Smith & Nephew PLC (SNN) 2010 Q3 法說會逐字稿

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Good day, ladies and gentlemen, and welcome to the third quarter 2010 results conference call. For your information, today's conference is being recorded. At this time I'd like to turn the conference over to Mr. David Illingworth, CEO. Please go ahead, sir.

Good morning, everyone. This is Dave Illingworth. Welcome to our third-quarter results presentation. I'm going to start out today talking about the business and then, as we usually do, I'll hand it over to Adrian Hennah, our Chief Financial Officer, who'll follow me to talk about the numbers. I'll then give a brief summary for the quarter before we move on to take questions.

So starting with the highlights for the quarter, overall our revenues were up 4% this quarter, a performance we are very pleased with. As we expected market conditions continue to be challenging. We're confident that we put all of our businesses in the right position to perform in this environment and, with the benefit of hindsight, we focused on efficiency at just the right time.

We are particularly pleased that reconstruction, driven by strong knee growth, had generated revenues at above market rate. Trauma has grown its revenues at market rate, a steady progression of improvement over the past few quarters. In Endoscopy, sports medicine continues to perform well although weaker capital revenues have offset some of this growth. Advanced Wound Management grew its revenues above the market, fuelled by both negative pressure wound therapy and advanced wound care. In the emerging markets, these have grown across the board, with revenues in China growing by over 20% in the quarter.

We've also strengthened our trading margin slightly this quarter to 22.9% and earnings per share is $0.161. Our cash generation continues to be strong this quarter as well, at 95% of trading profit and consequently, our net debt is now $600m. We continue to be focused on our customers, on being efficient and investing for future growth.

I'm now going to look at each business in turn. I'll start with Orthopedics. Orthopedics performed very well in the quarter with global revenues up 2% and reconstruction growing above market rate and trauma at market rate. The market environment is pretty much as we expected with pricing pressure steady at 1% to 2% decline and mix benefits available where clinical and economic value can be demonstrated. We believe innovation will become even more important in these challenging markets, which is why we are focusing our R&D on two things predominantly, reducing procedural cost and improving clinical outcomes.

In reconstruction, our traditional hip products continued to perform very well for us. Globally our hip revenues were a shade behind market growth rates as BHR continues to be impacted by the metal-on-metal, the ongoing metal-on-metal debate. The outstanding clinical data for BHR clearly differentiates it from the other resurfacing products and we're confident that our program of reinforcing this both with surgeons and patients will be effective. We believe our hip business has very good momentum globally.

In knees, our FDA approved 30-year wear claim for VERILAST -- is clearly driving revenues and we believe our knee performance in the quarter was market leading.

Trauma continued to improve this quarter, increasing revenues by 5% globally and in the US by 3%. The increased tenure of the US sales force and new product introductions are driving continued incremental improvements in this business. In clinical therapies, EXOGEN performed very strongly in the quarter and now has Europe-wide approval for use on all bones, excluding the spine and skull. This is a very significant expansion of indications for use. In the emerging markets, they continued to be strong and China in particular showed good growth this quarter.

And looking at the margins, the margins in the quarter at 22.2% reflects the investment made in direct-to-consumer advertising, which has noticeably increased patient searches for surgeons using our products.

Now if I turn to the Endoscopy business, in our business this quarter, arthroscopy grew by 8%, our repair business grew in double digits and resection continued to grow in single digits. Our focus on shoulder repair saw revenues grow strongly as BIORAPTOR, our knotless-suture anchor, a recent new product, performed very well for us. In the past two years, we've worked on transitioning our sales force and now two-thirds of our US sales force are direct employees. Visualization revenues, which were reduced by 19%, as we continue our strategy of focusing on those capital items most closely tied to our Arthroscopy business.

Margin in the quarter increased slightly to 22.8%, benefiting mainly from product mix.

Now if I move on, I'll talk about Advanced Wound Management. The market for advanced wound care remains challenging clearly. In Europe and the US we saw increased price pressure in some segments. But against this backdrop, Advanced Wound Management is performing very well and had a strong quarter, growing at well above market rate in advanced wound care and negative pressure wound therapy. Infection management grew by 5%, exudate management grew by 3%, as new product launches gave expanded indications with product range. Negative pressure wound therapy grew strongly in all geographies as our products gained momentum in the marketplace.

We had a number of positive outcomes to intellectual property cases in the quarter and as all of you know, we had a very significant positive outcome in the US after the quarter end. We continue to be focused on investing in our product range and offering our customers real choice in these products in the marketplace.

Advanced Wound Management increased its margin by 280 basis points in the quarter, as our drive for efficiency continued to deliver material gains and margin.

I'm now going to hand it over to Adrian to take you through the numbers.

Thank you, Dave, and good morning, ladies and gentlemen. We turn firstly to slide nine and the income statement. Revenue in the quarter was $941m. This represents underlying growth of 4% after adjusting for exchange rates on quarter three last year. There were the same number of sales days in quarter three this year as in last year. Trading profit in the quarter was $215m, an underlying growth also of 4%. Reported trading margin was 10 basis points higher than quarter three last year. Interest costs are down from last year, reflecting both lower debt and a lower interest rate.

Moving to the next slide, which is slide 10, and moving further down the income statement, tax charge for quarter three was 31.4%, our estimate for the full year rate. The tax charge in quarter three last year was reduced to 24.1% as a result of a favorable settlement of some tax disputes. Adjusted attributable profit for quarter three was $143m. Adjusted earnings per share was $0.161, a reduction of 4% principally due to the lower tax charge last year.

