Smith & Nephew PLC (SNN) 2006 Q3 法說會逐字稿

Good day ladies and gentlemen and welcome to the Smith & Nephew 2006 third quarter results conference call. For your information this conference is being recorded. Before we begin we would like to read out the Safe Harbor statement.

This presentation contains certain forward-looking statements within the meaning of the US Private Securities Litigation Reform Act of 1995. In particular statements regarding planned growth in our business and in our operating margins discussed under outlook are forward-looking statements as are discussions of our products pipeline. These statements, as well as the phrases aim, plan, intend, anticipate, well-placed, believe, estimate, expect, target, consider and similar expressions are generally intended to identify forward-looking statements.

Such forward-looking statements involve known and unknown risks, uncertainties and other important factors including, but not limited to, the outcome of litigation and regulatory approvals that could cause the actual results, performance or achievements of Smith & Nephew, or industry results, to differ materially from any future results, performance, or achievements expressed or implied by such forward-looking statements.

Please refer to the documents that Smith & Nephew has filed with the US Securities & Exchange Commission under the US Securities Exchange Act of 1934, as amended, including Smith & Nephew's most recent annual report on Form 20F, for a discussion of certain of these factors.

All forward-looking statements in this presentation are based on information available to Smith & Nephew as of the date hereof. All written or oral forward-looking statements attributable to Smith & Nephew, or any person acting on behalf of Smith & Nephew, are expressly qualified in their entirety by the foregoing. Smith & Nephew does not undertake any obligation to update or revise any forward-looking statement contained herein to reflect any change in Smith & Nephew's expectation with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

I will now pass you on to Sir Christopher O'Donnell, Chief Executive Officer of Smith & Nephew.

Well good afternoon everybody and welcome to the Smith & Nephew quarter 3 results conference. I'm Chris O'Donnell, I'm the Chief Executive of Smith & Nephew and I'm here with my colleague, Mr. Adrian Hennah, our Chief Financial Officer.

It will be our pleasure today to take you through the quarter 3 results of Smith & Nephew. And at the end I will also comment on the other statement that we put out to the Stock Exchange this morning concerning our discussions with other companies.

So by way of introduction, this has been a very positive quarter for Smith & Nephew. Our new products have driven stronger revenue growth. We've seen signs of strengthening in the US marketplace for our products, particularly in Orthopedic Reconstruction. It has to be said that healthcare spending constraints remain a challenge in some European markets and that's likely to remain the case.

We do also, and we'll talk more about this, have a systematic review of margin improvement opportunities underway. It's early stages. but we think there are some opportunities there on a go forward basis.

If we look at the highlights of our business for quarter 3, our Group revenue growth was up 10% to $679 million. Trading profit was up 15% to $134 million and this was produced by good performance across all our businesses.

Our Reconstruction revenue grew very strongly at 13%. Trauma improved its revenue growth rate sequentially to be up 15%. Endoscopy achieved an increased revenue growth of 13%, a big step up on the first half of the year. And Advanced Wound Management revenue remains on track at 1% reported and 5% after adjusting for our exit from DERMAGRAFT last year. So those are the highlights.

What I'd like to do is to pass over to Adrian to talk you through the numbers. I'll then return and talk about some product trends and how the business is going forward. Adrian.

Well thank you Chris and good morning ladies and gentlemen.

If we could turn to slide 6 and the income statement. Revenue in the quarter was $679 million. This represents a growth of 10% at constant exchange rates on the comparable period last year. The slightly weaker dollar in quarter 3 led to a further 1% increase in reported revenue at 11%. Trading profit in the quarter was $134 million. This represents a growth of 13% at constant rates. The trading margin of 19.7% was slightly ahead of the comparable period last year.

Amortization of acquisition intangibles was $4 million. This includes $1 million in respect of OBI, which was acquired in July. Net interest income in the quarter was $2 million and was in line with expectations. We are looking at about $10 million for the full year.

Moving then to slide 7 and further down the income statement, the tax charge is 29.5%, in line with the expectation for the full year that we indicated at quarter 2. Adjusted earnings, or attributable profit, was $97 million, a 7% growth on quarter 3 last year. With a slight increase in the number of shares in issue, this means a 6% increase in adjusted earnings per share. As you know, EPSA growth in the current year is negatively impacted by the disposal of our joint venture with BSN and by the loss of net interest income deriving from dollar sterling interest rate differences and our accounting in sterling. Together these reduced EPSA growth by about 7 to 8% year-to-date.

Turning then to slide 8 and an analysis of revenue by business segment. You'll hear from Chris in a moment in more detail behind the numbers for each business. I will therefore make only a couple of financial points in respect of this and the next two slides.

