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Smith & Nephew (NYSE:SNN)

Q2 2012 Earnings Call

August 02, 2012 3:30 am ET

Executives

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

Analysts

Veronika Dubajova - Goldman Sachs Group Inc., Research Division

Yi-Dan Wang - Deutsche Bank AG, Research Division

Edward Ridley-Day - BofA Merrill Lynch, Research Division

Martin Wales - UBS Investment Bank, Research Division

Michael K. Jungling - Morgan Stanley, Research Division

Thomas M. Jones - Berenberg Bank, Research Division

Ingeborg Øie - Jefferies & Company, Inc., Research Division

Unknown Executive

[Audio Gap]

factors that could cause actual results to differ materially from what is expressed or implied by the statements. For Smith & Nephew, these factors include economic and financial conditions in the markets we serve, especially those affecting health care providers; payers and customers; price levels for established and innovative medical devices; developments in medical technology; regulatory approvals; reimbursement decisions or other government actions; product defects or recalls; litigation relating to patent or other claims; legal compliance risks and related investigative remedial or enforcement actions; strategic actions, including acquisitions and dispositions; our success in integrating acquired businesses; and disruption that may result from changes we make in our business plans or organization to adapt to market developments; and numerous other matters that affect our markets, including those of a political, economic, business or competitive nature. Please refer to the documents that Smith & Nephew have filed with the U.S. Securities and Exchange Commission under the U.S. Securities Exchange Act of 1934 as amended, including Smith & Nephew's most recent annual report Form 20-F for a discussion of certain of these factors.

Any forward-looking statement is based on information available to Smith & Nephew as of the date of the statement. All written or oral forward-looking statements attributable to Smith & Nephew are qualified by this caution. Smith & Nephew does not undertake any obligation to update or revise any forward-looking statement to reflect any change in circumstances or in Smith & Nephew's expectations.

Operator

Good morning, ladies and gentlemen, and welcome to the Smith & Nephew 2012 Q2 and Half Year Results. For your information, this conference is being recorded. At this time, I will turn the call over to your host today, Mr. Olivier Bohuon. Please go ahead, sir.

Olivier Bohuon

Good morning, everyone. This is Olivier Bohuon. And I'm here with Adrian Hennah, and welcome to our second quarter results call. I will cover the highlights and then hand over to Adrian to take you through numbers. And when he has finished, I will update you on how we have progressed on delivering our strategic priorities. As usual, we'll take questions at the end.

This quarter, Smith & Nephew again delivered underlying top line growth and an improved trading profit margin in challenging markets, completing a good first half. We are delivering on our financial commitment and implementing our strategic priorities to reshape Smith & Nephew to provide the right commercial models, innovation and efficiencies to win in our markets today and the future. Taking into account this combination, we're pleased to announce a substantial step change in our dividend. Our Q2 revenues were up an underlying 2% to $1.029 billion. This is against challenging markets, particularly in Europe. This revenue growth is after the formation of Bioventus, which we completed in the early part of Q2, and Adrian will take you through the financial implications. For us, the transaction realizes value for reinvestment in near-term opportunities while retaining access to the exciting area of orthobiologics.

Trading profit increased 6% underlying to $234 million, giving a 80 basis points improvement in our trading profit margin to 22.7%. This is evidence that the structural improvements we have made to our organization, particularly creating the Advanced Surgical Devices, are beginning to come through. Adjusted earnings per share were $0.181. Our cash generation remains excellent, and the group now has a net cash of $150 million.

We have consistently delivered revenue and earning growth and strong cash generation in a challenging market for the last few years. This financial strength and our confidence in delivering against our strategic priorities has enabled us to announce a 50% increase in our dividend and a progressive policy for the future. Our focus on pursuing and evaluating acquisitions of a range of size to generate shareholder value and our ability to fund them is unchanged. Of course, the board will continue to keep under review the appropriate capital structure for the group, including the potential for capital returns to shareholders.

This slide captures our underlying growth in the quarter. On the left-hand side, geographically; and on the right, by product franchise. Geographically, our revenue growth rate in Q2 were very similar to those we achieved in Q1. In the U.S., we again grew at 2%. In the rest of our Established Markets, growth was slightly slower, reflecting the volatility of the macro environment in Europe. The growth in our emerging industrial market was again double digit with a very strong growth in China, India and in the Middle East. On the right, across our product franchises, hip implant sales reflect the ongoing metal-on-metal headwinds. But on a more positive note, sports medicine joint repair returned to double-digit growth and trauma had a much better quarter. I will now turn to look at each of these in more detail.

First, looking at knee and hip implants. So our global knee implant growth was plus 3%, tracking the overall market growth rate. This was in line with our guidance in the context of the very strong growth we achieved in the comparable period last year. As we said at our joint reconstruction seminar last month, we have now launched our LEGION hinge product. Not only does this fill a need in our portfolio, it's redefined the expectation of what an hinge knee should deliver for a patient. In the same seminar, we also announced the limited market release for our new next generation of the JOURNEY knee. Early feedback from both surgeon and patients have been very positive. In hips, the negative commentary on stem metal-on-metal total hips intensified, partly ahead of the FDA hearing in June. Hence, sales of our BHR system were down globally 3%.

Outside of that, we continue to achieve good growth in many of our total hip products such as ANTHOLOGY stems, [indiscernible] surface product [indiscernible]. We also announced the limited market release of our new REDAPT revision hip system, which significantly improved our hip revision product offering.

Turning to sports medicine – so sorry, turning to sport medicine joint repair, we returned to double-digit growth. All segments contributed to this growth: Knee, shoulder, hip, and extremities, with knee repair being particularly strong driven by the FAST-FIX 360. In Arthroscopic Enabling Technologies, which consist primarily of our Resection and Visualization products, sales of capital-related items, such as camera, slowed.

