Good Example Of Thus, A ‘’hold’’ Recommendation Was Issued For The Company. Report

Type of paper: Report

Topic: Company, Finance, Business, Investment, Debt, Products, Taxes, Nephew

Pages: 5

Words: 1375

Published: 2020/12/28

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Executive Summary

Smith and Nephew is a leading manufacturer of medical equipment and appliances. The company offers a diversified range of products related with wound management surgical equipment and has operations in more than 100 countries. The company has been targeting aggressive growth through acquisition activities and has recently acquired Arthocare for $1.2 billion.
Analyzing the company we found that during the past three years, the profit margins of the company are declining, and so do the operating cash flow. In addition, the increasing debt position and interest expenses while the liquidity and cash flow position seems unpromising forced us to give a credit rating of ‘C’ to the company.
However, market analysts are expecting that the latest acquisitions by the company and the optimistic health care policy by the Government around the world will drive sales and profit in the future. Moreover, the stock value of the company was also found to be undervalued using the comparable method of valuation.

Accounting Policies
-Revenue Recognition
Revenue of the company is comprised of sale of its product to the third parties at amount net of trade discounts or rebates. The company recognizes the revenue once the risk and reward is transferred to the customer, general, at the time of the delivery of the product. However, the sale of inventory, which is kept at the customer’s premises for immediate use, is recognized once the notification of the product being implanted or used is received.

Considering the manufacturing nature of the company, we believe that this policy is appropriate.

The company follows straight line depreciation method to write-off the value of capital asset, and the amount is recognized in profit and loss statement of the company. This policy is appropriate for a firm with manufacturing process involving multiple capital intensive equipment.
Both, finished goods and work-in-progress are valued at factory cost, including appropriate overheads. All the inventory of the company is reduced to net realizable value, where any inventory reached at lower than cost levels, is valued at selling price less cost of disposal.
-Fair Value Accounting
As disclosed in the annual report, the company declares that many of its accounting policies and disclosures requires the use of fair value accounting where the assets and the liabilities, both financial and non-financial are measured at market observable rate.Important to note, fair value accounting has been repeatedly criticized by the accounting professionals. Thus, it would have been appropriate for the company to follow historical value costing because not only this policy is welcomed by the investors and the accounting industry, it would have also added consistency to the value of the financial items for a capital intensive company like Smith and Nephews.
-Going concern basis

It gives confidence to investors that the business is not in jeopardy of shutting down.

-Intangible Assets
Being a manufacturer of medical equipment, Smith and Nephews need to have an appropriate accounting policy for the valuation of intangible assets such as Patents, Trademarks, Licenses and Distribution Rights. The company declares that unlike its other assets, intangible assets are measured at cost price, i.e. fair value at the date of acquisition.

Strategy Overview

Smith and Nephew operate in medical appliances and equipment industry, and are facing rivalry from companies like Zimmer Holdings, Johnson and Johnson, Stryker Group and Boston Scientific. Each company in the industry has its own differentiated line of product, with Johnson and Johnson leading the industry both in terms of product offerings and revenue figures. When analyzing the whole medical equipment industry, few things stand out Smith and Nephew:
-The medical equipment and appliance industry is highly diversified and involves huge cost of manufacturing. In addition, strict government licensing rules, and stringent quality checks by external agencies, are some of the factors that promotes low threat of new entrant in the industry. Hence, Smith and Nephew are most likely to stay away from spending times over formulating strategies against any threat from new entrants.
-One risk which Smith and Nephew would ensure won’t disturb it again, is the failure of its new products. The company cannot afford to make mistakes when rivals are posing cut-throat competition by introducing new products every quarter or so. Important to note, despite of utmost focus on technological efficiency of its products, some of the products of the company were not able to succeed due to undermined level of safety. The metal liner in its R3 Acetabular System was recalled on June 1, 2012, because it was associated with implant dislocation, infection and bone fracture that required revision surgery. Similarly, its hip product, Birmingham Hip Modular Head implant, was also marked as failure by the customers because of increased possibility of implant failure as patients were complaining of pain and poor mobility, post operation.
-Smith and Nephew, which holds a wide diversified range of products, enjoys ace position in the industry in the Sports Medicine segment, followed by Hip& Knee implant segment. The company is looking to sustain and expand its market share in Sports Medicine segment through the acquisition activity of Arthocare Corporation which took place in 2014 for an amount of $1.5 billion. The existing technology and products of Arthocare will enhance the company’s portfolio and will drive it towards global opportunities for its Sports Medicine segment.
-Medical Equipment industry is largely dependent on Government Policy for Healthcare Expenditure. In most parts of the world, the expenditure on healthcare is controlled by Government forces only as allocation of funds in this concern is decided in the union budget of every nation. Hence, all the companies in this industry are largely dependent on increased funds commensurate with the increasing demand for medical equipment. Hence, product pricing by Smith and Nephew is exposed to external risk related to reimbursement policy and tax policy of the various Governments.
Smith and Nephew growth strategy is emphasized on expanding its product line, and exploiting opportunities in its leading business segment of Sports Medicine through acquisition activities. The company, during 2014, has also globalized its functions relating to Finance, IT and Legal so as to support its business growth. However, overall competitive advantage of the company lies in its zeal to bring error-free technological efficient products to existing product line, and expanding the market share of its various segments, of which the company already ace the Sports Medicine segment.