On this schedule you can see the growth rates in the quarter for each of our business segments. The growth rates in the Reconstructive, Trauma and Endoscopy businesses have all increased in quarter 3 above the rates achieved in the first half of the year. As Chris has already mentioned, the important new products in the Reconstructive business have performed in line with our internal expectations.

Reported revenue growth and Advanced Wound Management continues to be impacted by the sale of the DERMAGRAFT business. This reduced growth by 4% in the quarter.

Turning then to slide 9 and the analysis of revenue growth rates by segment and by geography. You can see that revenue growth increased from the first half in each of the three main regions and that it increased most significantly in the USA. Growth in the USA increased from 6% at half 1 to 12% in quarter 3. There was a significant increase in the Endoscopy growth rate in the USA but on a relatively weak 2005 comparative. We had a stronger quarter 4 comparative in Endo in 2005.

The biggest driver of the increased growth in the USA was the Reconstructive business. This had a slightly weaker comparative but the greater part of the improvement was, as expected, the recent product launches. In particular the JOURNEY and LEGION Knees and the BHR Hip are progressing in line with our expectations.

We continue to be pleased with the progress of our relatively small Wound business in the USA. After adjusting for the sale of the DERMAGRAFT business, revenue grew by 14% in quarter 3, up from the 9% growth in half 1, but again on a relatively weak quarter 3 comparative.

In Europe there were fewer specific adverse market factors than in half 1, without the fiscal year end pressures in the UK NHS, and fewer surgeon strikes in Continental Europe. The market environment however remained tough. Despite this market environment, our relatively small European Trauma business achieved good growth across all the larger European countries. We continued to experience quite high price-based competition in Wounds, our largest European business.

Turning then to slide 10, and an analysis of trading profit by business segment. Trading margins for the Group as a whole was 19.7%, up from a weak 19.1% in quarter 3 last year. It was beneath the 19.9% in half 1 in what is a seasonally weak -- seasonally slower quarter 3. The Recon business achieved an improved margin on last year, in largest part due to the impact of the new launches.

Trauma's margins remained beneath last year due mainly to the investment in the USA sales force following the split from the Recon business in quarter 1 and the associated slight disruption. We expect the new representatives to increase their productivity progressively over the coming quarters. Endoscopy margins continue to be impacted by, among other factors, investments in the visualization and digital operating room area.

The year-on-year improvement in Wound margins was wholly due to the disposal of the loss making DERMAGRAFT range. DERMAGRAFT was closed during quarter 4 last year, and therefore this year-on-year effect will reduce. The business continues to experience margin pressure as a result of competitive pricing.

We mentioned at the time of the quarter 2 numbers that we would be embarking on a program aimed at improving the operational effectiveness of parts of the business. We said that we recognized that our operating margins are lower than some of our peers in the industry and that we have been more focused for several years on successfully outgrowing a strong market rather than optimizing our operational effectiveness. We have engaged the assistance of an outside firm who have substantial experience with major re-engineering exercises to assist us. We launched the first phase of the program in October. This is a diagnostic phase, aimed at both getting a good understanding of areas of greatest potential and at energizing and engaging the leadership groups in the company. We expect then a shorter phase aimed at evaluating and prioritizing the specific opportunities and deciding which ones to pursue and in what order.

We expect to be in a position to give more information to investors during quarter 1 of next year on how we see the approximate scale, cost and timing of the opportunities. We are not however in a position to give any more information now.

Turning then to slide 11 and the cash flow. We generated $40 million free cash flow in quarter 3. Capital expenditure continued somewhat ahead of depreciation due principally to investment in MRP and ERP systems and in instrument sets to support the new product launches.

The working capital outflow of $78 million includes $42 million of deficit reduction payments -- of deficit pension payments in the quarter. You will see in the balance sheet -- in the press release, the corresponding reduction in the retirement benefit obligation. The remaining $36 million outflow in respect of working capital was mainly inventory to support the new product launches.

Turning lastly in this financial part of this presentation to slide 12 and the outlook. We are, as Chris has mentioned, not changing our EPSA guidance for the full year from that given at half 1. This was for EPSA growth after adjusting for the OBI acquisition of 3 to 5%.

As with the year-to-date number, the full year EPSA growth number is after an approximately 7 to 8% negative impact from the BSN JV disposal and the loss of net interest income from interest rate differentials. Our expectation for revenue growth in each segment has also not changed.

Our new products, especially the LEGION and JOURNEY knees and the BHR hip in the USA were the main driver of the increase in the growth rate in half 1 to quarter 3. Our expectation is that this will continue in quarter 4.