Turning to the next slide, slide 11, and an analysis of revenue by business segment, you've heard from Dave on the progress of each business. This schedule gives the growth rates in the quarter to which Dave referred. It's perhaps worth noting that the Ortho growth rate was 3% if one excludes the discontinued spine activities. In quarter three the value of the US dollar was slightly stronger year on year against the average of the currencies in which we operate, strength against the euro and sterling, offset by weakness against the yen and a number of less significant currencies.

Turning to the next slide, slide 12, an analysis of revenue growth rates by business and by geography, as well as the numbers on this slide, we will also refer to the growth rates of our main product types which are included as usual in the appendix.

At constant currency, sales in our Orthopedics business in the quarter grew 2% on quarter three last year. Hip sales were flat, knees grew at 6%, trauma fixation grew at 5% and clinical therapies declined by 5%. Across Orthopedics we saw price pressure in line with the previous quarter. Like-for-like price reductions were steady at about minus 2% and we achieved slightly positive mix.

Dave highlighted the continued headwinds for our BHR product, caused by the broader discussion around metal-on-metal implants. BHR sales account for around 15% of our hip sales worldwide and this weakness has lowered our overall hip growth quite significantly. BHR sales continue to be strong in the larger, more specialized higher volume hospitals. This, together with excellent clinical data, underlies our confidence in a strong future for the product.

Strong demand for, especially, VISIONAIRE knee cutting blocks and VERILAST Total Knees, is enabling us to improve our reconstructive growth, despite continued economic pressure on higher specification products and some trading down by hospitals in most Western markets. Continued focus on operational delivery is also steadily improving our performance in trauma, but we still have some way to go.

In the United States, overall Orthopedic sales were 2% higher. United States reconstructive sales were up 3%, growth in our US knee business was 5%, US hip sales were 1% higher, trauma fixation sales in the US were up 3%, clinical therapy sales in the United States were flat, a growth of 4% excluding the impact of a small spine disposal. EXOGEN growth strengthened, benefiting from additional data demonstrating the effectiveness of the product, and SUPARTZ continued to be under pressure.

In Europe, Orthopedic sales were 1% lower. We again saw solid performance in our traditional products, but weakness in BHR and continued pressure on higher-specification products in a weaker European market. The exit from our spine business reduced European growth by about 2 percentage points. In the rest of the world Orthopedic sales grew by 6%. The positive underlying trends in the emerging markets continue.

Endoscopy sales grew by 4%. Arthroscopy sales, which include both repair and resection, grew strongly again at 8%. Visualization and related sales were 19% lower. This is in line with our strategy to focus our capital sales more closely on equipment related to our arthroscopy activities. Visualization sales accounted in 2009 for about 15% global Endo sales.

Wound sales grew by 7% in the quarter. We continue to see clear signs of good progress with NPWT. NPWT sales contributed 3% to total wound growth. We saw as expected a further modest weakening of market growth in Europe, with some pressure on prices and volumes across several European countries. In Europe our NPWT products continued to grow very strongly. In the United States, NPWT also continued to grow well. Sales growth outside NPWT is improving, but we have more work to do.

Turning to the next slide, slide 13, this shows the usual analysis of trading profit by business segment. As we have already noted, the reported trading margin for the Group was up 10 basis points in the quarter.

In Orthopedics, margin decreased by 120 basis points compared to quarter three last year. We chose to invest quite heavily this quarter in supporting the VERILAST launch, in particular with direct-to-consumer material in the United States. Work is continuing to capture the significant opportunities available to improve the efficiency of our processes.

The Endo margin increased 40 basis points in the quarter, helped by the shift in mix away from capital items. As signaled previously, we see substantial opportunities to invest in our Endo business and as a consequence we continue to expect some modest reduction in margin for the full year.

In Wound, we again saw a significant underlying increase in the margin. We continue to benefit in particular from the lower cost in our China factory. Investment in NPWT, including in legal costs, continue to impact the Wound margin.

For the Group as a whole, we continue to see significant opportunities to improve our efficiency. Achieving these improvements will put us in a position to invest in the many opportunities we see for growth as well as to help deal with the price pressures as Western governments deal with their substantial deficits.

Turning now to the next slide, slide 14, and the cash flow statement, we had another good quarter of cash generation, with $144m of free cash flow in the quarter. We continue to make steady progress in improving the efficiency with which we use our inventory and our instruments, and you can see this reflected in these numbers. Restructuring spends continued in line with guidance. We include as usual an analysis of the total spend on the restructuring programs in the appendix. Net debt decreased to $600m in the quarter principally as a result of the free cash flow generation.

Turning then to slide 15 and the outlook, our view of the Company's outlook for 2010 is unchanged from early August when we published our quarter two numbers.

In the Orthopedic area, reconstructive and trauma, we believe that underlying global market growth decreased quarter on quarter from 5% in quarter two to 3% in quarter three. We expect to continue to improve our growth relative to the market through recently launched products, especially VERILAST and VISIONAIRE, and by continued focus on operational performance. Within Orthopedic clinical therapies we expect competitive pressures to continue. The discontinuation of our spine activities reduced total Orthopedic sales growth by 1% in the quarter. We expect a similar impact until this annualizes in quarter two next year.

