Smith & Nephew: Osiris Looks Like A Nice Bolt-On Deal

About: Smith & Nephew plc (SNN), OSIR
by: The Value Investor

Smith & Nephew announced a nice bolt-on deal for Osiris.

The deal improves the growth profile of the business at a reasonable price.

I like the move being made and reasonable valuation of SNN at large, although it remains a long-term underperformer versus the wider industry.

While SNN looks compelling, certainly as it might be an acquisition target itself, I am still cautious and not rushing to buy shares at current levels.

Smith & Nephew (SNN), which is often named as a key acquisition target, actually made quite a nice bolt-on deal itself as it is acquiring Osiris Therapeutics (OSIR) in a $660 million deal.

The deal is somewhat surprising as the company only recently was reportedly interested in NuVasive (NASDAQ:NUVA), as Smith & Nephew seems to act proactively rather than being bought out itself. Despite the arguably nice bolt-on deal, I am not in a rush to buy shares at these levels despite reasonable valuations and improving growth.

About The Deal

Smith & Nephew has reached a deal to acquire publicly listed company Osiris for $19 per share, valuing equity of the business at $660 million. With the deal, the company gets its hands on a rapidly growing business which delivers regenerative medicine products, including skin, articular cartilage substitutes and bone graft. The solid growth of the regenerative medicine market has attracted Smith to pursue this deal in order to accelerate its own presence in this market segment. With the deal, Smith & Nephew gets its hands on Osiris's important products Graffix and Stravix.

The deal does not come very cheap. Osiris reported $102 million in sales in the first nine months of 2018 which marks nearly 19% like-for-like sales growth. Third quarter sales even hit $36.5 million and were up more than 22% year over year. Annualising the third quarter sales numbers makes that revenues come in at $146 million, for a 4.5 times sales multiple. Osiris posted a nice small operating profit in Q3 of 2018 but has typically reported earnings numbers around the break-even mark as of late. It is obvious that financing costs of the deal price are greater than the earnings contributed by Osiris.

Nonetheless, the deal is expected to be accretive to adjusted earnings from 2020, and be accretive from there onward. While the 37% premium based on the 3-month average price being offered looks nice, reality is that it has been just a modest success for its shareholders. The company went public in 2006 at $11 per share, resulting in just 4-5% returns per annum for shareholders. Furthermore, shares have traded at much higher levels than $19 at various occasions in the past.

SNN hopes to see better returns by leveraging its infrastructure to better market its products and drive growth from here.

Implications For Smith & Nephew

SNN has been around for over 160 years and operates in more than 100 countries all over the globe. The company has paid out dividends in an uninterpreted fashion over the past 80 years, generating just shy of $5 billion in sales in 2018.

The company is very diversified with activities in knees, hips, trauma, joint repair, arthroscopic enabling technologies, surgical businesses, wound bioactives, wound care and wound devices. After a few years of stagnant sales, the company has gained some momentum as Osiris will boost pro-forma sales by some 3%. The company reports solid margins and has seen net debt come down to $1.1 billion by the end of 2018, which will increase to $1.8 billion following this deal. This is still not a lot with EBITDA running at around $1.5 billion a year. The resulting 1.2 times leverage ratio still leaves plenty of room for more deals to come.

With operating profits of $1.1 billion, seeing underlying organic growth of 2.5-3.5% in 2019 and Osiris starting to contribute as well, Smith is looking with confidence into the future. With a market value at around $17.5 billion, SNN has been valued at $18.6 billion ahead of the deal if net debt is included, equivalent to 4.8 times sales ahead of the deal announcement. Given that observation, the 4.5 times sales multiple paid for Osiris looks quite compelling, although the acquired business is not that profitable, yet it is growing quite nicely.

Struggling, Yet Potential Is There

Trading just shy of $40 per share, SNN has been struggling a bit in terms of the share price if we keep in mind that shares hit the $35 mark already in 2014. Stagnant sales made that SNN has been underperforming peers in terms of organic growth for quite a while, mostly because of the fact that it is too small to be so diversified. This makes it a relatively small player in lots of different fields, making it hard to compete against even larger and more focused peers.

Hence, I am constructive on the shares as leverage comes in just above 1 times, even after the latest deal, while growth is improving a bit, and shares trade at a justifiable 19-20 times adjusted earnings, although some charges keep coming up. The reason for my constructive stance is that SNN itself is an obvious target to be acquired, of course.

Despite the reasonable valuation, improving growth, nice bolt-on deal and solid financial state, in combination with takeover rumours for SNN itself, I am not chasing shares here. This comes after SNN was rumoured to make a serious >$3 billion bid for NuVasive in early February as that deal required some serious synergies or real strategic justification to pursue at a premium.

For now, SNN probably remains a reasonably safe bet, expected to provide reasonable long-term returns, yet I still feel that the business is underperforming a bit compared to the potential and some of its peers, as a potential takeout of the business itself is of course close to impossible to time.

If shares were to re-test levels in the mid-thirties, I would be happy to buy into the shares, but for now see the risk-reward as reasonably balanced, with few drivers other than an acquisition to drive compelling returns from here.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.