Our Trauma growth was 3%, or 5% excluding the expiring royalty payments in the U.S. And this compared to a market growth of around 3%, which is a much better performance and skewed 30 days. Finally in Trauma, we launched 2 new plating systems for ankle fractures. They are both designed to provide additional option for surgeons and treat ankle fusion.

Advanced Wound Management grew at 4%, double the market rate of around 2%. The global market growth rate have slowed just slightly, reflecting increased price pressures across all products groups and the macroeconomic issues in Southern Europe. We had a strong quarter of launching new products, 11 in total, including ALLEVYN Life. ALLEVYN Life is the next generation of our core ALLEVYN foam range. It has many unique benefits to deliver improved patient and economic outcomes. These innovative features include a change indicator to avoid unnecessary dressing changes, a hyper-absorbent core to prevent leakage of exudates and masking to prevent patient embarrassment caused by visible exudates through the dressing. These all combined with unique shapes to ensure better dressing retention and our gentle border silicone adhesive to minimize pain at dressing change.

The growth from our Negative Pressure Wound Therapy portfolio remained strong in all geographies. In traditional negative pressure wound therapy, we continue to win major [indiscernible] accounts backed up by steady release of new products. PICO sales are increasing, supported by additional clinical data and a broadening product range. Its unique design was recognized in the International Design Excellence Awards in May.

In the quarter, we announced the acquisition of Kalypto Medical, adding further innovation and IP to our Negative Pressure Wound Therapy portfolio. And finally, the acquisition of Aderma last quarter is proceeding ahead of its integration and sales plan.

And last but not least, I'm happy to report that we have received the approval on July 31 of RENASYS, a negative pressure wound therapy in Japan, and this opens a very significant market for us in this geography.

And now over to Adrian.

Adrian Hennah

Thank you, Olivier, and good morning, ladies and gentlemen. If you could perhaps turn now to Slide 10 in pack, on the income statement. Revenue in the quarter was $1.029 billion. As Olivier mentioned, this represents 2% underlying sales growth on quarter 2 last year, after adjusting for exchange rates and for the Bioventus transaction. Trading profit in the quarter was $234 million, an underlying increase of 6%. The trading margin was 22.7%, 80 basis points higher than quarter 2 last year. Restructuring costs charged in the quarter were $14 million, all related to the efficiency program announced in October. Olivier will give you an update on our progress to this program in a moment.

Turning then to Slide 11 and moving further down the income statement, the Bioventus transaction completed on the 4th of May for a total consideration of $367 million. This gave profit on disposal of $251 million that you can see here on this chart. The loss on Associate of $1 million that you can see here is essentially the group's share of the Bioventus loss in the quarter. The entity made a loss due to start-up costs. On the 4th of May, United States CT business transferred to Bioventus. The much smaller O.U.S., outside the United States, businesses will transfer progressively over the next 18 months. These Q2 numbers, therefore, include a part quarter's trading for the U.S. business of CT/Biologics, and full quarter's trading for the small O.U.S. components, a gain on the disposal, 2 months' interest receivable on the vendor loan note to Bioventus and 2 months' of our share of the associate's results. We have set out in 2 appendices for this presentation, the trading history of the CT business for the last 6 quarters and each of the individual P&L and balance sheet items arising from this transaction. The appendix also shows the minus 3% EPSA dilution in Q2 from the transaction.

Looking forward, we expect interest income of about $3 million per quarter on the loan note owing by the venture. With regards the Associate line, the goal of Bioventus is to build a strong entity in bioorthopaedics. We expect this is going to involve material early investment. This is likely to restrict short-term profitability and hence, our Associate income. As a consequence of this, and the low yield earned on the cash received as part of consideration, we expect the venture to have 3% to 4% dilutive effect in our EPSA in the near term.

The tax rate for quarter 2 on trading profit was 30.2%, in line with the rate in quarter 1 and the expected full year rate. EPSA in quarter 2 were $0.181, flat on last year. This is lower than the underlying growth in trading profit due to the strength of the U.S. dollar and the impact of the Bioventus transaction, offset by the lower interest charge and a small reduction in the tax rate.

Turning to the next slide, Slide 12 and an analysis of revenue by business segment. The impact of currency was quite material in the quarter. In Q2, the value of the U.S. dollar was 3% stronger 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. And here you can also see that the Bioventus transaction reduced reported group revenue growth by 3% in the quarter, and we expect that it will reduce it about 5% in half 2.

Turning to the next page, Slide 13, an analysis of revenue growth rates by division and by geography. Olivier has talked the shape of our revenue, and I will add only a few more detailed points. Across our business as a whole, we saw essentially the same price picture in quarter 2 as in recent quarters. Across our reconstructive and trauma implant range, we saw a like-for-like price reduction of around 2%. We continue to see this reduction partially offset by positive mix changes.

In Sports Medicine, the pricing environment continued to be slightly easier than implants, with a like-for-like pricing broadly flat. In Wound, we continue to see modest price reductions across advanced wound care. The worldwide ASP growth of 2% comprised growth 3% in Knees, a 5% decline in Hips, a 3% growth in Trauma, 10% growth in Sports Medicine and a 4% decline in Arthroscopic Enabling Technologies. These numbers are all shown in the appendix to your pack.

Hip sales continued to be held back by metal-on-metal concerns. BHR sales declined by 37% in the quarter and now account for less than 8% of our hip sales. And that is labeled 1% of total group sales. As noted in previous quarters, sales growth in trauma was reduced by the progressive expiry over the last year of several agreements, under which we received about $10 million per annum in royalties. This reduced worldwide trauma sales growth by 2% and U.S.A. sales growth -- and U.S.A. trauma sales growth by 3%. There will be a smaller impact in quarter 3 and in quarter 4 with full expiries fully annualized.

