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Smith & Nephew plc (SNN - Snapshot Report) reported adjusted earnings per share (EPS) of 18 cents or EPADS of 90 cents in the second quarter of 2013, slightly better than the year-ago EPADS of 89.5 cents. However, the adjusted result missed the Zacks Consensus Estimate (EPADS) by a penny.

On a reported basis, EPS of 14.3 cents or EPADS of 71.5 cents in the second quarter significantly lagged the year-ago EPS or EPADS by 55.9%.

Revenues

Revenues were $1,074 million in the quarter, up 3% (underlying, after considering currency translation, inclusion of Healthpoint growth and exclusion of Bioventus transaction) year over year as well as ahead of the Zacks Consensus Estimate of $1,085 million. On a reported basis, revenues improved 4% from the prior-year quarter.

Currency translation had an adverse effect of 1% on revenue growth. One lesser sales-day in the last quarter led to revenue increase of approximately 1%.

On a regional basis, revenues from the U.S. and Emerging and International Markets recorded underlying growth of 3% ($455 million) and 18% ($143 million), respectively. The Healthpoint acquisition led the growth in the U.S. market. Growth in Emerging and International Markets was led by robust sales in most of the emerging nations.

On the other hand, the macroeconomic environment in Europe affected the company’s performance in Other Established Markets as revenues in the region remained flat on an underlying basis ($476 million).

Segments

Smith & Nephew’s business framework comprises two divisions – Advanced Surgical Devices (“ASD”) and Advanced Wound Management (“AWM”).

ASD recorded revenues of $741 million in the quarter, up 1% on an underlying basis. Within this business, Smith & Nephew experienced 1% decline in the U.S. Segment revenues in other Established markets decreased 2% on a year-over-year basis as the situation in Europe continues to remain an overhang.

Maintaining the momentum, the company recorded 16% growth in the Emerging and International markets. Also, pricing pressure for the ASD segment remained unchanged in the quarter.

While the knee implant business reported 1% decline in revenues globally, against the market growth rate of 2%, revenues from the hip implant franchise decreased 1% against market growth rate of 3%.

Smith & Nephew continued to battle headwinds such as timing of the product cycle against other players, sluggish European market and softness in the company’s largest market in Europe besides ongoing softness for metal-on-metal franchise for its orthopaedic reconstruction business. However, the company expects the situation to improve in the second half of 2013.

Smith & Nephew recorded 6% growth in its sports medicine joint repair franchise, while arthroscopic enabling technologies remained flat on a year-over-year basis. The company plans to launch several new offerings under sports medicine joint repair business in the second half of 2013.

The performance of arthroscopic enabling technologies was affected by pressure on hospital budgets in end-markets. Nonetheless, Smith & Nephew improved its franchise performance in Other Established Markets. It also commercialized a value camera system in the Emerging Markets in the quarter.

The trauma business failed to maintain its positive momentum and recorded 2% growth, below the market growth rate of 5%-6%. This was on account of lower benefits from a competitor’s product recall and no major tender wins in the reported quarter.

AWM recorded strong underlying growth of 10% year over year to $333 million in the quarter against 2% market growth rate. Growth was led by the NPWT portfolio and strong contribution from Healthpoint products. Excluding the impact of the Healthpoint acquisition, AWM revenues inched up 5%. Revenues in the U.S. surged 16% on a year-over-year basis.

The company witnessed 4% growth in the Other Established Markets with balanced growth across all regions. The Emerging and International Markets recorded a robust hike of 25%, reflecting another quarter of solid growth.

Under AWM, advanced wound care revenues increased 1% to $211 million on the back of improved performance in Europe and significant contributions from emerging countries. Revenues of advanced wound devices shot up 27% to $52 million as Smith & Nephew continued to gain market share in NPWT and sustained momentum in the Japanese market.

Advanced wound bioactives revenues were $70 million, up 35% from the prior-year quarter on the back of inclusion of Healthpoint’s portfolio and promotional activity for Santyl in the quarter.

Margins

Although gross profit improved 4.2% year over year to $796 million, gross margin contracted 10 basis points (bps) to 74.1% in the quarter. The company witnessed a 7.4% increase in selling, general and administrative (SG&A) expenses to $550 million and a 38.1% rise in research and development (R&D) expenses to $58 million. As a result, operating profit declined 10.5% to $188 million in the quarter. Consequently, margin contracted 290 bps to 17.5%.

Overall, trading profit margin (operating margin after taking into account one-time transactions) contracted 110 bps to 21.6% in the quarter. Among the segments, ASD trading profit margin expanded 10 bps to 22.9% on the back of structural efficiency. However, the trading profit margin at the AWM division recorded a contraction of 370 bps to 18.7% due to the Healthpoint acquisition and higher SG&A and R&D expenditure.

Financial Position

Cash and cash equivalents were $101 million, down 45.7% year over year. Net debt was $281 million in the reported quarter compared with $137 million in the sequentially prior quarter.

Trading cash flow was $187 million in the quarter. Smith & Nephew purchased 6.4 million shares worth $75 million year-to-date.

Our Take

Smith & Nephew reported a dull second-quarter that missed the Zacks Consensus Estimate on both fronts. As expected, the company’s weak orthopaedic reconstruction performance continued. Despite improvement in end markets, Smith & Nephew faced lower revenues for hip and knee franchise. The lower revenue growth for trauma business was another downside in the quarter.

Nonetheless, we are encouraged to note the gradual stability in the U.S. market and modest improvement across Europe. Notably, the company’s increasing focus on AWM franchise is paying off. We are also encouraged by the company’s focus on the lucrative emerging markets such as Turkey, China, India and Mexico. We believe that expansion of portfolio in these fast growing markets should catalyze growth for Smith & Nephew.

Currently, the stock carries a Zacks Rank #3 (Hold). While we remain on the sidelines for Smith & Nephew, we are positive about Hanger, Inc. (HGR - Analyst Report), carrying a Zacks Rank #1 (Strong Buy). Other industry stocks such as Boston Scientific Corp. (BSX - Analyst Report) and Alere Inc. (ALR - Snapshot Report), carrying a Zacks Rank #2 (Buy) are also worth considering.

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