A Stock to Heal Your Aching Bones

03/10/2009 9:59 am EST

Focus: GLOBAL

Allan Nichols

Equities Strategist & Editor, Morningstar InternationalInvestor

Allan Nichols, editor of Morningstar InternationalInvestor, says a British orthopaedic device maker is gaining share amid bone-crunching competition.

Smith & Nephew (NYSE: SNN) is a UK-based company with more than 150 years of operations. Orthopedic devices—including knee and hip implants and tools to set bone fractures—accounted for 57% of 2008 sales. The balance of sales comes almost equally from two other units—endoscopy tools for minimally invasive joint surgeries and advanced wound-management dressings and other devices.

In our favorite of the three—orthopedic implants—Smith & Nephew remains in a middle tier of competitors, substantially trailing Zimmer (NYSE: ZMH), Johnson & Johnson (NYSE: JNJ), and Stryker (NYSE: SYK) in market share.

However, we think Smith & Nephew’s unique strategy of pursuing relatively young, active patients should serve it well, producing volume growth and perhaps protecting prices if the reimbursement landscape changes. With increased scrutiny on health-care expenditures, we think more burden will be placed on device makers to prove the worth of new products.

We think Smith & Nephew has proved its innovative chops in recent years by introducing revolutionary products, such as the Birmingham hip resurfacing and Journey Deuce knee products, that help keep younger patients physically active for longer.

Smith & Nephew claims the number-one market position in arthroscopy tools, which helps endear it to doctors in a fast-growing medical specialty, sports medicine. By gaining access to doctors who treat patients in the early stages of joint deterioration, the firm hopes patients will remain in the care of doctors who utilize its products, which could feed into the orthopedic implant business.

The firm is also aiming at Kinetic Concepts’ (NYSE: KCI) virtual monopoly in negative-pressure wound therapy market. Smith & Nephew has some cutting-edge products in fast-growing areas of health care. It faces tough competitors in its chosen medical device niches, but we think its products offer compelling value propositions.

We’re keeping our fair value estimate at $59 per share. After 13% growth in 2008, including benefits from the Plus acquisition, we expect 8% compound annual sales growth through 2013. This estimate is based on 8% annualized growth in orthopedics, 8% annualized growth in arthroscopy, and 10% annualized growth in advanced wound management.

Plus’s problems and integration have kept operating margins in the mid-teens for the last couple of years, but we project operating margins will rise to about 24% by 2013. The revenue mix should improve, [too,] as more sales come from the highly profitable orthopedic business and the more profitable negative-pressure wound therapy niche. (The stock closed at $30.57 Monday—Editor.)

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