In our worldwide wound business, sales grew by 4% in the quarter. Growth was reduced by 1% by wholesale ordering patterns, giving an in-market growth rate of around 5%. NPWT sales again grew very strongly and contributed most of the reported wound growth. Growth in the emerging and international markets was 10%, in line with quarter 1. In quarter 2, the growth of these markets contributed about 40% of the group's revenue growth.

Turning to the next slide, Slide 14. This shows the usual analysis of trading profit by business segment. As you're aware, it's important not to overanalyze quarterly movements in the margin. As mentioned earlier, group trading margin in the quarter was 22.7%, 80 basis points above quarter 2 last year. This is slightly higher than we expected at the end of quarter 1. Broadly, we continue to see margin uplift from our efficiency programs. We continue to need to deal with modest but widespread pricing pressure, and we continue to invest in new products and in our capability to bring those products to customers. Specifically, margin continued to increase in ASD by 120 basis points in quarter 2. We saw improvement in gross margin. In SG&A, we saw the benefit of the actions taken since quarter 4 of last year under our restructuring program, and we saw a normal quarterly variation. Margin decreased in wound by 60 basis points in the quarter. This reflects the phasing we highlighted in quarter 1 and also of course normal quarterly variation. Spend in the quarter on R&D increased from 4% to 4.1% of sales.

Turning to Slide 15 and the cash flow statement. We had another good quarter of cash generation. Like many health care companies, we benefited from an effort by the Spanish government to pay 3 2012 receivables. We received $51 million under this heading in quarter 2. Inventory levels continued to improve in ASD. Inventory levels are broadly flat in Wound after the modest increase in quarter 1. We had net cash of $150 million at the end of the quarter, improved from $28 million net debt at the end of quarter 1 and improved from $346 million net debt a year ago.

Turning to Slide 16 and the dividend. As Olivier mentioned, the board has decided to change the company's dividend policy, increasing interim dividend by 50% and moving to a progressive dividend policy going forward, with future dividend increases broadly in line with growth in adjusted earnings per share. For the avoidance of doubt, we would expect the 2012 final dividend increase to be in line with the increase in the interim dividend. From 2013 onwards, the board will review the appropriate level of total annual dividend each year, in light of the full year results and the outlook for the group. The board intends that the interim dividend will be set by a formula and will be equivalent to 40%, 4-0%, of total dividend for the previous year.

Turning then briefly to the last slide in this part of the presentation, Slide 17, and the outlook. As is normal, we have seen some variation of performance at a franchise level in the first half. We do not, however, see any change in the outlook for the group as a whole for 2012 from the view which we set out with our full year numbers in February. In terms of the markets served, we saw significant challenge in Europe, where we have 1/3 of our revenues. Judging from the pressures on the ground, we expect this to continue and possibly get tougher through half 2.

We continue to expect a modest increase in margin for the full year. However, as the implementation of the restructuring program continues to proceed well, we do expect a margin improvement at the higher end of the modest range. Importantly, this does not change our view of the medium-term margin potential of this business.

On a more detailed note, we've hopefully given all the information needed to model the impact of Bioventus transaction, including a 3% to 4% dilution in EPSA in the short term. And lastly, on the outlook, if the exchange rates at the end of quarter 2 were to be sustained for the rest of the year, we would expect reported sales and profit to be reduced by about 3% by translation exchange effects in the full year.

And with that, I'll hand back to Olivier.

Olivier Bohuon

Thank you, Adrian. I want to spend a few minutes reminding you of our achievements to date and our task for the rest of 2012. Hopefully, after 12 months, you are now all clear on our 5 strategic priorities. By narrowing the focus of our management on markets with similar dynamics, we are seeking to drive better growth by concentrating them more effectively on fewer priorities. Innovation is and remains more than ever at the heart of our business. And finding these areas is a need to simplify and improve our operating model, not only to develop resources for investment but also to make our institution more agile and faster. And through acquisition, we believe we can add further growth to our platform as well as significant value for our stakeholders.

So looking in more details at these priorities. So winning in established market is the first one. Our ASD and Advanced Wound Management senior management teams are in place and are stable. The creation of ASD has been executed to plan. We have progressed well. We saw significant U.S. restructuring and are on track in Europe. Financially, we have seen the benefits in our improved trading profit margin while importantly, maintaining revenue growth.

Regarding the second point, accelerating development in emerging markets, we have created this emerging markets organization uniquely focused on Brazil, Russia, India and China. We're investing in the infrastructure and people to drive the better growth we believe we can achieve. For example, we have made progress registering and selling more of our existing products. We're approaching 40, 4-0, new introduction in the first half of 2012 along across our full range of product franchise.

Regarding specific products for the middle demographic tier in these countries, we are doing detailed work on both the right product categories and right business model to serve these customers effectively. In the last couple of years, we have made a number of small bolt-on acquisitions and actually combination technology acquisition ranging from TENET Medical in LifeModeler in ASD, to Aderma and Kalypto in Advanced Wound Management. All have been integrated to plan and are performing at or ahead of our expectations. We have strengthened both our business development teams and as importantly, our skill set around integrating acquisitions. This gives us great confidence in our ability to supplement our organic growth through acquisition. We have a number of exciting opportunities under review and we're working in a very disciplined manner to ensure we move these forward appropriately, mindful of our responsibility to deliver shareholder value.

Innovating for value. As we have said before, I am particularly pleased we are maintaining our high level of innovation during this period of change and restructuring. And Q2 was not an exception, with 11 new products launched in wound and exciting new additions in our hip and knee implants and also in the trauma franchise. We have established a robust group-wide R&D evaluation process. From this platform, we'll now be accelerating our R&D investment in line with our previously disclosed plan.