Within Endo we continue to expect to grow ahead of the market in arthroscopy. Within Wound, we continue to expect good progress with NPWT sales to push growth ahead of the market.

We have as usual included in the appendices a table setting out the number of business days in each quarter, and I would again remind you there will be four less days in quarter four.

And with that brief update on the outlook on 2010, I will hand you back to Dave.

Thank you very much, Adrian and let me just give a short summary before we move on to the Q&A. The -- we're very pleased with the third quarter performance of the Company, particularly given the market conditions that we anticipated. And in the near term we don't really see any major changes in market conditions going forward.

We are focusing our innovation to meet the needs of our patients, our customers and the healthcare providers. We have a focus on medical education and clinical data and we're reducing -- and we're trying to reduce procedural costs while improving clinical outcomes. We have identified significant opportunities for future growth and an increased number of good quality investment opportunities. Our increased efficiency enables us to fund investment in new products and geographies as well as dealing with the market pressures. We've strengthened our management team over the last few years. This team is now established and performing very well for us. Our strategy for delivering shareholder value is working well and remains unchanged.

And with that I'll move on to taking -- Adrian and I will take, do Q&A.

Thank you, sir. (Operator Instructions). We'll take our first question today which comes from Mr. Tom Jones, from Berenberg Bank. Please go ahead.

Good morning and thanks for taking my questions. I just had two very quick ones actually. I was wondering if you'd be so kind as to give us your traditional breakdown of hips, knees etc. in the o-US markets.

And then second, I just wondered on the Wound margin, you obviously had a very solid performance this quarter. I just wondered what you felt would be, without trying to lead you into giving any specific guidance for next year or the years beyond, but what you think a peak sustainable margin would be in the Wound business and where you think over the years that can get to. That's all, thanks.

I'll -- let me take, while you're digging out the data for the hips and knees, let me take the second one because it's the easiest one. We don't give guidance on those margin numbers for obvious reasons, but we do believe that there is further scope for efficiency in the business. We have been investing very heavily in negative pressure wound therapy and clearly as we grow that business and we get scale that will also contribute to our ability to provide better margins in that business. We also see a lot of investment opportunities and we also see a lot of pricing pressure in the marketplace. So I think when you take all those factors into account, it's hard to give an exact number, but we do see greater scope for efficiency and we're going after it.

Adrian, let me let you handle the knees and hips outside US.

Sure, and just for completeness I'll give the US, global and the o-US. So in the case of hips, flat globally, 1% growth in the United States, flat o-US. In the case of knees, 6% globally, 5% in the US, 7% o-US. And for completeness, trauma, although you didn't ask for it, Tom, 5% globally, 3% US, 7% o-US.

Perfect. That's very helpful. And just as a follow-up question, I wonder if you could -- Europe is a difficult market at the best of times, but I wondered if you could just give some color as to what's driving your improved performance in knees and trauma in the European markets as compared to North American markets. I know you spent a lot of money on DTC in North America in your knee business, but the European business seems to be growing faster without any DTC spending. So I just wondered if you could share some thoughts on that issue for us.

We've been making very good progress in our Trauma business in Europe for quite some time. Clearly we had some fairly well-discussed and documented challenges that we were dealing with in the United States due to some of our structural issues that we were working through in our business. But we didn't have that same level of issue in Europe. We've had a good trauma business there for a while.

In terms of the, I think in terms of the knee business in Europe, I think the VERILAST technology is just as exciting for customers and patients in Europe as it is in the US. And I don't think it takes just a direct-to-consumer marketing campaign in order to get the word out. I think it's something that's getting a lot of buzz in the marketplace. The fact that this is the first time that anybody has gotten a claim for wear of this length of time and that there's real mechanical testing that backs up the load bearing surface here, it's a big deal. And we're aggressively trying to get the message out.

Was the knee performance in Europe just a combination of a little bit of growth everywhere or were there any sort of big one-off type tender things that made the difference in Q3?

No. I think it must be the former because I can't recall any large --

There's nothing unusual, Tom.

Any large unusual items this quarter.

No, there's nothing unusual in it.

Okay. That's very helpful. I'll get back in the queue.

Thank you. We now move to our next question today, which comes from Matt Miksic from Piper Jaffray. Please go ahead.

Good morning. Can you hear me okay?

Yes, Matt, we can.

So just to follow up on what you're seeing in the US in knees, I know VERILAST, I know that VERILAST has been a strong performer. But moving outside of that specialty category, can you give us some color around your sequential performance in knees?

And then the other thing I wanted to -- second question on negative pressure wound therapy. Any sense of pricing just generally in the market, if you could give us a sense of how that's pricing in the market sequentially and negative pressure, particularly in the US. Thanks.

Okay. Thanks, Matt. We'll try to double team this, Adrian, if you don't mind. Let me take a shot at the knee thing. First of all, it's not -- I don't want to give you the impression it's just VERILAST. We're seeing good performance across the broad range of our knee offerings, everything from the traditional knee products to the impact of the VISIONAIRE product that we have in the custom -- in cutting blocks, that is adding to the ability for us to get these knees out on the marketplace, the OXINIUM technology that we have, the VERILAST technology. I think we're hitting on all cylinders right now for the first time in a while and it's showing.

We've -- you don't have to go very far back in time, Matt, to when we were consistently leading the Orthopedic space in knee growth quarter after quarter after quarter. And it's nice to be back in that position again for the first time in a while. So I think it's just a lot of things being done well on the knee side. It's not just VERILAST and I certainly don't want to leave you with that impression.