With regard to guidance for 2007, we have had strong support from investors for the intent we signaled with our half 1 numbers to provide less specific numerical guidance in future. We have not finalized the exact form of the future guidance, but we do plan to include some indication of our expectations for 2007 with our 2006 full year numbers in February. We do expect our new products and the efficiency program to be important influences of our numbers. And we do therefore expect to provide some indication of our expectations in these areas. We will also, of course, continue to signal any unusual items we expect, if there are any.

And with that, I'll hand back to Chris to talk about the business behind the numbers.

Thank you Adrian. We turn to slide 14 dealing with Reconstruction. I think this is an exceptionally positive slide. At the overall level, I'm really pleased to say that we've been successful in hitting our launch targets for all our new products this year across all our businesses. And the most challenging profile has actually been in Reconstruction where we've launched two new knees and actually three new hips, including BHR. And we've brought forward the last one that we announced, EMPERION, from quarter 4 into quarter 3. So this is a terrific performance by our business and our people in Reconstruction.

The results in quarter 3 are that in the US we grew 14%, and outside the US we grew 11%. Knees, a very strong performance at 15, and hips at 11. We have seen a modest market recovery in the US. The market has ticked up to somewhere between 7 and 8% on our best calculations globally, which is an improvement on the first half, but conditions do remain challenging in some European countries.

Our new product launches, as we've been saying consistently to you, are the key to our revenue growth, but we're very pleased to get these all out on time. And for perspective, the last time we launched a new knee system was in 1998, and we've launched two new knee systems this year. So very significant in knees, and a similar story in hips. So this is building opportunity for us, not just for this year and 2007, but out into the future. Knee growth was outstanding.

Hip growth showed recovery, and I'm particularly pleased to say that our Birmingham hip resurfacing product, the launch in the US is on track. Our surgeon training program is exactly where we anticipated and the surgeries that we are seeing are being very, very successful. So very strong performance in Reconstruction which I am extremely pleased with.

In Trauma we've seen another very good performance with a pick up in growth in the quarter over first half. In this case US performance at 13% and the performance outside the US at 18%. Fixation 12% growth and clinical therapies 20 as a big driver of this growth profile.

You'll see in the picture attached to this slide 15 that we have launched our upper extremity PERI-LOC system which is very important in sustaining our growth momentum. We acquired the license to DUROLANE which is a single injection joint fluid therapy for osteoarthritic pain just before the end of quarter 2, and the integration is progressing very well, particularly in Europe here. And I'm pleased to say that Trauma now have 20% of their revenue in new products year-to-date on our rolling three year calculation.

Endoscopy had a very strong quarter, particularly in the US and again led by new products. So a very strong performance by our business here and thanks to all the people who've contributed there. 14% in the US, 12% outside the US.

Our repair business, knee, shoulder and the newly emerging hip repair business grew in total at 22%. And a very strong performance in the quarter for Digital OR and visualization, which was somewhat lighter in quarter 2, but has come back strongly in this quarter at a 20% growth rate.

We also got an up tick in resection growth and I would draw your attention to the item in our announcement where the Loma Linda study on reprocessed blades reinforces our argument that we should really stick to single use of these very, very intricate arthroscopic shaver blades.

Our integration of OsteoBiologics is on track, which is very encouraging, and an important building block for the future. And new products here is a staggering 27% of revenue across the whole of the business.

I'm also pleased with Advanced Wound Management. Not such spectacular growth; they do have the drag of DERMAGRAFT, so their reported number is 1%. On a global basis taking the DERMAGRAFT effect out, it's 5%. And in the US it's an outstanding 14% in the quarter. ALLEVYN continues strongly as does wound bed preparation.

So our revenues are on track with what we've told the market. This is a transition year for the business as it exits DERMAGRAFT and it focuses on building the business, particularly in the US and in each of the segment leading products that we have. And the US business is going very well, but we have seen some healthcare spending constraint pressures, particularly in Europe.

In the quarter we also had low growth in ACTICOAT, not in wound bed preparation in total which is the category it falls into, as the price point moved downwards in terms of silver. And we'll be looking at that in terms of the product profile we offer in this segment on a go forward basis into next year.

ALLEVYN growth strengthened with the launch of the updated range of ALLEVYN products in Europe, and these are now being rolled out into the US. So we're excited about the opportunity for keeping this significant product growing very strongly into the future.

And we've had strong progress in VERSAJET. Small numbers in absolute terms, but dramatic growth rates in our hydrosurgery system, particularly since we now have the important burns approval in the US. New products here are 10% of revenue year-to-date, and we look forward to seeing this tick upwards as the year goes on.

