Smith & Nephew Questions Remain

We are maintaining a Hold recommendation on Smith & Nephew, PLC (SNN) after the company’s second quarter results.

The company follows an effective strategy of investing a significant amount in research and development (R&D) activities, to bring new products to market. This strategy has yielded results in the past, and should contribute to growth going forward. The company is benefiting from its Earnings Improvement Program (EIP), and the recent stock buy-back should provide support to the stock.

This program is designed to continue the company’s investment at a level which will maintain above market revenue growth rates and to drive a renewed focus on costs. SNN expects the EIP to increase trading margin by an average of at least 1% per annum until the end of 2010, including a significant increase in 2007, followed by larger increases in subsequent years. In 2010 this margin improvement equates to at least an additional $150 million in trading profit.

Underlying sales growth in all divisions has been slowing, from over 10% in the previous years to below 10% in 2008. Moreover, Smith & Nephew’s orthopedics division faces tough competition in both domestic and international markets.

The stock is trading below its peers, but with the uncertainty surrounding sales practices at its European subsidiary, there is little upside in the near term. The stock is currently trading at 19.9x our 2008 EPADS estimate which is higher than the average of its peers of 17.7x. Our six-month price target is $63.00.

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