Regarding the simplifying and improving our operating model, here, a strong operation platform allows us -- our commercial team to focus on what they do best, meeting our customers' needs through innovative products and exceptional service. We are significantly strengthening our team across IT, supply chain and logistics, to name a few. We have initiated a number of cost improvement programs. For example, a European-wide projects to standardize and simplify our key business processes, as well as provide better data with which to make the right commercial decisions. We have identified substantial opportunities in our cost of goods sold base, which we are acting upon. Our work to optimize our manufacturing footprint is in place. This quarter, we announced proposals to move more of the manufacturing of some wound products from Hull to Suzhou in China. We also expect to complete the transfer of all manufacturing from the older, leaner plant in Beijing to our new facility there by the end of the year.

In terms of the financial benefits, we expect to complete structural efficiency programs to deliver annual savings of at least $150 million. We are delivering on these programs and expect to achieve about half of the total of these benefits by the end of this year.

In summary, Smith & Nephew has completed a good first half. In Q2, we continued to grow revenues and again, improved our trading margin as a program focused on delivering resources for investment are delivered. When I set out our strategic priorities, I said this was an ambitious achievable agenda, focusing on the things which will make our business fit and effective for the future. I'm pleased by the manner and pace of our progress. In our established markets, we combined orthopedic endoscopy to increase efficiency without disrupting the sales team.

In the emerging markets, we have thoughtfully built resources and are refining our business models. Regarding innovation for value, we have brought more discipline to our R&D processes and are now ready to increase investment in line with the plans. We have many programs underway to simplify and improve our operating model, not just cost control but sustainable improvement, and we are approaching acquisition opportunities in a very disciplined way.

Our cash generation is strong, and our priority remains on using this to drive greater organic and new organic growth. This has not changed. And the increasing dividend should be taken as a reinforcement of our trenched [ph] strength and our confidence in delivering against our strategic priorities. Our markets remain challenging, but we are delivering on our midterm commitments and we are transforming our group to take advantage of how our markets are changing and the opportunities this creates.

Thank you and this ends the formal presentation. We'll now take questions. George?

Question-and-Answer Session

Operator

[Operator Instructions] Today's first question is coming from Ms. Veronika Dubajova of Goldman Sachs.

Veronika Dubajova - Goldman Sachs Group Inc., Research Division

It's Veronika here from Goldman Sachs. I have 3 questions, if I can. First on the pricing pressure. Given that like-for-like was at around minus 2 and that you did see the biannual pricing cut in Japan, I'm just wondering is it fair to assume that actually pricing pressure in the U.S. and Europe moderated slightly? My second question is regarding the wound manufacturing relocation. Just wondering what additional proportion of the portfolio you're moving to Suzhou and where that puts the overall proportion of wound products manufactured there versus rest of the world? And the last one, which should be quick in financial, just wondering what the retirement benefit obligations there, with the $50 million increase versus Q1, just wondering what drove that?

Olivier Bohuon

Do the last one?

Adrian Hennah

Yes, the defined benefit obligations, I will just look it up to make sure I give you a technically accurate answer, Veronika. The -- it was almost completely driven by the reduction in the U.S. discount rate in the quarter. There were other ups and downs with regard to the U.K. But in fact, the discount rate movement and the expected inflation in the U.K. just about netted each other out. So in our case, the bulk of the increase was U.S.A. discount rate reduction from 4.6 to 4.1 and also a small weaker asset performance expected but absolutely nothing out of the usual, Veronika.

Olivier Bohuon

Veronika, it's Olivier. On the question regarding the Wound relocation, actually, it's a small -- very small proportion. So it's not a step change. So I think it's not, I would say, marginal, this one. Regarding the pricing pressure, well, it's not improving, actually. It is stabilized in the U.S., no doubt, and as expected, between 3% and 4%, and you have seen that this seems to be pretty well shared within the industry. Regarding Europe, I think that Europe is difficult. I mean the Wound pressure, for example, has been higher than what we were used to see in the past. We have not seen a lot of increased pressure in the minimal invasive surgery in terms of price. But I think that there is not much change, actually, so I do not make any type of extrapolation on what could become the price pressure in the future. I think it's stable.

Adrian Hennah

And if I may just add to the mechanical part of your question, Veronika. Yes, clearly, in our numbers is now a sort of high-single-digit reduction for Orthopaedics in Japan because that were the announced numbers. The fact is in the round, it doesn't disturb the notion like-for-like. That does not mean there's been an offsetting improvement in Europe and the United States. That's not the way we're seeking to portray it at all.

Operator

We'll now go to Yi-Dan Wang of Deutsche Bank.

Yi-Dan Wang - Deutsche Bank AG, Research Division

Just to cover the question Veronika asked. Can you give us a sense of what proportion of wound care's products Smith & Nephew makes versus what it buys from OEM manufacturers? And what percentage of these are manufactured in low-cost countries now versus what would be at the end of the additional amounts it's proposed to transfer from Hull? And how will this transfer impact the margins in this business? And then the second question I have is, can you -- I mean, with guys hopefully delivering efficiency benefits, which seems to be ahead of expectations, and increasing your margin outlook for the year slightly, Adrian, can you help us with your indication that, hopefully quantifying it if you can, what you mean by at the upper end of your original guidance? And then to what extent has this been a function of your ability to place the investments that you planned at the beginning of the year? Is that proceeding also ahead of expectations? Or is that a bit behind expectations?