So in summary, we're encouraged by the modest improvement in the US market, particularly the growth in reconstruction. There are still challenges in Europe and you can see from what Adrian told you that our growth in Europe is lower than in our other sectors -- in our other geographic sectors. Reconstruction benefits from its new product successes, you can see that starting to impact. A strengthening performance from our Trauma business, which is very encouraging, and improved arthroscopy growth fuelled by our investments in the product line in repair and in digital operating room. And for the future we expect the positive impact of these new products to continue into quarter 4, and into 2007 and beyond.

Now that concludes the review of the quarter 3 results. Before I move to questions, what I would like to do is just comment a little bit on the other announcement we put out this morning. We've made an announcement that we have had very preliminary discussions with Biomet along with preliminary discussions that we have with many other companies in any given period of time. And in the same way as we view any other transaction, we would only take this forward if we could see significant strategic and, of course, shareholder value. We've made a complete statement and we don't intend to make any additional comment today beyond what we've said in today's press release.

So, with that, I'd like to turn the conference call back to our operator, Duncan, and ask you if you would invite questions?

Thank you, Sir Christopher. [OPERATOR INSTRUCTIONS]. Our first question comes from Ed Ridley-Day from Lehman Brothers. Please go ahead.

Thank you. Good afternoon.

Good afternoon Ed.

If I could just follow up in terms of the BHR. Could you give a little bit more detail, I don't know if you can, in terms of maybe numbers in terms of the details, how many surgeons you've done? Or just a little bit more about -- I think you said previously, talking about full year sales of BHR of 10 to 11 million. If you could just reconfirm that?

But also, on pricing and talking about the UK and European environment. Could you talk a little bit about the Novation DHL deal with the NHS and how you see that affecting your business in the UK? And also if, and what we should be looking for in Germany in terms of potential impact on your businesses there?

Chris O'Donnell. Okay. Let me try to deal with those in a fairly straightforward way. We're up to around 150 surgeons trained by the end of the quarter, which is significantly ahead of our training run rate. We still do anticipate that BHR will make a small but significant positive contribution this year at around $10 million. We believe we're on track for that. And I think you know that our aim here is to have a very, very methodical and careful launch of this product; it is different surgery, it requires intensive surgical training. I'm very pleased to say we're getting excellent clinical results as a result of the thoroughness of our training program. And we're going to continue down that track.

So it is a measured launch, but this is the foundation for a significant growth in 2007 and beyond and the numbers we would then expect to step up. So BHR is going exactly where we see. We're arguably a bit ahead of our surgeon training program.

Okay.

To answer your question about the UK, this outsourcing of procurement and distribution to Novation and DHL is, quite frankly, a very confused picture at this point in time. It is likely to increase the price pressure on medical device companies to some extent. But quite frankly, it is likely to play to the advantage of the bigger companies, because that is the way GPL organizations work. So we're really going to have to wait and see there, Ed.

Okay.

With regard to Germany, the change to DRG systems for Germany is now into its third year. It's typically around this time when DRG systems are introduced that rationality, as opposed to panic pricing pressure takes over. It's very important for us to [inaudible] our products in DRG systems. It's very considerable because of the way we [inaudible] economic program alongside our clinical benefits, but it will probably be next year before that really works through.

We believe that pricing in Reconstruction in Germany is negative. We have the opportunities in Trauma and Endoscopy, but the climate for Wound is also pretty highly pressurized from a price point of view. So it's a mixed picture. We don't anticipate any significant improvement in the balance of this year, but look to see some [quality] and some more structured improvement in 2007 and beyond.

Thanks very much. That's very helpful.

Okay. Next question, please?

Thank you. Our next question comes from Michael Jungling of Merrill Lynch. Please go ahead.

Great. Thank you. I'd like to ask three questions, firstly please on the gross margin. You have a gross margin in the third quarter of 74.5% which is no improvement over the first quarter of 2006, despite achieving significantly more sales and also a greater weighting towards your traditionally higher Orthopedic margin business. Can you explain why we haven't seen an improvement in the gross margin?

Secondly, on the operating costs. They've been running in the past two quarters at about $375 million. Can you give us some guidance as what that number would be for the fourth quarter?

And then the third question is on fixation, despite seeing a significant greater shift towards your premium price lock in compression plates, we've seen no real improvement in the United States with respect to growth rates. And it's taking a very different trend to what the market leader at the time experienced, and I'm curious as to why the growth rates aren't better. Thank you.

Right. Well, I'm going to ask Adrian to deal with your questions on margin and operating costs, and I'll deal with the fixation question. So Adrian, what can you help Michael with?