Ratio Analysis

-Current ratio of the company is declining after attaining the peak level of 2.31 in 2012. In addition, the present current ratio of 2.10 is below the industrial average of 2.75 and also falls below to that of all the rival firms with Zimmer holding heading high with current ratio of 4.13. However, we cannot give a negative rating to the company with current ratio of 2.10 as having current assets twice the current liabilities, is indeed a sustainable position for any entity.
The fall in the current ratio began in 2013 and was constant during 2014. The decrease in the ratio multiple can be attributed to higher proportion increase in the current liabilities that shoot up by 15.36% in 2013, while the current assets increased by only 5.22%.
-Debt-Equity ratio of the company has been increasing steadily, and now around 42.2% of the capital structure of the company constitutes of the debt borrowings. During 2014, the debt borrowings of the company increased from $288 million to $1613 million. We may also notice that debt-equity ratio of the company is below the industrial average multiple of 58.80%, indicating capital intensive nature of the industry.
The major reason for increase in the debt position of the company has been its focus on growth through acquisition. After acquiring Advanced Wounds in 2012, smaller acquisition in Turkey, Brazil and India, Smith and Nephew financed the acquisition deal of Arthocare worth $1.3 billion majorly through debt borrowings.
Investors should take a note that this increase in debt position will be justified if the acquired entities yield good returns in the coming future else, the company may get itself into financial trouble
-Profitability of the company has been on a tidal ride for now. The profit margins of the company peaked during 2012. However, post that period, the bottom line margins are on declining trend, and now stands at 15.46%. The profit multiple is only marginally higher than the industrial average of 14.99%, but significantly lower than that of core rival firms such as Zimmer Holdings and Johnson& Johnson. The decrease in the profitability during 2014 could be attributed to persistent increase in the operating expenses, and most importantly to increased interest expenses by the company to support the acquisition.
- Investors will not be happy to witness the declining trend in the ROE multiple of the company that has been decreasing consistently since past 3 years, and now stands at 12.40%. The decrease in ROE multiple is attributed to decreasing net income since past two years because of higher proportion increase in the operating expenses and interest expense of the company.
Although the ROE multiple is above the industrial average of 10.87%, and better than all the rivals except for Johnson& Johnson and Medtronic, but the company should be concerned with the ongoing trend as negative trend in ROE forces the investors to lose their confidence in the company.
-Similar trend is also witnessed in the operating margins of the company that after peaking at 26.52% in 2012 went down consistently during 2013 and 2014, and now stands at 16.22%. The operating margin of the company is below than the industrial average of 16.33%, and also falls below to that of its leading rival firms, Johnson &Johnson, Medtronic and Zimmer holdings.
It should be noted that the operating margins of the company has been soaring down because of higher proportion increase in the operating expenses of the company that are increasing at a greater pace and are eroding the operating margins.
-The trend in the Return on Capital Employed (ROCE) multiple of the company has been the most depressing. Over the period of four years, the ROCE multiple has cut short from 16.63% to 8.90% in 2014. This indicates that the company has been employing its capital inefficiently. Although the multiple is still above the industrial average of 8.21%, but it falls behind to that of leading rival firms, Johnson &Johnson, Medtronic and Zimmer holdings. The persistent decrease in the ROCE of the firm is its inability to generate increase in the operating income; while increase in capital employed (Total Assets- Current Liabilities) did the worse.
Investors should be alarmed by considering the ROCE multiple as it is a clear indicating that the company has not been able to generate sufficient returns on the capital invested.

