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Business diversity strengthens credit at Smith & Nephew

| February 26, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

Since its debut deal in October of 2020, Smith & Nephew PLC (SNLN) retains one of the strongest credit profiles relative to its medical device peers given its low debt levels and strong cash balance. While the medical device credits have all been impacted by COVID, certain credits performed better than others depending on the degree of “electivity” of their product lines. This gives SNLN greater flexibility to invest in its core business, while providing some headroom should any of the newer strains of the COVID virus further delay the elective surgery market. In particular, Zimmer Biomet Holdings (ZBH) 2030 bonds only trade 4 bp wide to SNLN (g-spread) yet the company has net leverage that is over two turns higher.

Medical device credits witnessed a significant decline in revenues in the second calendar quarter of 2020, however some rebounded faster than others to positive top line growth, including Stryker Corp. (SYK – Baa1/A- (n)) and Medtronic PLC (MDT – A3/A). Both SNLN and Zimmer Biomet Holding Inc. (ZBH – Baa3/BBB/BBB) continued to see sales declines in 4Q, but both credits are estimated to post strong top line growth of 16% and 13%, respectively, in 2021.

Exhibit 1. Medical Device Comparison

Source: Company Reports; Bloomberg; Amherst Pierpont Securities

Leverage Target Supports Existing Ratings

SNLN has a stated net leverage target in the 2.0x-2.5x range. While the company is currently below its target range, we expect net leverage to rise as it uses cash raised in its debt offering to fund its acquisition strategy. SNLN focuses on tuck-in size acquisitions and recently closed on a $240 million acquisition of Extremity Orthopedics (1/4/21). Over the past 2 years, SNLN has completed 9 acquisitions, of which financial terms were disclosed for only two. The current ratings and respective stable outlooks at Moody’s and S&P factor in management’s acquisition strategy and leverage target. An increase in net leverage to management’s stated range will not impact existing ratings or outlooks. SNLN’s track record of maintaining strong credit metrics coupled with its disciplined approach to acquisitions lend to the existing ratings.

Diversification Mitigates Downward Risk

Not only is SNLN geographically diverse with 80% of its top line coming from established markets such as the United States, Europe, and Japan, the company maintains good diversity amongst its product lines. Its three distinct business lines: orthopedics; sports medicine/ENT; and trauma/advanced wound management, each account for roughly one third of its top line. Management noted that its trauma/advanced wound management business remained relatively resilient during the pandemic as it posted positive growth in key European markets in both the most recent quarter as well as the full year. SNLN’s recent acquisition of Extremity Orthopedics is expected to further add to growth in the trauma division and will be included in results going forward.

Peer ZBH’s recent announcement to spin off its spine and dental business will reduce the company’s product diversity, something viewed as a modest negative by Moody’s. The business accounts for roughly 13% of ZBH’s top line, thereby making it more reliant on its elective knee and hip business unit, which will account for over 60% of the top line. While proceeds will be used for debt reduction to offset the lost EBITDA, leverage is only expected to decline to the low 3.0x area by year end 2021.

Cash Position Limits Debt Needs

SNLN’s net leverage is expected to increase closer to its stated target range as the company uses is strong cash position to execute on its growth strategy which includes tuck-in acquisitions as well as R&D. Additionally, the company’s free cash flow generation more than supports its current dividend program. That said, SNLN has little need to tap the debt market over the intermediate term. Furthermore, its 2030 bond remains its only issue outstanding and does not need to worry about refinancing upcoming debt maturities. Conversely, ZBH has an active debt maturity schedule with approximately $4.3 billion maturing over the next five years. While ZBH will be looking to reduce debt with some of proceeds from the spin of its spine and dental business, the spin is not expected to happen until mid-2022. ZBH has over $1 billion of debt maturing before the spin is expected to close.

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