Global

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Chief Financial Officer's review

Dear Shareholder, 

Smith & Nephew delivered a solid financial performance in 2018. We improved performance, delivered meaningful efficiency savings, sustained investments in R&D for growth and continued to generate strong cash flow. This was achieved while also making important changes to our leadership, structures and culture which all position us well for further progress in 2019 and beyond.

2018 Performance

Group revenue in 2018 was $4,904 million, an increase of 3% on a reported basis and 2% on an underlying basis.1 Our performance accelerated across the year, with 3% revenue growth on an underlying basis1 in the second half, and we take good momentum into 2019.

The reported operating profit for 2018 was $863 million, an 8% reduction from the previous year primarily reflecting the costs of the Accelerating Performance and Execution (APEX) restructuring programme as described below.

Trading profit1 for the year was $1,123 million and the trading profit margin was up 90bps to 22.9%. This reflects both the 50bps benefit of a one-off legal settlement and improved trading performance and cost control.

The reported tax rate was 15.1% (2017: 12.7%). The tax rate on trading results1 for the year to 31 December 2018 was 16.1% (2017: 17.1%). This was lower than the guided rate of between 20–21% mainly due to a one-off benefit from a tax provision release following expiry of statute of limitations and a beneficial geographical mix of profits.

The reported tax rate was lower than the tax rate on trading results as a higher proportion of non-trading items were in higher tax jurisdictions, notably the US.

Basic earnings per share (‘EPS’) was down 13% to 76.0¢, also primarily due to APEX restructuring charges. Adjusted earnings per share1 (‘EPSA’) was up 7% at 100.9¢, reflecting the legal settlement gain, improved trading performance and the lower tax rate on trading results.

I’m pleased to report that trading cash flow1 was $951 million, up from $940 million in 2017, and we had another year of strong cash conversion (as defined on page 195) at 85% (2017: 90%). Return On Invested Capital (ROIC1 – as defined on page 198) was 12.5% (2017: 14.3%), reflecting the reduction in operating profit over the prior year noted above.

Capital Returns 

The appropriate use of capital on behalf of shareholders is important to Smith & Nephew. The Board believes in maintaining an efficient, but prudent, capital structure, while retaining the flexibility to make value enhancing acquisitions. This approach is set out in our Capital Allocation Framework which we used to prioritise the use of cash and ensure an appropriate capital structure.

Our commitment, in order of priority, is to:
1. Continue to invest in the business to drive organic growth;
2. Maintain our progressive dividend policy;
3. Realise acquisitions in-line with strategy; and
4. Return any excess capital to shareholders.

Net debt2 was $1,104 million at year-end, a decrease of $177 million from $1,281 million at 31 December 2017. As part of our strategy to expand in higher growth markets, we expect to participate actively in value-enhancing M&A opportunities, and I am pleased with progress of our REGENETEN business, acquired from Rotation Medical in Q4 2017, which exceeded expectations throughout 2018. We have a strong balance sheet and substantial capacity for acquisitions. Appropriate financing for larger acquisitions would be considered on a case-by-case basis, as opportunities arise.

Ceterix Acquisition

In January 2019 we completed the acquisition of Ceterix Orthopaedics, Inc., the developer of the NovoStitch Pro Meniscal Repair System. The acquisition supports the Company’s strategy to invest in innovative technologies that address unmet clinical needs. The cost of the acquisition was $45 million upon completion, $5 million deferred and up to a further $55 million over the next five years, contingent on financial performance.

Efficiency

Our new Strategic Imperatives include Become the Best Owner. One of the ways we will do this is through simplifying the organisation and its processes, including through the APEX programme, initiated at the end of 2017.

We are on track across all three workstreams of 1) Manufacturing, Warehousing and Distribution, 2) General and Administrative (G&A) Expenses, and 3) Commercial Effectiveness. APEX is expected to drive an annualised benefit of $160 million by 2022 for a one-off cost of $240 million.

We continue to keep the programme under review to ensure the delivery of benefits and assess any further incremental opportunities that may arise.

In 2018, APEX incurred restructuring costs of $120 million with actions undertaken that resulted in benefits of approximately $60 million in the year.

During the year, I was pleased to take on responsibility for our Global Business Services (GBS) and IT functions. Both functions have important roles to play both in supporting delivery of the business strategy and delivering efficiencies as part of the APEX programme.

Expert people, improved systems and effective processes are core to those functions and both functions provide high quality service to the business from a mixture of locations, both near to our business and in cost effective regional centres.

We now have fully functioning GBS centres in Costa Rica, Malaysia, India and Poland. Our employees in these locations are integral members of the Smith & Nephew team and we expect all the centres to expand to take on more work in the coming year.

UK’s Withdrawal from the EU

The Group does not believe that the UK’s decision to leave the EU will have a significant impact on our long-term ability to conduct business into and out of the EU or UK. We are making good progress with our preparations for the various scenarios. Early in 2019, our preparations were assessed by external advisors on behalf of the Internal Audit function, with the findings reviewed by the Audit Committee.

Outlook

Our 2019 guidance for further improvement in underlying performance at the top and bottom line is an important step in realising our medium-term ambition to outgrow our markets.

In terms of revenue, we expect our underlying growth to be in the range of 2.5% to 3.5% in 2019. On a reported basis this equates to a range of around 1.8% to 2.8% at exchange rates prevailing on 1 February 2019 and including the effect of the Ceterix acquisition.

We expect 2019 trading profit margin to be in the range of 22.8% to 23.2%, a further 40–80bps improvement over 2018, excluding the one-off 50bps legal settlement benefit.

The tax rate on trading results for 2019 is expected to be in the range 19% to 21%, subject to any material changes to tax law, or other one-off items.

Following the implementation of the new franchise-based organisational structure from January 2019, we have concluded that we will have reportable segments for our three main franchises; Orthopaedics, Sports Medicine & ENT and Advanced Wound Management, from 2019 onwards. I hope that investors and others will benefit from the additional information this will provide.

Yours sincerely,

Graham Baker
Chief Financial Officer