Well, you're absolutely right, Michael that there has been some movement in the mix towards Recon overall from -- away from other areas overall. But within each of the businesses including within Recon, there are also a set of other mixed shifts, which haven't all gone in our favor. There is no single theme we can point to. One could give examples for -- but there are in fact a whole series of things moving in there on gross margin. So I can't -- we can't, I'm afraid, give you a single explanation for that.

On operating costs, we're not -- well, as you know, the trend we're giving in guidance, Michael, we're not going to move beyond that in terms of the year-end EPSA guidance and the year-end revenue guidance we've given. We're not going to give margin guidance including margin guidance by the back door.

Okay. With regard to fixation in the US, we have seen an improving trend there. The timing of the launch of our PERI-LOC product was towards the back end of quarter 3 -- sorry, of our PERI-LOC upper extremity. And therefore, we didn't see much impact in that area. We have seen a very strong international performance from fixation. We didn't see as much growth in quarter 3 as we anticipated, perhaps, in the US, but we do anticipate that on a go forward basis this will progressively improve, particularly as we've now got this strategically important complete product line in PERI-LOC, both upper extremity and lower extremity. And on the plus side, we have exceptional growth from our clinical therapies group, back up into the 20% territory, which is extremely encouraging, and a very strong performance.

If I could ask a follow up question for Adrian? When I look at your guidance for the full year, to achieve your margin guidance you really need to keep operating costs constant, which is an unusual trend given that the fourth quarter usually has higher operating costs. So I'm trying to understand how you see the margin development in the fourth quarter, because as I said before, you probably need to keep operating costs constant, which is an unusual trend [inaudible].

Well I think again, if we just compare quarter 3 -- going back to your cost of sales number, the cost of sales number in quarter 3 this year, just doing the reverse of yours, it's 25.5%, which actually is of course an improvement on quarter 3 last year. So that is in the right direction. And in terms of the progression of SG&A, no, that is taken into account, for sure, in terms of our earnings guidance.

Okay great. Thank you.

Thank you. Next question, please?

Thank you. Jason Wittes of Leerink Swann has our next question. Please go ahead.

Hi. Thank you very much, Chris. Thanks. First off, you mentioned some recovery in the US. Could you break it down a little bit? How much is related to Katrina, how much is pricing and how much is just you gaining share?

Are you talking particularly about Recon?

Yes, specifically about Recon; hips and knees.

Well broadly probably the Katrina effect was worth at least 8 percentage points in the quarter but it was right at the back end of quarter 3 last year. We see -- in the marketplace we see volumes not shifting up particularly significantly. We do see a share gain and we see a mix effect and if I were asked to divide those up, I would say that our increase above market is probably about half and half mix and units. The encouraging thing, particularly with BHR is that is a market expanding device and we believe that any growth in BHR substantially is expanding the total market as well as obviously improving our market share.

Okay and I assume with BHR right now I think you said 150 docs have been trained in the US, if I heard correctly.

That's right.

And those are, I would assume, all Smith & Nephew docs or are some of those new docs to come into Smith & Nephew?

No, a significant number of those doctors are doctors who are not currently using Smith & Nephew prostheses.

So this really has been a driver, or looks like it's been a driver this quarter and should continue to be a driver of share growth in hips?

Absolutely. I mean -- but we're aiming for 10 million this year because we are being very specific and making sure the training and the follow up is right. But at the point when we've done the first 1,000 plus surgeries, we will have surgeons, US surgeons who will be in a position to train others because they'll have done enough, seen enough and be practiced enough to become trainers. At that point, we can multiply up the training effort very, very substantially. That point doesn't arrive until some time probably late on in the first half of next year.

Okay. And in terms of LEGION and JOURNEY in knees, how much contribution was there from those products?

Well, I think the way you should probably think about our orthopedic business is the majority of the growth in our orthopedic business is coming from our new products. The rest of our business is stable and growing a little bit but the majority of the growth is coming from LEGION, JOURNEY, BHR, anthology which is one we don't talk about a lot but it's an MIS that we launched this year and EMPERION is added to that. So a lot of that is going to be -- the majority of the growth is coming from our new products.

Okay. And for just -- I may have missed part of this but I believe you say you won't be providing the 2007 guidance until February at this point. Did I hear correctly?

That's correct yes.

Okay, I guess that's all. Thank you very much.

Thank you. Next question?

Thank you. Our next question comes from Ilan Chaitowitz of Redburn Partners. Please go ahead.

Good afternoon.

Good afternoon.

Just a few questions. Firstly on the Birmingham hip. Just looking at your competitors and their manufacturing catalogs, it looks like metal on metal devices at the moment are priced at a premium to other models, certainly in excess of $10,000. And I was wondering if your Birmingham hip is a premium product to even those metal on metal devices that are currently in the market?

