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Questor: accelerating earnings growth and a better valuation could drive capital gains from S&N

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Smith & Nephew joint graphic
Smith & Nephew joint graphic

Earnings forecasts keep dribbling lower, as input costs rise and the omicron variant potentially pushes back the recovery in the volume of surgical procedures, and as a result we are rather bereft of a near-term catalyst in the turnaround story that could yet develop at Smith & Nephew.

We shall simply have to be patient, especially as the “strategy for growth” outlined last week by the chief executive, Roland Diggelmann, suggests that the shares are cheap if his mid-term goals are met. The replacement knees, hips and wound care giant is now targeting compound organic revenue growth of between 4pc and 6pc a year until 2024.

Smith & Nephew is also seeking to drive its operating margin back to 21pc by 2024 and then make further improvements in return on sales after that. These goals are based partly on the promising product pipeline in orthopaedics and strong growth in sports medicine and wound care, as well as manufacturing and cost efficiencies.

If achieved, Smith & Nephew could rack up around 70p in earnings per share come 2024. However, there are clearly several ifs, buts and maybes about that, and a return to something more like normal volumes of surgical procedures would surely help. But a share price of £12.12 equates to less than 18 times that theoretical 2024 earnings per share figure.

If Smith & Nephew gets there, such a rating would surely be too low for a cash-generative firm that achieves returns on sales of more than 20pc and double-digit returns on capital employed. American peers trade on multiples of earnings in the mid-20s.

The combination of accelerating earnings growth and an improvement in valuation could yet offer substantial capital returns and they could be supplemented by dividends and share buybacks. Smith & Nephew paid an unchanged dividend of $0.144 per share at the first-half stage and has committed to a progressive payout policy, while Diggelmann and the board have now outlined plans for a $200m to $300m buyback in 2022.

For a company whose market value is more than £10bn that does not really move the dial and is almost neither here nor there from the point of view of this column, which is more interested in security of dividends. But such buyback aspirations at least speak of confidence in the future and if the company can deliver then our patience could yet receive its full reward.

The shares could be worth buying on any virus-inspired weakness. Otherwise they are a hold.

Questor says: hold

Ticker: SN

Share price at close: £12.12

Update: ContourGlobal

It must be said that the share price chart for ContourGlobal over the past 12 months is no thing of beauty, as it simply goes from the top left-hand corner down to the bottom right.

But that slide means the shares now offer a forecast dividend yield that is nudging 9pc and this may catch the eye of income seekers in particular. The shares even ignored an upbeat trading statement at the start of this month, which nudged profit estimates higher by some 4pc thanks to an unexpectedly strong performance from a power plant in Spain.

The weakness may relate to interest rate increases, especially in emerging markets, since Latin America and Africa represent 40pc of earnings before interest, tax, depreciation and amortisation (Ebitda). Utilities tend to underperform when rates rise for three reasons.

First, they are seen as bond proxies (and bond prices fall as bond yields rise, which they may do in sympathy as headline borrowing costs go up).

Second, they tend to have plenty of debt – $4.1bn in net borrowing in ContourGlobal’s case – so higher interest bills eat into earnings.

And third, the “discount rate” goes up, so the theoretical “net present value” of future cash flows goes down, taking the perceived value of the shares down with it.

However, more than four fifths of the company’s Ebitda derives from energy supply contracts that are index-linked and more than four fifths of the firm’s debt is fixed-rate. Both offer some degree of protection.

The stock still feels like a valuable option for income seekers.

Questor says: hold

Ticker: GLO

Share price at close: 190.2p

Russ Mould is investment director at AJ Bell, the stockbroker

Read the latest Questor column on telegraph.co.uk every Sunday, Tuesday, Wednesday, Thursday and Friday from 5am.

Read Questor’s rules of investment before you follow our tips.

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