The other was negative pressure wound therapy. I don't think there's anything really to report there. We are -- I don't think we've changed our positioning in the marketplace substantially for quite a while. We're out there as the market leader in terms of treating hard-to-heal wounds. We're in most of these accounts. There's a lot of customers out there that want a choice. We're bringing -- we're able to sell now our products, all of our products in every geography, so we're not restricted to sell those products. And our customers are responding.

And I think you're going to see all the companies, us and our competitor, really competing on outside of the courtroom really for a change in the marketplace, and we welcome that. So it's, I think it's going to be an exciting time for us.

And you've had foam on the market for a while now. Is it -- I know you've been iterating on that and improving that. Is that business still predominantly a gauze business for you or where are you in terms of uptake in foam?

It's a mixture. It's a mixture. We've always said that our business is not about gauze, it's not about foam, it's not about any one product. It's about giving our customers a choice and allowing them to use the right product in the right application at the right price point. That's what it's all about. And we've always wanted to be able to offer a broad range of interfaces for the wound therapy so that we could give our customers that choice.

We've had, clearly we've had a steep uphill climb in getting foam into the US market, only because there's been this cloud that possibly we would not be able to sell this because of the litigation. And I think that having that removed recently with the judge's decision is going to give us some nice tailwinds to work with.

Great. Thanks for taking our questions.

Okay Matt.

Thank you. We now move to our next question today, which comes from Ed Ridley-Day from Bank of America. Please go ahead.

Good morning and thanks very much. Just to follow up on negative pressure firstly and obviously your momentum with that, in the US what do you feel -- how quickly do you feel you can capitalize on that court decision?

And also could you to your better knowledge comment on the extent to which negative pressure may be included in the DME bidding process as the new contracts are potentially arranged next year and whether that's an opportunity for you?

And also on the US wound market, could you also comment on the other segments? Which particular segments are you seeing price pressure? Those would be my first questions.

Okay. Let me take a shot at it and please jump in, Adrian. I think it would be wrong to think that this court case, any court case is going to be a predictor of radical change in trajectory of how we're doing in the marketplace. We've had -- there's been a lot of these, Ed, so we've been through this now -- we win two, we lose one; we win four, we lose one. You know it's up and down, up and down, up and down. We've always said that regardless of how this court case comes out, it's not going to change our resolve and our commitment and, ultimately, how positive we feel about being able to grow this business in the US to be able to give our customers real choice.

And with the judgment in our favor, we still have that point of view. I don't think it's going to radically change. We have a good, very strong competitor out there that developed this market from the beginning. They're well entrenched, they have good products, and we're out there competing giving our customers choice and we'll continue to grow our business. So I wouldn't take this court case as an indication that you're going to see a radical change in trajectory of our business. Number one.

I think the -- any bidding that comes in terms of the DMEs will be an opportunity for us. We're going to be able to have -- there will be more than one name on the ballot going forward and that's going to be a great thing. So, yes, I think there will be an opportunity for us. We'll just have to see how that develops.

I'm not -- I think you did ask a question about price. I don't remember. I didn't write down.

No, sure. Just to follow up on that DME bidding, do you have any idea of the exact timing that we might start to get news-flow on your next round?

No, I don't. I honestly don't, not off the top of my head.

Yes, sorry, my last question was just on which segments you are seeing pricing pressure that you mentioned.

I think we're seeing it across the board. I think we're seeing real austerity measures out there. I think folks want to use the right product, in the right setting, at the right time. And clearly there's like-for-like pricing pressure that we've commented on now for several quarters in a row. We're seeing that somewhere between 1% and 2% and, quite frankly, it's across the board. We're seeing -- there are some areas where we're seeing a little bit more. We saw some in Europe on the Wound Care products. Some of it is country specific. It comes and goes, but it's nothing overly remarkable. It's just something that we've learned to deal with.

Okay, sure. No. Thanks. And just a quick follow-up question on margins. Your R&D has been at a fairly stable level of sales for several -- for a long time now. But obviously given your comments about investing in new product, could you give a little more color about how you feel R&D spending is going to go forward in terms of how we can look at that and model that?

I can't give you exact numbers, but I can give you a little bit of a steer. The steer is that you will probably see us spend a little bit more on R&D in the near term over the next two, three, four, five years. We -- as a percentage of our business.

We do see some real opportunities for us to develop innovative products that make us part of the solution, so to speak. We think that innovation is going to be very much alive and well, given the pressures in the marketplace. The market is crying out for products that can help reduce the cost of the procedure and also improve the clinical outcome, and we want to be front and centre part of that effort. So that's an area we're going to invest in, in a very focused way.

We also see some investment opportunities in other adjacent spaces as well. And it's really across our entire range of businesses, everything from Wound Care to Endoscopy to adjacent spaces in Endoscopy. We're making some investments in the gynecology market that are paying off for us. Some good, very good growth there. So, yes, you should expect to see us spend more as a percent on R&D going forward.

That's very helpful. Thank you.

Thank you. We'll now move to our next question today, which comes from Michael Jungling from Morgan Stanley. Please go ahead.

Great. Thank you for taking my call. I have three questions on recon growth. For the first time you seem to be outgrowing the market. You indicated that this would happen at the beginning of this year and therefore the question is, is this something which is going to be sustainable now for the next 12 months?

