Who Will Buy Smith & Nephew? And Why?

For a company that is not officially for sale, Smith & Nephew, plc (SNN)is attracting a lot of buying interest.

Most recently Medtronic, Inc. was mentioned in the financial press as a prospective buyer—until they squashed that idea at an analyst meeting.

Before that, in late May, The Financial Times reported that Stryker Corporation (SYK) was preparing a takeover bid for Smith & Nephew. Big companies don’t usually like their internal merger and acquisition musings splashed all over the raucous press.

Smith & Nephew, however, is a London based company and has to abide by the rules of the UK Takeover Panel. The Panel, which was established in 1968 to issue and administer the City Code on Takeovers and Mergers, regulates takeovers. They try to make sure shareholders are treated fairly. In their view competition and mergers are matters of public interest.

So when the Panel heard rumors that Stryker might be interested in Smith & Nephew they contacted Stryker and popped the question: are you planning to bid for Smith & Nephew in the next six months?

As it happened, the very day the news broke about the UK Takeover Panel’s inquiry to Stryker, CEO Kevin Lobo was appearing on Fox Business News. So on May 28, Lobo was asked on national television about Stryker’s heretofore private sizing up of Smith & Nephew.

He was ready and said, essentially, nothing. To quote: “We were in preliminary evaluations about considering a transaction. For the next six months we are not in a position to make an offer.”

Notice the key words: “…preliminary…considering…evaluating.” “…not in a position to make an offer.”

Naturally every major Wall Street analyst heard Lobo and assumed that Stryker would buy Smith & Nephew.

To be fair, the analysts did cite one hard fact—Zimmer is buying Biomet.

Analyst Speak

From Wells Fargo’s research department to its institutional investors:

“We think that an acquisition of SNN by SYK would make strategic sense, given the recently announced ZMH/Biomet transaction and the speculation of further consolidation in the orthopedic industry. The combined SYK and SNN would have over 30% market share of the hip and knee markets, second only to the combined ZMH/Biomet, assuming the acquisition is completed. Given that SYK was only at an early stage of evaluating a takeover of SNN, we would not be surprised to see SYK eventually bid on SNN.”

From Royal Bank of Canada’s research department:

“Scale is becoming more important in orthopedics, and SNN looks ripe for the picking. JNJ management highlighted at its recent MD&D day its thoughts on the potential benefits of scale going forward in this “new” healthcare environment. The potential acquisition of SNN would vault SYK into the clear #1 or #2 market share position in several important key orthopedic markets such as recon, trauma, and sports medicine. For example, we estimate that SYK/SNN would have the following combined worldwide market shares: sports medicine ~37%, recon ~34%, and trauma ~25%.”

Spasm of Consolidation

The power structure of medicine is almost certainly shifting. It appears to be moving from the healthcare provider to payers and government.

Changing regulations, reimbursement policies, medical device taxes, healthcare reforms and rise of payer power are altering the structure of orthopedics and driving companies to consolidate.

Synthes Inc., a Swiss medical device company, was recently acquired by Johnson & Johnson for $21.3 billion. In their explanation of the deal to investors, Synthes cited more aggressive bargaining by increasingly budget controlled hospitals and the slow growth of key products as the proximate reason to drive economies of scale through consolidation.

Harvard business professor Michael Porter, Ph.D. (the Thomas Kinkaid of management science) developed a simple framework for looking at competition in any industry. Using the Porter model, here’s how the shifting balance of power in orthopedics looks.

Five companies (Zimmer, Biomet, Stryker, DePuy, Medtronic Spine and Smith & Nephew) sell more than 90% of all orthopedic implants. Their products are a close substitute for each other. In practice, they compete fiercely and drive points of differentiation which, to an outsider, may seem minor but to the Stryker or Zimmer or Smith & Nephew or DePuy rep, are EVERTHING.

Excepting for a minute MicroPort Scientific Corporation’s purchase of Wright Medical Group, Inc.’s large joint business, the threat of a new, diversified orthopedic implant entrant coming into the market is almost nil. Likewise the power of suppliers of titanium, stainless steel or polymer—the raw materials for most implants—is also negligible.

In terms of substitute products, that threat is also low, but the rise of biologic and cellular treatments for arthritis and degenerative disc disease are dark horse threats to traditional implants.

Rise of the Buyer

The bargaining power of the buyer of orthopedic implants, however, is changing fast. The principal source of competitive pressure in orthopedics today is coming from the buying side of the business.

Buyers of orthopedic implants and instruments are growing in strength and negotiating power. So much so, in fact, that orthopedic implant companies like Stryker or DePuy or Zimmer are arguably at a competitive disadvantage to the buyers.

Who are these ever more powerful buyers? They are the large integrated hospital chains, they are the massive payers like Medicare, Aetna, United, Cigna and so forth and they are the regionally powerful bundlers of healthcare services.