Adrian Hennah

Fine. Thank you for those questions, Yi-Dan. I think we're going to disappoint you slightly on the first one in terms of -- or probably both of them actually. But certainly, the first one, in terms of the level of quantification, we think it's sensible to give. One of the reasons for that is conceptual. When you say what proportion is sourced from outside, the fact is you source from outside a whole set of products at different stages of their manufacture. So some you can just source the very basic raw material, others halfway through. And then a few, in our case, not very many, that you buy in the final good. We do not have very many in that category. What's happening here in Suzhou is Suzhou had already become a material part of our wound footprint and established itself very successfully under good leadership of our wound team over the last several years. And what we've done now is to expand that Suzhou facility, both in terms of its capacity to do stuff but also up-skilling it in terms of the sort of things it's capable to do. We retain, however, the philosophy that Hull is the core manufacturing unit where the bulk of our development is done, and Suzhou, although it will begin to do development relative to its markets or its type of markets, is still the sort of daughter unit at the moment. And so what we're doing here is there is indeed some movement of production from Hull to Suzhou, which does have economic advantages, but there's also stuff coming into Hull, too. So this is tough, this is a part of being a multinational company and optimizing our footprint, and we're not going to give specific percentages of what those are. These are now both very material, very important and particularly in the case of Suzhou, getting ever more capable factories. In terms of your second question, Yi-Dan, I knew that when I -- that when Phil and I suggested we were at the higher end of modest, that we'd have Yi-Dan, among others, saying, "Well, what is the range of modest?" and all that sort of stuff. We're not going to give a range. The fact is that we are -- well, the most important fact is that although we are indeed slightly ahead of our expectations on margin in quarter 2, ahead of the expectations we had when we stood up in quarter 1, that does not in any way impact our view of the margin potential of this business. It's just the pace at which the program has been going and has been slightly ahead of what we expected. That is good news. But we remain very, very focused on the investments we want to do in emerging markets. We remain very, very focused on investments we want to do in new products. And we also remain very, very conscious that it is our core scenario that we're going to face modest like-for-like price reduction for a long time to come. So yes, it has been a tweak up. Yes, there may well be a tweak up in our expectations for the full year too, but it really doesn't change the shape of this business in all the sense in any way at all.

Yi-Dan Wang - Deutsche Bank AG, Research Division

Okay. And in terms of the investments, are you -- where are you according to your plans there?

Adrian Hennah

Yes. Well, one of these doubly good uses, if you like, you can see that actually at $14 million in the quarter, the restructuring spend is relatively modest today. So we have a sort of double good news; the program has been going in time-wise in line with our expectations, but actually in spend-type it is slightly slower than we expected. That does not affect, however, our view of a, the total cost of the program or the total benefit of the program. We are working very hard on flushing out the next and subsequent phases. They will become -- we will use the cost up, it'll just be slightly phased, slightly later than we'd originally expected, Yi-Dan.

Yi-Dan Wang - Deutsche Bank AG, Research Division

Right. My question was actually on the investments that you -- having got the efficiencies, how the investments side are progressing according to your plans?

Adrian Hennah

Okay. I'm sorry. Well, I'm pleased to have answered the question you didn't ask. But the -- well, the 2 main categories of investments, they are both progressing well, but they both take time if you're going to do them well and be solid about them. So our investment in R&D, as we signaled on several occasions, a couple of major categories of new types or new focuses for investment, one is around the emerging markets and products for that. We have been working very hard and I think very successfully on the underpinnings that, that required; skill sets you need to have in the marketplace, the connections you need to have between those skills in marketplace and the core engineering talent in the organization in order to properly define products of use to the marketplace and then move through to deliver them. So lots of good underpinning work is going on ahead. That underpinning work is less expensive than the work that we will when we actually get fully into it will be. And that's reflected in what you see is the R&D spend as a percent of sales, which has not gone up that very much. We do expect it to increase faster going forward. And the same applies to the other important switch of emphasis we're engaged in, and that's the switch towards the sort of biomaterial-type stuff, particularly in our arthroscopic business, which again is for us, a new skill set. We have some of it, but we are pushing the boundaries of our skill sets. That takes time to make sure one does it thoroughly and thoughtfully and as you get into an area. So again, we've been very focused on the underpinnings and very thoughtful on programs we're being forward. And you will, over time, I don't mean here quarter 3, quarter 4, you're going to see step changes. But you will, over coming quarters, see that R&D rate pick up as we've got the underpinnings in place, that the resources flow there.

Yi-Dan Wang - Deutsche Bank AG, Research Division

And on SG&A?

Adrian Hennah

What do you mean by on SG&A?

Yi-Dan Wang - Deutsche Bank AG, Research Division

Right, so on SG&A, you've talked about the investments in R&D, but I [indiscernible] planning SG&A investments as well?

Olivier Bohuon

Yes, let me take this, Yi-Dan. I think that in SG&A, you have the G&As and the G&As, we have been working hard on these G&As as you can see to avoid the duplication following the restructuring and so on. We are committed to invest in the sales part of the SG&As pretty strongly, whether it is in the emerging markets or to keep a good share of voice in the established markets. So there's no change, actually. I mean, to summarize what Adrian said, I think that we are just trying to have a very disciplined way of spending the money. We have prepared the base of the programs for the emerging market R&D programs. Here they are. We slightly increase the amount of money spent in R&D. We are still on track to spend 5% on sales at the end of the plan, of the period, I was announcing. So this is – I mean there's no change here. We are just committed to spend the money, investing on the right place to deliver the best revenue.

Yi-Dan Wang - Deutsche Bank AG, Research Division

Okay. So would it then be fair for me to say that your efficiency benefits are coming through faster than you expected, but then the investments that you're placing are not coming -- are not going as fast as you had originally planned? So that the margin improvement that we have seen come through this year, which has ended up being higher than expected, that will then kind of reverse as those pace of investments pick up?

Olivier Bohuon

We have done better in terms of the savings, okay? But we have spend what we had to spend this quarter. Actually, if you look at the end of the year, we have to spend money in many things. Then, as Adrian said, we will be on track to deliver what we're supposed to deliver in terms of cost savings and we are going to invest. That's why when we're talking about the modest improvement, we remain committed to this modest improvement versus last year. Again, the range of modest can vary. So it's -- whether it's high modest or low modest, it's still modest.