Question number two is BHR. Is it still declining sequentially in the US and in Europe?

And the third question is on Orthopedic DTC. Will you continue with this type of investment in 2011? Thank you.

Okay. Thanks, Michael. Let me -- I'll take the first one and we'll figure out how to divide up all three of these. You're asking for some forward-looking guidance on recon. We clearly would like to think that the efforts that we're making are sustainable. I think we'll have to see how the next quarter goes. There's been a little bit of a saw-tooth activity in this marketplace with not only us but the rest of the competitors in the market in general. But we've -- yes, we did indicate that we would get there about this time of the year and we're thrilled that we've been able to perform like we have. So our expectations are that we'll continue to be able to be at or slightly above the market growth rates going forward.

In terms of BHR, we're still seeing a drag with that product. The specific, do you want to --

Yes, I think Michael was distinguishing between year on year and sequentially. Year on year we're clearly seeing a significant drag. Sequentially it is leveling out. And as we signaled, particularly encouraging to us is that in the higher-use hospitals, hospitals that use high volumes, more specialized hospitals, particularly in the US, we haven't seen loss. We've actually seen many of them growth which for us is a very good sign. So, yes, we are we believe seeing the bottom of this, Michael.

And then on DTC, Michael, that's a very, very interesting question and it's one that gets a lot of debate in our organization in terms of should we or shouldn't we and if we do how much and for how long. DTC campaigns have come and gone from us and a lot of the other competitors over the years and they haven't had a lot of longevity associated with them. The reason we launched this direct-to-consumer campaign that we did a few months ago was because we had two very highly-differentiated products in the marketplace that we wanted to get the message out in a big way.

First was we felt like the BHR, which is clearly the gold standard in resurfacing product, was being dragged into a very general debate about metal-on-metal, large metal-on-metal heads. And we don't believe that all metal-on-metal bearing surfaces are created equal, especially when you talk about our BHR and the fact that we have almost 100 or over 100,000 documented cases and some of the best clinical data out there and the highest survivability, and it goes on and on. And we just felt like we were getting sucked into this debate about metal on metal in general and we wanted to be able to get that message out. So we used that as a bit of a kick-start.

The second highly differentiated area was this area of VERILAST. It was an opportunity for us to get a message out quickly. We were quite excited about the results that we got from our laboratory testing on this bearing surface and clearly the FDA was impressed as well because they gave us at the time, which was unprecedented, a 30-year wear claim for this bearing surface. And we just felt like those were two highly-differentiated products that we could get the message out very quickly.

Now in retrospect we did it in a big way, we were trying real hard to try to figure out how to determine the value of that effort. We believe that it's had value for us, both anecdotally and in real terms in looking at the growth in our business. And we've decided to continue it in a very targeted fashion. We're now trying to triangulate in on what the impact really is by using some very targeted campaigns in certain geographic areas in the United States so that we can get a better idea of the impact of this kind of spend.

So I think the jury's out. You'll see the DTC for the next quarter or so and then I think the jury's out and we'll evaluate whether or not it really pays off for us.

Great. And then one follow-up question please on the margins. Why is it that your Wound Care business, which probably has the lowest product differentiation of the other two, is now leading your margin profitability out of all the divisions? Is this a sign that Wound Care was the first business area to really focus on and therefore we can expand to see similar types of developments in Ortho and Endo? Because to me conceptually Ortho and Endo should be a higher margin business than Wound Care.

Yes. Thanks for that. I think the reason we're doing so well in Wound Care is because you challenged us so directly for so many quarter after quarter after quarter about our Wound Care business, Michael. So I think we owe our success to you in a big way. But all kidding aside, we started first in our Wound Care business. We always said that we thought we had about half of the margin expansion opportunity coming from our Wound Care business and the other half was going to come from the split between Orthopedics and Endoscopy. And that's kind of how it has worked out.

If you're looking to be able to take that and project that on to where we have to go in our other businesses today, I think probably if you looked at it today the biggest opportunity for us is in our Orthopedics business. I think we've done a great job of getting at the inefficiencies in the Wound Care business. We have a really good team of management in there now and they're really doing well. We could not be happier with the way that the management team is running that business today. So I think we'll be able to sustain that and I think that we're looking towards the Orthopedic business to get most of the future efficiencies.

Thank you.

Thank you.

We now move to our next question today which comes from Martin Wales from UBS. Please go ahead, sir.

Hi, thanks for taking the questions. When you look at your reconstructive business and the pricing pressures that you're facing going forward, I guess the real question is how much further -- do you have any sense of how long this pricing pressure is going to continue? Do you have any sense of how much further the prices continue to be pushed down?

If you look at the variation across your different customer bases and different territories, is your working assumption that Ortho in total is just going to continue to be negative 2% going forward, which seems to be your default assumption? It sounds like it's flat in trauma and slightly worse in recon if we look at Ortho as a whole. Is that a reasonable statement as well? Maybe you could just address those issues first as much as one can.

Yes. Thanks, Martin. I think it's a good question. I think what we tend to forget and not admit to ourselves is that like-for-like pricing, we always have pressure in like-for-like pricing. I've made this comment before. I've been in medical devices in four or five different specialties now for 32 years and I can't remember a year when we didn't have like-for-like pricing pressure.