Cash Flow Analysis

The ratio of operating cash flow to sales is calculated to be 14.79% for 2014. As we can witness, the ratio multiple of the company is the least amongst all its rivals, and is also below the industrial average of 22.42%.
The overall trend in the CFO/ Sales ratios was depressing as post 2012, the ratio multiple has been consistently declining. This shows that the proportion of operating cash flow as part of the total revenue figures is declining, which is indeed a negative sign from the growth perspective of the company.

Capital Structure and Solvency Position

As noticed from the latest annual report of the company, Smith and Nephew’s capital structure is composed of 44.70% debt capital, indicating that majority of the funding by the company is sourced from the debt borrowings. We do understand that although the debt-equity ratio of the company is well below than the industrial average of 51.6%, and off all the rival firms(except for Boston Scientific), Smith and Nephew has the least amount of debt in its capital structure, but what will concern the investors is the increasing debt borrowings while the profit margins are declining.
Important to note, the company has been aggressively raising debt to accomplish its acquisition targets irrespective of its financial position. During the three year period from 2012 to 2014, the company has spent $2428 million on acquisition, primarily funded from debt sources, with latest acquisition of Arthocare for $1.4 Billion. However, during the same period, the net profits and the cash flow from operations have attained a declining trend. Thus, the company’s future performance depends primarily on the outcome of these acquisitions, and if the results turn against the company’s expectations, we might see the company pushed into financial troubles associated with debt financing.

Credit Analysis

Debt Rating: C
We are issuing this rating to the company, after considering both short-term solvency and long-term solvency position. As witnessed from the trend in the current ratio of the company, the multiple is steady at 2.10 with overall declining trend from past three years as the current liabilities are increasing in the higher proportion in comparison to the increase in the current asset base.
Similarly, the long-term debt position of the company is also not promising. Over the past three years, the company has added millions of dollars of debt financing in its capital structure nut has failed to impress the investors as the net profit margins are declining and so is growth in the operating cash flow. Thus, we believe that Smith and Nephew have exposed themselves to huge debt exposure, making them vulnerable to interest rate fluctuations and risk of default as the plan to acquire more and more debt was not justifiable considering their present financial condition.


The revenue of the company has been on consistent growth pattern, with an average growth rate of 5.70% from 2012 to 2014. However, for the future, we expect the growth rate to increase to 10% courtesy the much awaited acquisition of Arthocare Limited during 2014. Even the company has stated that their Sports Business segment will be further strengthened with product portfolio of Arthocare. In addition, several other factors such as increasing expenditure on health care by most of the nations, will favor the company with increased revenue figures.
-Net Income
Net Income of the company has showed a declining trend post 2012 period. This we had attributed to increasing operating expenses and interest expenses associated with increased debt borrowings of the company. However we expect the net income to be back on bullish trend as both the company and the market sentiments believe that the company will benefit from its latest acquisition activities and company-friendly economic policies being adopted by various nations. We have assumed that the net income will increase by 8% for 2015 and 2016.
The sluggish trend in the EPS for 2013 and 2014 is attributed to high cost and expense proportions of the company. However, we expect that the EPS will bounce back as the company is expected to witness revenue and net income figures.


Now, to proceed with the valuation of the company’s stock, we have used the comparable method, under which calculated the intrinsic value using the industrial average PE ratio and Earnings per share (average for past 4 years). Followed are the results:

Average Industrial PE: 42.50

Average EPS for past 3 years: (1.63+1.24+1.12)/3= $1.33/share
-Intrinsic Value: EPS* Average Industrial PE
= 1.33* 42.50
= $56.52/ share
- Current market value: $34.27/share

Result: Undervalued

Recommendation- Hold
Thus, considering the current market value of the company on NYSE at $34.27, we believe that the stock is relatively undervalued. However, since we have applied only one set of valuation model, we cannot issue a strong buy rating to the company, although we do issue a ‘’Hold’’ rating for the stock as new health care reforms in US, India and other targeted nations of the company will drive the revenue and profit figures of the company. Moreover, the future performance of the company is highly contingent on the outcome of acquired companies like Arthocare. However, considering the market sentiments and the belief that acquisition will assist the company’s growth, we issue a ‘’hold’’ recommendation for the stock.

Works Cited

(2014). Annual Report 2014. Smith and Nephew.
Smith & Nephew Hip Replacements. (n.d.). Retrieved March 22, 2015, from Drugwatch:
Smith & Nephew PLC-Industrial Average . (n.d.). Retrieved March 22, 2015, from Morningstar:

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Good Example Of Thus, A ‘’hold’’ Recommendation Was Issued For The Company. Report. Free Essay Examples - Published Dec 28, 2020. Accessed September 25, 2021.

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