Smith & Nephew: Operational Challenges Below the Surface Are Likely To Linger

The uptick in U.S. medical utilization provides a favorable backdrop for medical device firms as the rest of 2023 unfolds. However, we think Smith & Nephew SN. may not be able to fully capitalize on these conditions, as it remains hampered by some operational issues. Despite the near-term speedbumps, Smith & Nephew remains a sizable competitor with attractive businesses that should hold their own over the longer run, and we’re holding steady on our fair value estimate. In particular, Smith & Nephew enjoys intangible assets and switching costs that add up to a narrow economic moat. We’ve seen little to change our thinking there.

Though we were surprised by previous CEO Roland Diggelmann’s abrupt resignation last year, since then it has become clear that Smith & Nephew has been dealing with considerable operational issues. The addition of CEO Deepak Nath has shone a light on these challenges, and we think he’s made substantial progress in the last year. Some of this amounted to better blocking and tackling. For instance, the reprocessing of orthopedic instrument sets. The faster these reusable tool sets are cleaned, decontaminated, and sterilized, the sooner they can be put into circulation for joint replacement procedures. Smith & Nephew has reduced this reprocessing time by 40% in the first half of 2023. This was especially critical because the firm was also having problems with assembling compete tool sets. Those that weren’t complete couldn’t be sent out for use, and would represent sidelined working capital. Significant reductions in incomplete sets have also helped improve the efficient use of tool sets and allowed for greater capacity to handle procedure volume.

These green shoots have given us more confidence that Smith & Nephew is on its way to greater efficiency. Nonetheless, we expect it could take another 12 to 24 months to fully iron out operational friction.