Cevian holds stake in Smith & Nephew. How it could help improve margins

Business: Smith and Nephew is a British medical technology company that operates worldwide. The company develops, manufactures, markets and sells medical devices and services. Its segments include orthopaedics, sports medicine and ear, nose and throat, and advanced wound management. Its orthopaedics segment includes a range of hip and knee implants to replace damaged or worn joints, robotic-assisted and digital technologies, and trauma products used to stabilise severe fractures and correct hard tissue deformities. Its sports medicine and ENT businesses offer advanced products and instruments used to repair or remove soft tissue. Its advanced wound management portfolio offers a comprehensive set of products to address broad and complex clinical needs.

Market value: ~£9.6 billion (£11 per share). The stock is also traded in the US as an American Depositary Receipt under the symbol “Social networks” . “

Ownership percentage: 5.11%

Average cost: 9.68 pounds

Activist’s comment: Cevian Capital, founded in 2002, is an international investment firm that acquires significant stakes in listed European companies whose long-term value can be enhanced through active participation. Cevian Capital is a long-term and active shareholder of listed European companies. It is often referred to as a “constructive activist” and is the largest and most experienced dedicated activist investor in Europe. Cevian’s strategy is to help its companies become better and more competitive in the long term, and to generate returns through an increase in the long-term real value of the companies. The firm’s work in companies is typically supported by other owners and stakeholders.

Cevian acquired a 5.11% stake in the company as it believes Smith & Nephew operates a fundamentally attractive business. The investor believes there could be significant upside potential by improving the operating performance of the company’s businesses.

Smith & Nephew is a global leader in medical technology. The company develops and sells medical devices and services in three segments, maintaining a dominant global market position in each of them: orthopedics, sports medicine and ENT, and advanced wound management. Smith & Nephew is well known for the quality of its products and its brand perception is very strong. In addition, the company operates in growing and consolidated markets with good competitive dynamics. In general, customer behavior is very predictable and the market shares of the industry leaders are stable. In 2023, the company generated $5.55 billion in revenue, of which 40% came from orthopedics, 31% from sports medicine, and 29% from wound medicine. However, the profitability profile is quite different. After apportioning overheads, orthopedics has only 11% operating margins, while the sports and wound care sectors have double that with operating margins of 22%.

Despite its market leadership and favorable industry dynamics, Smith & Nephew has failed to generate shareholder value for many years – down 44% since January 1, 2020, and 33% since its post-Covid price on January 1, 2021. This is not surprising, and the reason seems obvious: the operating margins of its largest business, Ortho. In 2019, Ortho had operating margins of 23%, which fell to 13% in 2020. They are now at 11% today. This is due to self-inflicted problems related to supply chain management, logistics, and manufacturing, resulting in backorders and required implants or tools not being in the right place at the right time. This problem is somewhat unique to Ortho, as it is a much more complex business than Wound and Sport and requires timely delivery of not only a variety of implant sizes, components and devices for each procedure, but also the specific tools associated with the procedure. Another major factor contributing to the company’s missteps is that Smith & Nephew has experienced a significant amount of management turnover over the past five years.

Management has now released a 12-point plan, a key component of which is to get Ortho back on track to regain momentum and gain market share. While this is a step in the right direction and this management team is able to successfully execute on this plan, it won’t happen with continued leadership turnover. It’s impossible to execute a long-term operating plan when there’s a new CEO every few years. This is a company that clearly needs an activist, but the good news is that Cevian is the perfect activist for a company like this. The two things Smith & Nephew needs most are a long-term mindset and operational improvements. Cevian is a long-term activist – the average holding period for the company is four to five years, but they will often hold positions for eight to ten years – with a focus on operational performance. The company has a long history of helping companies improve their operations, whether as an active shareholder or board member. There’s no reason why the company shouldn’t be able to increase Ortho’s operating margins to at least their pre-pandemic levels and perhaps even higher, closer to peers like Stryker and Zimmer Biomet.

We expect Cevian to seek board-level participation in this initiative, as they hold board seats in most of their activist roles. Currently, Cevian professionals sit on the boards of 10 portfolio companies in six different countries. Given the firm’s experience and the fact that it is the company’s second-largest shareholder, we expect Cevian to be able to secure a board seat here as it does in most of its engagements – amicably or by invitation.

Ken Squire is the founder and chairman of 13D Monitor, an institutional research service on shareholder activism, and the founder and portfolio manager of the 13D Activist Fund, a mutual fund that invests in a portfolio of 13D activist investments.