FTSE 100 firm Smith & Nephew’s (LSE: SN) shares are down 21% from their 1 August 12-month high of £12.46.
Such a fall raises the possibility to me of a bargain to be had.
Why did the stock fall?
Much of the price drop followed 31 October’s Q3 results release. These saw the firm reduce its 2024 underlying revenue growth guidance to “around 4.5%” from 5%-6% previously.
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And the key reason for this was the ongoing rollout of China’s Volume Based Procurement (VBP) programme. This is a scheme in which the government bulk-buys drugs through a tender mechanism aimed at securing the lowest prices.
For Smith & Nephew, this means that maintaining and then increasing profits will require higher production as prices fall. This will take time, and before then its revenues in the country will fall. The VBP effect is likely to continue into 2025, according to the firm, and remains a principal risk for it in my view.
What about the non-China business?
Otherwise, in the Q3 results, overall revenue rose 4% year on year to $1.412bn (£1.11bn). Orthopaedics revenue increased 2.3%, while Sports Medicine & Ear, Nose and Throat jumped 3.9%. Advanced Wound Management revenue was 6.5% higher.
Consensus analysts’ estimates are that Smith & Nephew’s revenue will grow by 5% a year to the end of 2026. Its earnings growth to the same point is forecast to be 22.7% each year.
Revenue is the total money a business receives, while earnings are the remainder after expenses. And it is earnings growth that ultimately drives a company’s share price and dividend over time.
Are the shares now a bargain?
On the key price-to-sales stock valuation measure, Smith & Nephew trades at just 1.9. This is bottom of its competitor group, which averages 3.
This comprises EKF Diagnostics at 2.2, Carl Zeiss Meditec at 2.3, ConvaTec at 2.8, and Sartorius at 4.8. So, it is a bargain on that basis.
The same is true on the price-to-book ratio, with Smith & Nephew presently at 2.1 against a competitor average of 3.4.
To nail down what this means in share price terms, I ran a discounted cash flow analysis. Using other analysts’ numbers and my own, this shows the stock to be 39% undervalued at its current price of £9.81.
So a fair value for the shares would be £16.08, although they may trade lower or higher than that.
What’s my verdict?
Following the Q3 results, there had been rumours of major shareholders pushing for a break-up of Smith & Nephew supposedly to unlock value.
The firm’s chairman Rupert Soames scotched these on 14 November stating that the firm’s strategy “encompasses all three of our business lines”.
If he had not done this, I would never consider buying the stock. I can do without this sort of damaging break-up talk driving the share price lower for longer.
That said, unhappy investors may continue to push for a break-up. And as it is, I am focused on high-yield stocks and Smith & Nephew returns just 3.1% a year. If it was not for this, I would seriously consider buying shares in the firm for its strong earnings growth potential. This should push the share price and dividend much higher over time, I think.