I think what we lacked over the last few years in Orthopedics specifically was we didn't have a lot of innovation coming through the pipeline so we weren't seeing a lot of potential mix uplift. And I think the innovation that's going to come out in the future is going to be much different than the innovation that came out before. I think it's going to be much more of a solution-based innovation to be able to reduce the procedural cost overall and also to improve the clinical outcome versus just being a feature type of a thing.

So I think we'll continue to see the like-for-like pricing pressure in that range, but I also believe you're going to see some innovation that will potentially give us some mix uplift as well. I know you'll see it from us because we're working hard on it. And hopefully we're going to make the right calls and our judgment is correct, and we're going to be coming out with products that make a difference.

So I think that's how I would explain it. I think that continued like-for-like pricing pressure, nothing unusual. Might be a little bit more acute, might feel like the heat's turned up a little bit, but if we've developed the right kind of products and get the innovation back into the pipeline in the right way I think we're going to have a pretty healthy business model to work with, especially given the demographics and the fact that we do believe that the volumes will remain fairly consistent and strong.

Okay. And just a clarification on how you're thinking about efficiencies and investments going forward. If I understand you correctly you think you can take significant further cost out of the Orthopedic business. Some efficiencies will be reinvested in R&D, hence that will go as a percentage of sales. We'll have to see how the DTC pans out. But you seem to be saying that you feel the margin structure post the end of this year, as in that, the original EIP target, feels like the right sort of margin going forward sustainably. Is that a fair comment?

I think that's fairly fair. I think that's well said.

I've taken the words out of your mouth. I'll leave it there. Thank you.

Thanks, Martin.

Thank you. We'll now move to our next question today which comes from Yi-Dan Wang from Deutsche Bank. Please go ahead.

Thank you very much. I have three questions. The first question is on your knee business. Can you give us some sense of how much benefit you guys have had from patient-specific instruments? I suppose I'm more interested in competitively how you guys have fared. Clearly some of your competitors have been out of that market, not being able to promote that, so I just want to understand how sustainable the out-performance in knees will be.

The second question is on the CapEx part of the Endoscopy business. You've been refocusing that part of the business for quite some time. Can you give us some sense of how far that has gone and when we could see this drag bottom out?

And the third question is more of a big-picture question and it relates to tenders. Can you give us some sense of how much of your Ortho business is coming from public tenders? The concern from my end is that with less scale you would be more exposed to potential loss of those contracts. So how big of a risk do you think this would be for -- what will it be to Smith & Nephew? Thank you.

Do you want to take the first couple and I'll jump in at the end or --

Sure. How much benefit are we getting from patient-specific? Is it sustainable? No question we're very happy with progress on the patient-specific on our VISIONAIRE product. Going very well, opening up lots of opportunities for future development as well as here-and-now interactions with customers and sales to customers. So, yes, we're very pleased. We're not going to give precise numbers Yi-Dan as you'd expect, but we're very pleased.

Will it be sustainable when all the competitors have sorted out their offerings? Clearly there'll be a different dynamic in the market when that's the case, but we have a great product. It's well received. We believe it has competitive advantages out there against some of the other players and those --

Yes, I think if I may add and interject something here. I think that we believe Yi-Dan that this is really just the tip of the iceberg, that being able to have more customized implants and more personalized medicine is really going to be something that is going to be an enabler going forward, not only in the clinical outcome but the ability for us to manage the amount of capital that we deploy in the field.

We deploy a lot of inventory for support of the customers for a $4,000 or $5,000 implant that's ultimately implanted into the patient. And if we can get to a just-in-time type of a situation with instruments and implants and packaging we can dramatically impact our business, and also dramatically impact the cost of delivering that procedure for the customer. So that's something that we're putting a lot of effort into.

So I think what you're seeing with the cutting blocks is just really the tip of the iceberg in terms of our thinking. So in terms of sustainability, absolutely yes unless something happens where we change our opinion about the direction we're headed.

Yes, absolutely.

On CapEx, do you want --

Yes, on CapEx, I'm just trying to rack my brains here, but I think four years ago when I joined the business roughly a third or something of Endo sales roughly -- I may have got the number a bit wrong -- was in the capital arena. And our strategy has been very much one of focusing our activities in that area on adding real value to arthroscopic procedures, so focusing on the visualization around our core repair and resection activities. And that is opening up new vistas as we look forward, what intelligence can you add to that activity as well as pure visualization.

So it's come a long way down, we're now down to about 15% of Endoscopy sales in the capital arena. Exactly where it will go in exact number, hard to say, but we certainly have brought it down the bulk of the way it's got to go. And as we look forward over the medium, longer term you can expect it to slightly change shape from being pure cameras to having hopefully some more interesting things attached to it Yi-Dan.

And the last question?

Yes, let me take a shot at the last one because I think I may answer it a little bit differently than what you might expect Yi-Dan. We think the -- I hate to call it public tenders because I don't think it's the public tenders that we're concerned with as much as it is the integrated healthcare systems and the large corporate customers, the folks who are trying to consolidate their decision-making across multiple vendors etc. We see that as a continuation of that consolidation in the marketplace.

And one of the things that we've done is we've implemented a new group called Healthcare Systems Group where we have a President of that that reports directly into me. And that individual works to coordinate the activities across all of our businesses, all the Smith & Nephew businesses, so that we can go in when there is a corporate buyer who is interested at consolidating the number of vendors that they have, that we can take our message in in a very strong way.