Operator

We'll now go to our next question, which is going to be asked by Mr. Ed Ridley-Day of Merrill Lynch.

Edward Ridley-Day - BofA Merrill Lynch, Research Division

To start with the increase in your payout ratio, obviously very welcome, and sort of 2 questions related to this. Firstly, what would be the criteria, if there are any, for another raise in the payout ratio? So sort of whether there would be a time table for that? Or whether how related to another increase in the payout ratio is sort of the acquisition time table that you are looking at? And the second question is related to M&A. I know obviously you said that it hasn't an effect what you do. But does this perhaps mean that we should be thinking more about small- and mid-sized deals, and that you are not now looking at, shall we say, very large strategic deals, for example, in the wound space?

Olivier Bohuon

Thank you, Ed, for your question. Actually, let me start by the second one. No, it doesn't change anything. So again, if we have the right opportunity, it's a big opportunity, we'll take the big opportunity. Small one, we'll take the small one. It doesn't change at all our focus. It doesn't change at all our strategy. So there is -- it's absolutely not significant here. Regarding the payout ratio, I mean, the criteria for another raise, I mean, again, the board is looking at that very seriously as you can imagine, and we have a very strong balance sheet. If we do not do acquisitions, we'll certainly have to look at that again in the first half of 2013. But at this stage, we have done this interim increase. We are committed to acquire good opportunities making financial sense and strategic sense for the company and for the shareholders. So that's where we are.

Edward Ridley-Day - BofA Merrill Lynch, Research Division

Yes, and just a sort of quick sort of follow-up. I mean, would you -- to what extent are you prepared to gear the balance sheet to address your acquisition potential?

Adrian Hennah

Ed, I would think – most important thing, there's no change in the approach that we have been articulating now for several quarters reflected by this dividend change. And this dividend change is now because we have an interim dividend to announce, and so why not do it now, was essentially the board's logic. So there is no change. And as part of what we said previously, we said it is our board's absolute intention that whenever we do on acquisitions, we will retain a solid investment-grade rating. We don't have a rating at the moment, but if we were have to have one or if we didn't have one, the equivalent of a solid investment-grade rating. So that is parameter in which the board is very clear that we will work and obviously puts a parameter around it. But basically, had no change. There is no change. This dividend -- our dividend in the year is $150-odd million last year, so a 50% increase is a $75 million. It doesn't affect the shape of our ability to pursue the acquisitions that we have been working or possibilities that we're working.

Edward Ridley-Day - BofA Merrill Lynch, Research Division

No, I understand that. No, I was just really perhaps, visiting on your, should I say, willingness to borrow for the right acquisition.

Adrian Hennah

Yes, we will borrow for the right acquisition. It will be within the context of a unquestionable solid investment-grade rating. And we will flesh that out as part of the total statement on our view of the balance sheet that we've said we'd do for the first half of next year. But I think you should be able to get enough of a feel for it from what we've been saying over last few quarters.

Edward Ridley-Day - BofA Merrill Lynch, Research Division

Okay. Understood. And secondly, in terms of the hips business, just in terms of getting back to market growth but sort of retaking share in that business. And I'm talking of sort of away from BHR here. Is there anything you can point to in terms of your confidence on new products you're developing or actions that you're taking, that a potential timeline to sort of retaking share in the core hip business?

Olivier Bohuon

Well, regarding the hip business, it is true that we have not been performing very strongly actually on this quarter. If you take the figures I was mentioning, we're minus 5% for the hip business and the market is at 2%. So this is true. Now we have a number of reasons. Again, the headwind that we are facing in the BHR, I mean due to the metal-on-metal issue, is very strong. As I was telling you, it's minus 37% for the BHR, so it definitely brings us some negative headwinds. We are, however, not unhappy with many of our hip products actually. And again, it shows you why innovation is important. When you talk about products like OXINIUM, ANTHOLOGY, Stem, R3, I mean all these products are doing very well actually and growing for most of them at double digit growth. So it – we have cycles in the hip business. It is true that we are down here, but I'm very confident that we will be able to come back on track soon.

Operator

Our next question is coming from Martin Wales of UBS.

Martin Wales - UBS Investment Bank, Research Division

If one looks at the top line performance of your businesses, and I think the previous questioner partly alluded to this, you're under growing the market in hips. Excluding BHR, your knee growth has dropped to market growth. If you take out Negative Pressure Wound Therapy, you're not growing in wound management at all, and by definition, under growing the market. When -- I'm guessing you're not particularly satisfied with any of these performances. So in what timeframe can we expect to see you return to market or above market growth more generally?

Olivier Bohuon

Martin, it's Olivier. Okay, hip, I think we just give a comment on hips, so I'm not going to come back on the hip business. Knee, again, we have been growing 3% in a market growing at 3%. Again, that problem here is the very strong comparable last year. So I don't see why, with all the products that we plan to launch in knee business, we'll not be able to grow better than the market, or at least at the market rate for the recon business as a whole. Regarding Advance Wound Management, we have been basically doubling the market rate. This is a fact for a while now. I do expect that this will continue. So we expect the full year doing much better than the market for the Advanced Would Management business. Regarding the Trauma, you have seen that we are back on track in Trauma, which is a good sign of the refocus that we have on this business. So I'm not as pessimistic as you are on the situation. So I do believe that we do well and we plan to do better.

Martin Wales - UBS Investment Bank, Research Division

And in what timeframe do you think you can start to do better then, given the planned timeframe of investment that some of the previous questions have alluded to?