Second question is, is that you were targeting 400 surgeons to be trained up by the end of 2007. At your current run rate it looks like you're going to be training up between 500 and 600 surgeons. Is there any reason to assume that the training is going to slow down or can we expect some even greater penetration into 2007?

And the final question relates to just something I've seen on the newswires. I think it's quoting you Chris in terms of what you envisage would be a good margin expansion and that best in class would require a 3 to 5% margin improvement. Is that something you would like to see in the near term?

Let's deal with those in order. BHR we are pricing at a premium. I couldn't actually tell you whether or not it is higher or lower than other metal on metals and -- but it is a premium product and we're putting a heavy investment behind it in terms of training.

The second question was around -- can you remind me?

Surgeon training.

Oh, surgeon training. Yes we are ahead of the run rate. Whether or not we actually hit a higher number, we actually set that out as an initial number. We are getting much more interest from the surgical profession than even we thought would be the case. Now whether or not it actually hits over 400 by the end of next year, I don't really know because one of the things that might impact that might be the entrance of other competitors some time later on next year. But right now, we are ahead of the run rate. If we can stay ahead of the run rate then we'll continue to work on that. So that's the answer to that question.

Now I don't quite know what the wires are saying but I'll tell you what I said which is, I was asked the question what is the margin gap between where you are, broadly by business segment, and best in class. And I said, well it's between 3 and 5% but there are many factors that you need to take into account in thinking about that. There's no way that we're in a position to set that as a target. It is an observation at this point in time.

So we are doing, as Adrian said, a very systematic approach to this. The top priority for us remains to grow this business in these growth market segments but we are going to put more energy and resource between Adrian, as our Chief Financial Officer, and Dave Illingworth, our Chief Operating Officer, into looking how we can structurally improve margins over a multi year period. It is a major program for us and we're giving you a heads up on it, but it is a heads up at this stage.

Thank you very much.

Thank you. The next question?

Thank you. Our next question comes from Hans Bostrom of Goldman Sachs. Please go ahead.

Good afternoon gentlemen.

Good afternoon Hans.

I have a couple of questions. Firstly Adrian, if you could list your priorities with regards to the improvement program that you are hoping to unveil in the first quarter of 2007? And I would think particularly about your cost structure generally, your cash generation and your capital structure. How would you rank those in terms of priorities?

And secondly, you also mentioned I think Chris, something about the product profile review for ACTICOAT, which I wasn't quite clear what that really meant. But it was said in the context of price pressure [inaudible] in the third quarter.

And if you could also give us a sense, third question, on the absolute price changes in your hip and knee business in the US going into 2007 and what you envisage for that for the next year that would be helpful. Thank you.

Okay, Adrian would you like to tackle the first one first?

Yes surely. I mean Hans we are in a diagnostic phase and that is -- that means what it says. That means we are -- we have a set of very high level of hypotheses we talked about before at quarter 2 that lead to suspect there's something here, but we can't action high level hypotheses. You have got to action things that are much more nitty gritty. So what we're engaged in now is getting the data out of the business at a nitty gritty operational level which you can action. It would be quite unwise not just to communicate but to actually, even within the company, jump to conclusions before you've got that data. And that's where we are.

I mean you mention cost, you mention cash, you mention capital structure. Certainly cost and cash are intertwined in our mind in this; how efficiently we use cash within the business, how efficiently we use working capital in its various guises. It is as much a part of the program as the level of spend that goes to the P&L, so both of those are in there. We will find root causes that underline one or other or both of those areas. But it is absolutely premature at this stage to be guessing what the outcome of that diagnostic would be. It is a diagnostic and that's where we are Hans.

Okay, let me tackle the other two. With regard to ACTICOAT, it's clear we've seen a slowing of growth in quarter 2 and quarter 3. What we're actually seeing is we're seeing a switch towards lower priced products in the segment. ACTICOAT remains the best product, it's got the most effective kill rate, it kills bacteria fastest, it is capable of dealing with MRSA but people are being selective in what silver product they use in which place. We obviously will continue to promote ACTICOAT because of its very specific capabilities and kill rates, but it is our plan to introduce a lower price point silver products on a go-forward basis. That'll probably be in the early part of next year. So that's what I was referring to in the announcement -- in the read through earlier, I beg your pardon.

In terms of prices for reconstructive products, on a like-for-like price basis ignoring mix, our expectation for the US market is that prices will be broadly stable, around neutral. It would be nice if they were up very marginally but we're talking about less than a percent for the sake of argument. It is possible they might be very slightly negative again to the tune of fractions of a single percent. Outside the US we do see that price pressures are likely to continue in continental markets, European continental markets. The jury is out in Japan as to whether or not there will be a further Recon price decrease but it is anticipated there will be some further Trauma price decreases.