We have a lot to offer. A lot of our competitors only deal in reconstructive orthopedics or only deal predominantly in trauma. We have the ability to go in and take a wide range of market-leading segments into the hospital segment and leverage the entire Smith & Nephew brand. And then you put in on top of that on Orthopedics you take the company that's the number one company in the world in treating hard-to-heal wounds and we have a pretty nice package to offer.

So we've actually put that in place at the beginning of this year and the individual that's running that business, that part of the business, is Jerry Goodman and he has hired a world class team and he's already making a difference. So we see it as an opportunity, not as a threat. We see it as a wave that's going to continue, consolidation of these large buyers, and we think we've got a heck of a lot to offer with our portfolio of businesses that we have.

Okay. If I may just follow up on that and perhaps challenge you a bit on that. If I look at the top line of your business and compare it to the top line of all of your key competitors' businesses, you're still smaller than they are. And if we look at the various product areas, so take Wound for example, not that much of the sales of the wound care market is in the acute care channel so we would probably have to discount that if we look at just large-hospital kind of buyers, which would suggest that your scale would be a challenge going forward in this environment. Am I thinking about it in the wrong way?

Yes, you are.

Okay. Please correct me.

Yes, I think you are. I think -- first of all our Wound Care business is very much an acute care business. We do a very large part of our business in that channel. We are in the hospital with our service network in literally everywhere, everywhere in the world, whether it be the major burn centers, wound diabetic centers, now in negative pressure. So I think we have a very, very strong presence in that segment.

And I think if you break it up into the individual segments, we're the leading company in the world, we're the number one company in the world in sports medicine, in the arthroscopic side of orthopedics. We're very, very proud of the fact that if you look over a long period of time at our growth rates in our reconstructive orthopedic business that we've been either very close to leading the market or leading the market for probably more quarters than we haven't over the last seven or eight years. So we have a very strong offering across the business so we're actually feeling pretty good about it.

Okay. It's good to know that that would be less of an issue in the current market. Thank you.

Thank you. We'll now take our next question today which comes from Charles Weston from Numis. Please go ahead, sir.

Good morning, everyone. I have a couple of questions on Endoscopy first, just going back to the visualization and capital issue. Last year there were -- it was difficult to sell to hospitals because they didn't have any money for capital equipment and that seemed to have stabilized in the last couple of quarters and yet you've seen a dramatic drop again in the third quarter. And whilst I appreciate that the trend over the last few years has been lower capital goods it seems like a very sharp drop in this quarter and I was wondering if you could explain that please.

Also in Endoscopy, I was wondering if you could talk a bit about your hip arthroscopy product. We heard about that I guess two or three, four maybe years ago, and how you're quite excited about that, but at the time it was quite a small business so I was just wondering if you could comment on how that is going.

And lastly a short question on negative pressure wound therapy. Is it profitable yet? You, I think, have given us an update each quarter so if you could help us this quarter that would be helpful.

Okay, thanks, Charles. Alright, let me -- we'll chop this up and see if we can go after it here. On the capital for Endoscopy, it's not -- shouldn't be any surprise. We've actually been planning it this way. We made a decision several years ago that we wanted to focus our efforts in the areas, as Adrian said earlier, that were directly related to our arthroscopy business and that we were not going to compete in the broader digital OR market for instance or areas that were outside the direct influence of arthroscopy.

And in fact the weakness in the capital markets over the last couple of years has helped us to have a realization of that strategy and we've been quite fortunate that the weakness in the capital market was there. We've always said that you should not expect a return to large capital buying and a large percentage of our business in Endoscopy being capital equipment. Where it makes sense for the sale of our sports medicine products then we're going to be in it in a big way. Where it doesn't we're probably going to take more of a back seat or a partnership type of a role with another player in the marketplace.

Turning to hip arthroscopy, we're moving along quite well with hip arthroscopy. In fact we had one of the probably the top hip arthroscopists in the world, Marc Philippon, from Steadman Philippon Research Institute, who addressed our executive team and our Board in Boston this week where he went through and showed all the developments and it's pretty exciting. It's still a developing marketplace. There's still only a handful of surgeons who are doing this procedure, but it's catching on pretty quickly and clearly we're the leader. So we're working with all of our luminaries across the world to develop that market as quickly as we can.

There were some things that we had to develop along the way in order to make it easier for us to develop the market, not the least of which was the ability to get better access. It's a very deep joint and there were some things that had to be developed in order -- instruments and tables and distraction devices that enabled the surgeon to actually get the right kind of access to do the work that they needed to do.

On negative pressure wound therapy, you want to take a shot at that because I'm --

Sure. No, Charles, NPWT, is it profitable? I'm not sure we do update each quarter on the profitability in NPWT, Charles. In fact we don't disclose the profitability of individual product lines, as you know.

But I think what we can say, a couple of things really. One, we continue to be extremely confident about the medium-term profitability, significant profitability of this product. In fact we get more confident as time goes on. As of here and now, we clearly still have non-trivial legal costs. You'll be aware of legal developments that were going on in the quarter. We still have a big focus on product development because there's some very exciting stuff to come in that arena. And despite that investment in NPWT, you can see what we're doing to overall Wound margins. So it's a great part of the portfolio and it will be a significant profit contributor over time is all we can really say, Charles.

Okay. And just a couple of follow-ups then, just to try and pin you down there. On hip arthroscopy, is it a significant part of your arthroscopy business at the moment?

