the company. So I don't know if I answer your question but I don't think it's…
I suspect another variance to the question is, do we think that we are too small to prosper in the new world in reconstructive surgery implants.
Unknown Analyst -
That's the corollary.
Well, I don't want to suspect that was going to be -- no, we absolutely don't. Is it necessary to do, to merge in Reconstructive to survive, we'll thrive in the [indiscernible]. We do not believe that to be the case at all. Period.
We believe again innovation, which is the driver. If you look at the statistics of who has spent money and what level of money has been spent in this industry in the past. I think it's what we have spent, we are extremely productive and [indiscernible]. I think this is the driver of the growth. It's one part of the solution. Then you can have innovations and be bad on the market, which is something different. So I think we have to both integrate both. But size, you know, it's a fact. I mean, we have a different market now. We have different players. We are bigger to spend more so we must do everything.
Unknown Analyst -
I have 3 questions. The first question is regarding your management teams in your established markets. Do you now know who those teams would be? And a follow-up from that is with the combination of Ortho and Endo. How smooth do you expect that process to be? Do you expect to see some disruptions from that and how long do you think that would say? The second question is with regarding to your investments in emerging markets. You gave us some targets for what you expect the BRIC countries to deliver. Can also provide some indications on the international markets? And then the final question is on your Knee business. Certainly, fantastic performance there. However, a number of your competitors are also coming out with products that have differentiated Smith & Nephew. Can you give us some sense of how much of your Knee outperformance is coming from VISIONAIRE versus VERILAST? Clearly, VERILAST has would be far as is that of VISIONAIRE, number competitive threats there.
Okay, let me start with the 4 first questions and the first one agent going to get. So establish market management first question. Yes, we have now announced the 2 heads of the established markets and the division so Advanced Wound Management based in the U.K. And Mike who is based in Dover running the Memphis facilities Endo and Ortho facilities. So this is announced and this is official. Will it be a smooth process? Yes, I do hope it will be a smooth process. We're now preparing the second line of management which will be announced early September basically. And we are very smooth process ongoing, so I do not expect any business disruption. This has been since the beginning, the target no business disruption, the opposite making it better and smoother. Investment in emerging markets versus investment in the international market. So investment in emerging markets. I cannot give you a figure. I gave you want to be at these high times bigger in 2015 but your questions were about the rest of the markets I tell you, I do believe we'll do better. Was an about it -- if you exclude India and China, I think it's about $350 million.
Less than $300 million in.
It's less than $300 million in international arena is pretty good at seeing double-digit compound almost so I do believe we have a slight improvement of this due to the focus of this management and improvement of the distribution channels and efficiency. Yes, I do believe so.
On your 19th question, essentially I think what is driving the Knee growth frankly probably both VISIONAIRE and are less our major competitors to that Knee growth. Wouldn't necessarily agree with you that VISIONAIRE is winnable yes of course number there is a comment on, but as said before, we see a whole area either instruments or potentially ultimately being a very for to want as we head into the future. I think that's it. Thank you.
Thank you very much. Have a good day.
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