So that's the situation that we're looking at and our assumption in our planning is that price in the US will be neutral in 2007.

And could I ask a follow-up question to Adrian?

Sure.

Taking into account the earlier statement today regarding the potential Biomet link up and your review of your financial structure and costs etc., can you share with us what you expect to be a sensible range for your, shall we say, net indebtedness or gearing? That would be very helpful. Or what you think are reasonable target levels for the company taking all potential invest -- well, transactions and no transactions into account.

I -- that just involves too much speculation Hans. It would be nice for me to answer that question but I'm not going to. Sorry about that. Okay, right. Can I have the next question please?

Thank you. Martin Wales of UBS has the next question. Please go ahead.

Good afternoon. Firstly, on wound management, could you clarify the impact -- the relative impacts of the low price for the competitors in ACTICOAT versus the spending constraints affecting growth outside the US? And outside of a leave and wound bed preparation in ACTICOAT, how much is the rest of the wound management business is growing?

Let me tackle that this way. The actual growth of ACTICOAT in the quarter was 1%. So the two biggest markets for silver are the US and the UK on a global basis, not just for Smith & Nephew; they're the two biggest markets. And growth for ACTICOAT was low in both those markets. There has been a bit of a tick down in growth rate for silver products in those markets but our growth rate was 1%.

The good news is we grew our US business 14% even though ACTICOAT only grew 1%. So actually that, for me, is actually very exciting. Now we have some things we can do with ACTICOAT and we're doing those but actually we are going to come out with products that are positioned to deal with that lower price point segment. The market essentially segmenting into a high price, high performance and a lower price and quite frankly adequate performance product and we need to deal with that. And our new management team that we have at wound management are getting on with it energetically. So that's the best way I can give you an answer on that.

Okay. And two further questions. Firstly, just a clarification on your observation about 300 to 500 basis points improvement. Is that across the entire business or purely related to the orthopedic segment of the business?

No, it's -- we are looking at this across the whole of the business. And the reason why I've made the observation is that where there is clear data, if you guys sit down and you just look at operating margins, you can see those kind of numbers. Now a lot of businesses that we compete with are buried inside bigger corporations and those numbers are harder to get at but we're trying to figure out what those might be. But we are looking across the whole of the business.

But presumably that's geared more towards orthopedics wound management [inaudible].

You shouldn't draw any conclusions and we haven't drawn any conclusions in that respect.

Okay. And one final question if that's okay. You -- obviously you have been pursuing a policy of making technology add-ons. Should we assume that will be on hold until we've seen some analysis of cost and utilization of cash as well as you've got a bit further down the line or not as the case may be with, in terms of any discussions that are ongoing with Biomet?

No. I think we continue to look for acquisitions across the board. We're on record as saying in any given year we probably talk to 30 companies. We're continuing to talk to companies so no, you shouldn't assume that's the case.

Okay. Thank you very much.

Okay, thank you. Next question?

Thank you. Yi-Dang Wang of Deutsche Bank has the next question. Please go ahead.

Okay, thank you. Chris, I was wondering if you could share with us, or provide some indications as to how BHR is benefiting the Group other than the BHR sales you are seeing? So for example how much business has Smith & Nephew done with surgeons who have been trained on BHR but who have not, historically, been Smith & Nephew customers?

Yi-Dang, I would love to be able to give you a statistical answer on that but we actually don't have one. The observation that I would make is that Smith & Nephew's hip business, outside the US where we were able to market BHR, and we still don't have approval in a form we can use in Japan, so it's really outside the US and Japan. Our hip business, with the exception of quarter 2 of this year, has grown in double digits since we acquired BHR. Some of that has been BHR but other parts of that, and it varies a lot by country which is why I can't give you a sensible number, has been pulled through of other Smith & Nephew products particularly other hip products.

We would like to think that we will see some effect of that in the US, and for that matter in Japan when we get to the market. But we probably won't see any of that until some time in 2007 or maybe even 2008 because a lot of the surgeons we're starting to work with now with BHR don't know Smith & Nephew as well as they may know some of the other companies in the marketplace and it takes time to get these things going. And we actually want them to focus on BHR and become real, real experts in BHR.

So, yes, I think there will be a beneficial effect. We can't quantify it but it's likely to take effect in 2007 rather than 2006.

Right, okay. And my second question is obviously the dental implant market's been growing very robustly and it seems that the margin there is very attractive. But would Smith & Nephew have interests there or would you rule out that sort of thing altogether given that it might be a slightly different business model to what you have at the moment?