Yes, Charles, we're not going to give you the number, but, yes, it's meaningful now and it's growing very well. But we're not going to give you the precise number. It's become a very attractive part of our repair business in arthroscopy.

And just going back to visualization, sorry to pursue this point, but a couple of years ago I thought you were averaging about $40m a quarter of sales, now $25m. Is that a kind of -- on average going forward is that the kind of level that you're looking at? I know that you said that you've pulled the sales down, you've done the lion's share of that, but it was such a big drop in the third quarter I just wanted to understand if there were going to be -- if we're now reaching that kind of stable level or there are further big drops to go?

You're going to see fluctuation. This is a capital business so you do see fluctuation quarter by quarter irrespective of the trend. So, yes, I think you're right to call that Charles, it was a pretty big reduction this quarter. But for us it was in line with trend -- with quarterly variations, because that's the nature of this business, you do get quarterly variation.

So, no, this thing probably hasn't completely got to the stable level but there isn't very far to go, A. And B, within the niche we see ourselves focusing on in capital in Endoscopy, looking to the medium term there is scope for innovation. There is scope for interesting stuff there. And that will affect it over time, but exactly how far and how fast we're not going to be saying. We don't know so we're not going to be saying.

Okay. Thank you very much.

Thank you. We'll now move to our next question today which comes from --

Two more questions we've got time for, okay.

Thank you, sir. From David Adlington from JP Morgan. Please go ahead, sir.

Morning, guys. Thanks for taking the questions, a couple of questions. Firstly, on the Orthopedic margins, which were down 120, 130 basis points year on year, I just wondered if you could give us a feel for how much of that was due to investment in the DTC campaign versus pricing mix pressure. Maybe give us a sense of how gross margins are performing on that front.

And then secondly just a bigger picture question that talks to your outlook statement where the longer term you see maybe an increasing number of investment opportunities as well as market pressure. I just wonder how we should be thinking about margins going forward given, the fact we're at the end of your EIP program?

Yes, how much of the reduction in Orthopedic margin was down to DTC, a material part, but not all, David. We do get quarterly variation in margins all the time and I think that's really all we can say about it.

I think gross margins are fine. They're in line with what we thought they were going to be and they're fine. A large percentage of it was DTC, but I don't know exactly how much.

It's around (multiple speakers).

It's pretty much what we had forecast it, David, so there were no surprises.

Yes, exactly right. And then long-term margin, I think there have been a couple of questions about it already and the way we think about it is, A, there are significant further efficiency opportunities, particularly in the orthopedic business. We are very committed to getting after them. We will get them. So that's on the upside. On the other side of the equation there is these price pressures that are around and again a couple of questions have already poked at how big, and certainly in our view is there will be price pressure for some time to come. We need to deal with that.

And then secondly investment opportunities. And we do see significant investment opportunities in emerging markets - somebody was asking about that earlier - in R&D across the business. And the exact balance of that, we're not going to be prisoners to short-term margin fluctuations. We don't see material changes in margin, but we don't think --

We're still in the process of making those decisions, quite frankly.

Exactly.

We still have some pretty active debates going on about how do we spend some of those efficiencies in 2011 and 2012 and how do we -- should we bank them, should we spend them? And those debates continue and when we get to the point where we can give the right kind of guidance we will.

Great. Thank you. And just in terms of those investment opportunities, you're talking about investment in SG&A and R&D rather than anything substantial on the M&A front?

Yes.

Yes, yes. That's correct. Last question?

Thank you. We now move to our last question which comes from Ingeborg Oie from Jefferies. Please go ahead.

Good morning and thank you for taking my question. You clearly made good progress on the reduction of your debt and I was wondering how you see the M&A opportunities. We've seen Stryker making some acquisitions and you're clearly moving in the direction of having a much stronger balance sheet. So how do you see the opportunities?

And secondly, in terms of your focus on innovation, how much of this should we expect to come from say external R&D that you buy in versus internally developed? Thank you.

That's a tough question to answer, but you'll see some of it come from bolt-on-type acquisitions. We've made a few over the last couple of years and we continue to look at things. We continue to see bolt-on technology type acquisitions out there. We evaluate them constantly so I think you should expect to see some of that.

In terms of the shape of how we're going to invest, I think you're going to see it pretty much spread across the board. I think we have internal programs. We have some bolt-on acquisition opportunities. We have geographic investments that we can make to strengthen our business. What Stryker has done really doesn't play a part or influence what we do.

We have a fairly well-thought-out strategy and where we want to take our business. We have a portfolio of companies that we think gives us some real breadth in orthopedics and also gives us some leadership position outside of orthopedics in another space. We continually look at adjacencies that make sense for us to enter into where we can leverage our technical skill sets and the science that we're familiar with. And I think you'll see us continue to evaluate those things.

Great. So we could see some further diversification of your revenue stream? You wouldn't exclude that?

We certainly wouldn't exclude it but I wouldn't take away from my answer that we're signaling that we're going to be diversifying any time soon. I think we've got pretty good discipline around this issue and where it makes sense for us we're going to pull the ripcord and where it doesn't we're not.

Great. Thank you very much.

Thank you. Alright, thank you all very, very much. Great questions this morning. I really appreciate the thoughtful questions and hopefully we gave you some reasonably good answers. And I look forward to seeing most of you over the next few months.

Bye.

That will conclude today's conference call. Thank you for your participation ladies and gentlemen. You may now disconnect.