Adrian Hennah

Well, I think, Martin, I guess you're coming from slightly different place. We have a portfolio of different areas and it's a fact of life that some -- to get every single one of them going at peak performance at the same time isn't usually the way that it works. There are some areas which today we are very pleased in. But you single out half of wound, the fact that the other half of wound is doing extremely well, and we're growing at twice the market rate and you can see great dynamic going along there. We're very pleased with the way that joint repair is growing, it's a strong market, and we're growing strongly within it. So there are some elements of strong markets growing very strongly. And at the other end of the spectrum, you rightly call out hip switches, it's something that we are -- which we are confident about will revert back and overtake that. But it isn't going to happen tomorrow. These things take time and these things take work. So in the round, we're very happy. There are individual elements of the portfolio, of course, we've got to work on. And of course we are working on, that's part of business. I don't – I think it's a little unrealistic to expect us to sit here and give you for each part of the portfolio, this is the evolution quarter-by-quarter. I don't think that...

Martin Wales - UBS Investment Bank, Research Division

No, and that's – no, I agree. And that's not what I'm not looking for. I guess I'm just slightly concerned that organic sales growth, the trend has been -- the group as a whole has been, if anything, the organic sales growth has slowed even relative to the markets you operate in. And clearly while you're delivering cost savings, the investment buy, as you actually keep on, is being very careful in how you get – to try and make sure you get that investment right. So I'm just kind of curious as to when we should start seeing the fruits of that investment?

Olivier Bohuon

Well, when? I do hope as soon as possible. Again, the pace of investment is good. I do believe we invest in the right place. If I take the Negative Pressure Wound Therapy for example, I think that's a good example of what we do well. If you look at the U.S. market, for example, I mean, we're used to fight 1 against 10, versus KCI. Well, one of the good news that KCI has reported a cut of 300-plus people, so we'll now up to be at 1 against 6, which is a very good news. So I think we have -- we're doing very, very well actually against a very tough market. We are increasing the R&D. This is a strong commitment. We are happy with the pace of launch of the new products, whether it is in Advanced Wound Management, again, I would mention the 11 new products, which is same number than what we had in Q1. I remind you also that we have launched 35 new products last year in the Advanced Wound Management. If you take the ASD business, we have launched also products in all the parts of our business. So yes, it will come. Again, Martin, I mean, I'm not going to tell you that you have cycles and you have quarters which are higher and some lower. Depending also the comparative, we had some strong comparative last year, particularly in the knee business. I mean, there is no, for us, any issue there. And we're very confident that we spend the right amount of money, that we spent well the money and much better than we were in the past. And I do believe also that the sales will come.

Operator

We'll now go to Michael Jungling of Morgan Stanley.

Michael K. Jungling - Morgan Stanley, Research Division

Three questions, please. Firstly, on associates. Given what you sort of mentioned, should we assume that associates will be a loss-making proposition in the second half of this year? And if it is, could it be more loss-making than we saw in the second quarter? Question number 2 is on the cost savings. Have we seen -- I presume we have not seen any material cost savings yet in Europe as a result of the restructuring. I think last time you mentioned that the restructuring for Europe would be completed by the end of the second quarter. And last question I have is on VERILAST hips, how would you assess the progress that you're making in trying to get a 30-year wear claim for VERILAST hips in the United States? Is this something that you think is possible this year?

Olivier Bohuon

On the VERILAST, let me take the 2 last question, then I will hand it to Adrian. On VERILAST, we don't comment this and so this is obviously, as you can imagine, commercially sensitive. Regarding the cost saving program, you're absolutely right. I think that the -- what has been done so far is mainly U.S. and we plan to implement -- we are actually exactly on track in Europe to implement the program as stated and as discussed previously. This is really on track.

Adrian Hennah

On the Associates, Michael, I mean, it's important to remember this is now not an entity we control. So they will do what they will do. Clearly, we have representation on the board, but they will do what they will do. Notwithstanding that, Michael, no, we would not expect it to be loss-making in the second half. Can't, obviously, guarantee that because it's not our entity, but we would not expect it to be loss-making in the second half. But we would expect it to be less profitable than the CT business would have been if they weren't going into this venture, a, because they've still got start-up costs over immediately; and b, because they are going to front-end load. I mean, they are -- they have a 7-year horizon, whatever it is, to make this business successful. They are going to front-end load their investments in some of the products and other activities. So we do expect this to be less profitable than it otherwise would have been.

Michael K. Jungling - Morgan Stanley, Research Division

And Adrian, on the cost savings for Europe, if I look at the first half, you've improved your EBITDA margins by 70 basis points with little help from Europe. Even if you were to make some adjustments or increase your investment in the second half, with the European savings coming through, why would it not be reasonable to assume that you can sustain a 70-basis-point margin improvement for the full year?

Olivier Bohuon

Because you forget one thing, is the investment that we want to do in geographies and in the different parts of our business. So that's why we are always talking about a modest improvement.

Operator

We'll now go to Tom Jones of Berenberg.

Thomas M. Jones - Berenberg Bank, Research Division

Just wanted to focus a bit on the ASD business. Just on the Arthroscopic Enabling Technologies, I'm sure you won't give a quantitative answer, but a qualitative one would be helpful. Just wondering whether that minus 4% that you reported that was coming from what you used to call the Visualization DOR business or was coming from softness on the consumables side on the shaver blades and the like? And then the second question was just on the hip business. I mean, the way the metal-on-metal, I mean I'm kind of guessing that you're probably selling less than 2,000 metal-on-metal hips a quarter now if you sort of back out the numbers that you've given. Is there a risk that this business becomes so low volume that it starts to become unprofitable to continue to produce and sell those hips? Or is that not a significant concern for you? And as sort of the second follow-on question to that is just on the modular hip side. There's some bubbling concern about modular hips in general. I just wondered how your short modular femoral hip is getting on against that backdrop at the moment?