The annual spending budgets of these actors are many multiples larger than the combined revenues of the top five integrated orthopedic companies.

In this industry, the buyer’s ability to apply competitive pressure to orthopedic implant suppliers has become painfully apparent to all industry participants.

Size negotiates with size. Larger buyers force sellers to get larger too. No one wants to negotiate from a position of weakness.

Scale, Not Innovation

Orthopedics is morphing into an industry driven by scale economics, not innovation economics.

The most important rivalries in the coming decade will not so much be between individual suppliers (i.e., DePuy, Stryker, Zimmer) as they will be between suppliers and buyers (payers and bundlers).

When asked by analysts about the causes of industry consolidation, Zimmer’s management pointed to consolidation among hospitals and private practices, and the presumption that such action will continue in the wake of economic and regulatory pressures as the primary drivers of industry consolidation. “They’re [buyers of orthopedic implants] going to be looking for savings…by partnering with fewer vendors that can offer a fuller portfolio of solutions, ” said David Dvorak, Zimmer’s CEO.

Michael Orsinger, chairman of Johnson & Johnson’s DePuy Synthes orthopedics unit, said on May 22 that customers are demanding a “one stop shop” approach toward implants. He predicted that it will drive continued consolidation in the industry. Volume is the name of the game, said Orsinger. And the shifting landscape may lead JNJ to accept “a slightly lower margin, but compensated by larger volume, ” and ultimately, he hopes, higher profits.

What is happening in the orthopedic industry today, in other words, is a structural change.

Smith & Nephew

Wells Fargo senior analyst for medical supplies and devices, Larry Biegelsen, expects that a merger of Stryker and Smith & Nephew would be highly accretive to Stryker shareholders and would change Stryker’s sector market shares as follows:

The new attractive gal at the orthopedic dance has been around for quite a while. Smith & Nephew, in fact, pre-dates the American Civil war.

The company was founded in London in 1856 by Thomas James Smith of Kingston upon Hull who went into business as a dispensing chemist. A few months before his death in 1896, Smith was joined by his nephew, Horatio Nelson Smith, and the business became known as T.J. Smith and Nephew.

In 1928 the company developed the wound management product Elastoplast. By 1977 the company acquired the pump manufacturer Watson-Marlow Pumps, before selling it to Spirax-Sarco Engineering in 1990. In 1986 it went on to acquire one of the pioneers of orthopedic implants Richards Medical Company for £201 million.

In 2002 the company acquired Oratec Interventions, a surgical devices business, for $310 million. It went on to buy Midland Medical Technologies, a hip resurfacing business, for £67 million in 2004.

The company acquired Plus Orthopedics, a Swiss orthopedics business, for U.S. $889 million in April 2007 and BlueSky, a U.S. wound care business, for $110 million in May 2007.

In September 2007 Biomet, Inc., DePuy Orthopaedics Inc. (part of Johnson & Johnson), Smith & Nephew, plc and Zimmer Holdings Inc. entered into settlement agreements, under which they agree to pay $300 million in total, adopt industry overhauls and undertake corporate monitoring to avoid criminal charges of conspiracy.

The company acquired Healthpoint Biotherapeutics, a specialist in the bioactives area of advanced wound management, for $782 million in December 2012.

In February 2014, Smith & Nephew announced the purchase of ArthroCare Corporation for $1.7 billion in cash. This was seen as a move to broaden the company’s sports medicine range for minimally invasive surgery moves the company into the ear, nose & throat market.

Last year Smith & Nephew posted up sales of $4.4 billion and operating profit of $810 million. The company earns about 18 cents on every sales dollar. Interestingly, Smith & Nephew pays out nearly 42% of its earnings to its shareholders. Which is the same as Stryker. Zimmer, by contrast, pays out only 18%.

What Now?

Once the dust has settled, will this be the new orthopedics industry?

Eight years ago, April 3, 2006 to be exact, Biomet stunned the orthopedic world by announcing that it had hired Morgan Stanley to conduct an auction to sell the business. The announcement came amidst a backdrop of board room intrigue which resulted in the shocking resignation of Biomet co-founder and industry legend, Dane Miller.

Two weeks later analysts on a conference call with then Zimmer CEO Ray Elliott and his CFO Sam Leno asked about the apparent Biomet sale. To be sure, the idea of a large integrated orthopedic company putting itself up for sale was slightly astonishing. Elliott answered analysts by saying that Zimmer’s M&A strategy was more geared to product or division “bolt-ons.”

Morgan Stanley’s auction of Biomet was a success. A consortium of private equity firms paid a 27% premium to buy Biomet for $10.9 billion later that same year.

Fast forward to 2014. Today the answer to the question of “Would Zimmer buy Biomet” has changed to “yes.” And with that answer, the strategic calculus at every other major firm shifts yet again. We’re in a brand new world in orthopedics.