It's not top of our thoughts, let's put it that way. We think we have some very interesting opportunities in the markets in which we are very strong and have good positions and that's where we're really focusing our efforts, Yi-Dang.

Okay, great. And my third question is you had said in the past that clinical therapy would benefit from the addition of a third product line. Do you have any -- have you made any progress there, so far? And when could we expect to hear from you on that?

I think there's an opportunity. If we can add a very relevant and well positioned third line to clinical therapies, it's something that we keep under review. As of today we don't have such a line. We're very encouraged, however, by the DUROLANE license which we think gives us a strong competitive position going forward, not just in the US but globally in joint fluid therapy. And we're concentrating a lot of our time and effort from our clinical therapies team and integrating that and making that successful. And ultimately that will, of course, be another variant of joint fluid therapy which our clinical therapies group will handle.

We are continuing to look for suitable opportunities but we're being very discriminating because it really does need to be a good fit. So it is an area which we continue to focus on.

Okay. I have one last question which is a sort of housekeeping I suppose. Adrian, would you be able to let us know what the effect of DERMAGRAFT could have on your growth rate in Q4, please?

I think I can tell you what the DERMAGRAFT sales were that we booked in quarter 4 last year which was $5 million.

Okay, thank you.

And there won't be any this year, for the avoidance of doubt.

Okay, thank you very much. Next question? I think we'll take two more questions and then we'll close.

Thank you. Jack Scannell of Sanford Bernstein has the next question. Please go ahead.

Hi, good afternoon. The first question, again, is around margins which, at a sort of macro level, have been broadly stable on SG&A and COGS in '04 and '05. And given the positive mix shift, is that because in Reconstruction for example you're either having to spend more to sell or else there's some sort of possibly more pricing pressure at the bottom end of your business? Not so much the new products. How do we think about that? Is it spending to sell or is it pricing that's kind of reigning in the margins a little?

Well, I'll let Adrian think about that while I give you at least an answer. There has been a change in the marketplace and in terms of pure pricing. And you actually said the margin hasn't changed in 2004 and 2005.

Sorry, I meant 2005/2006.

2005/2006. I think we are seeing tighter pricing this year particularly in the first half than we saw in the previous year. So has price had an impact? Yes.

Secondly, we have made a very big investment both in terms of revenue and in terms of working capital, in getting these major orthopedic products to market. And that means when you actually do the analysis you see that in fact our SG&A has not come down across the Group this year and therefore we haven't got any leverage out of it. But, as I said earlier, the last time we introduced new knees was in 1998, the last time we introduced a new hip was, I think, in 2002. We've introduced two new knees and two new hips. This is major stuff for future growth in sales and leverage on margin as the launch impact, because you have all the costs but relatively low sales, and you progressively get automatic leverage as these things roll forward.

So it's a bit of both, Jack.

Yes, thanks very much. The second question regards the Birmingham hip. And from a number of surgeons I get the impression that McMinn, its inventor, was so brilliant that the instruments are actually a little bit hard for mere mortals to use and some of the other resurfacing products may have slightly easier instrumentation. Now, could you tell me what you're doing around maybe second or third generation instruments for BHR?

We do have instrument developments which we work on pretty consistently. We work on them with Dr. McMinn who is the acknowledged expert in this area. The instruments are designed to give very good surgical results so we choose to change them very cautiously but -- and if you look at the data you do see that BHR had and continues to have better clinical results and better long term outcomes than the competition. So it's not so much the issue of can you make it easier, it's can you do the surgery right. And that is the number one priority for us here.

I think there will be some improvements, I know that we are working with Derek McMinn and he's being very, very helpful and thoughtful about it. So, yes, it's an area we're looking at.

Okay, thanks very much.

Thank you. We'll take a final question.

Thank you. Our final question comes from Peter Cartwright of Evolution. Please go ahead.

Yes, thank you. Making the hypothetical assumption that you did look for a large acquisition, can you tell me please what sort of interest rate you could borrow at in dollars? What would be the coupon rate and how would it vary with the size of the borrowing?

Well, Peter, that's miles too speculative and I'm afraid we're not going to answer it at all. It really is much too speculative and not appropriate for this kind of conversation.

Yes, okay, thanks.

Okay right. Thank you very much for your questions, ladies and gentlemen, that concludes our call. We will be setting call times for the quarter 1 -- sorry, for our prelim results in early February before too long and we look forward to talking to you and meeting a number of you on that occasion. Thank you all very much.

Thank you, Sir Christopher. Ladies and gentlemen, that will conclude today's conference call. Thank you for your participation. You may now disconnect.