Olivier Bohuon

Adrian, the first question?

Adrian Hennah

Yes, your first question, Tom, on AAT, Advanced Arthroscopic Technologies and what's driving the minus 4% number, the minus 4% in the quarter. You're quite right, Tom, the -- I mean, there's 2 elements to this business. One is the -- or 2 main elements. One is the blade business and the pump that sits behind it, which as you know is within our arthroscopic franchise, are very solid, but the lowest growing part of the franchise because of the nature of the -- the lower nature of the technological improvement there than there is in the core joint repair, the Sports Medicine Joint Repair sector. So that's one underlying driver. But then on top of that, there is the camera element, which although far, far more restricted and limited than the old DOR days, because as you know we've pretty much completely got out of that now, is still a lumpy business. We do still have ups and downs when there are some big camera deliveries. And so that's what you're seeing playing out here with the slight variability in this line. So you're absolutely right to infer that, Tom.

Thomas M. Jones - Berenberg Bank, Research Division

Okay. And on the hip business?

Olivier Bohuon

On other one is -- yes, on the other question, Tom, it's Olivier. You are asking about the modular hip systems. I guess you're referring to the recall of Stryker, of Rejuvenate and ABG II modular neck. So again, we have 3 modular hip systems in our portfolio: the SMF, the empirian [ph] and the new REDAPT that we have launched. And we have no reason actually when we are seeing this recall. We have looked at that, we have no reason to be concerned about any of our products. Because we take the safety very seriously and as always, we keep ultras and [ph] data sets under review. So I think that net-net, no worries on this. We're absolutely clear and fine. Regarding the metal-on-metal, well it's true that it is not -- BHR is not a big part of our business now because I think it's about 7% -- 7%, 8%, Adrian?

Adrian Hennah

Hip sales.

Olivier Bohuon

Yes, of hip sales. So it's less than 1% of the total sales of the company. We still believe it's a good product. So I do believe and I do hope that one day, we will see this product coming back and all the feedback we've got is very good. You remember the registries are excellent. So I'm not really concerned at this stage about the profitability of this product.

Thomas M. Jones - Berenberg Bank, Research Division

Okay. And maybe just one quick follow-up, and I'm probably [indiscernible] here. But would you be prepared to quantify what percentage of your hip business is modular versus non-modular hips?

Olivier Bohuon

On the modular hip piece, it's pretty small actually. So I don't give you the right impact number, but it's a small part of our hip business.

Operator

We'll take our next question from Ingeborg Øie of Jefferies.

Ingeborg Øie - Jefferies & Company, Inc., Research Division

Two questions, if I may. Firstly on the manufacturing footprint where you're stating that you're gathering pace. Could you elaborate on what the key objectives you're trying to achieve in the process are? And what the key considerations you're making when deciding on the appropriate place to manufacture some of your -- the specific products that you're looking at? Second question is on the R&D and the investments that you're making. Could you just help us understand the time frame over which we should see the projects coming to fruition? Maybe the 2 specifics one, you mentioned the products for emerging markets and the biomaterials?

Olivier Bohuon

Okay. On the -- let me start by the second question on the R&D. So when are we going to see products coming? Well, I think that you see products coming on a pretty regular basis. Again, it comes in every part of the company. We are very happy with the pace of innovation that we have. We do it better. We allocate better the resources. We'll spend more money. Again, I've been very cautious in asking the teams to present projects, which make sense for us and want to use well our R&D money. So the programs are starting to appear more and more, including the emerging market project. We have registered 40 products recently in the emerging market. That's very significant. Now the portfolio of the mid-tier for the emerging market is obviously extremely important, and actually they're related to your question regarding manufacturing footprint. You know that we have not launched mid-tier products in the emerging markets. When I talk emerging market, it's mostly the BRIC countries. We are working in defining a portfolio, which could be and will be a mix of acquisitions or/and organic product that we are going to develop specifically for these geographies. So obviously, if you want to be in Brazil, you better manufacture in Brazil. That's, for the mid-tier, absolutely important. So that could be one of the geographies. And we look at not putting all the eggs in one basket, so that's very important. So we look at the places where it makes sense, where we can fulfill the local needs, let's take India. Or we can also use this as a base for exporting the products. So we work on that. Actually, you will be happy to know that we have now a head of manufacturing for the emerging markets in place, and this is really his mission with the manufacturing team.

Ingeborg Øie - Jefferies & Company, Inc., Research Division

So it sounds like costs is not one of the key concerns when you look at the manufacturing footprint, if I understood you correctly?

Adrian Hennah

No, you didn't understand him correctly, Ingeborg. Just to give more a slightly more systematic answer. I would say there's 4 criteria. I mean quality is clearly preeminent. We won't – you aren't going to do anything in terms of location that jeopardizes quality. Security of supply is clearly very important and Olivier very much alluded to that one. And then there are, I think, 2 related more directly to economics in different ways. One of them, which Olivier absolutely rightly focused on, is there is an element in locational decisions that talks to support in the marketplace. And that sometimes is logistics driven, such as Brazil where you have tariff barriers and things to deal with. But also it's to do with development driven. We -- if there aren't tariff various-type things, logistics, actually isn't a huge driver in our business, but thinking about how you effectively develop products for a market is a factor in our thinking of the location of capabilities that we have around the world. And then lastly, but not leastly, is indeed, the cruder economic, the sort of arbitrage of the various costs that go into cost of goods sold, labor and the cost associated with labor, and location in particular. So all of those are things we play in and are becoming more systematic about.

Olivier Bohuon

So thanks a lot. So this ends this call, and wishing you a good day. Thank you.

Adrian Hennah

Thank you.

Operator

Ladies and gentlemen, we thank very much for your participation. You may now disconnect.

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