Smith & Nephew plc (SNN) Q2 2017 Earnings Report, Transcript and Summary

Good morning, ladies and gentlemen, and welcome to our Half Year Results Presentation. I'm here with Graham Baker, our CFO. He was in the room last time but not on stage. He joined us at the start of March; and also, with Phil Cowdy. You all know he's a smiley face. He's with us today. And I will start by covering the highlights of the half year, followed by a review of our second quarter trading performance. Graham will then take you through the numbers and our guidance, and we'll conclude with an update on strategy and on few topical areas. And as usual, we'll take questions at the end of the presentations. The underlying revenue growth of the first half was 3%. Currency reduced growth by one percentage point and the effect of disposal of GYN was two percentage points. We have started the year well in line with our plans and there are many highlights. We returned our Emerging Markets business to solid double-digit growth of 12%. Our Knee franchise delivered another period of above market growth led by a strong contribution from our JOURNEY II platform. In Advanced Wound Devices, PICO is transforming and expanding the way negative pressure is used and its strong growth continues. Our trading profit in H1 was nearly $0.5 billion, giving a trading margin of 21.1%. This represents a 30 basis point improvement on the prior year period. We have focused on improving our commercial and operational execution. As shown by the results, we're making good progress and there is still more to come. An improvement in tax rate and a one-off tax benefit had delivered EPSA growth of 15%, and Graham will cover this in more details. I'm pleased with this first half. Taking into account trading days, we improved our growth sequentially. This performance improvement I see in the business and new product rollout underpins my confidence in us delivering the full year guidance. Turning now to our Q2 trading performance. As usual, this slide captures our underlying growth, on the left-hand side geographically and on the right-hand side by product franchise. In the second quarter, we have seen a continuation of many of the trends that we saw in the first. It was one fewer selling day in Q2 compared to the prior year period. And on the slide and in the following discussion, the Q2 growth rates are not adjusted for selling days effect. The U.S., our largest market, grew 2% and was unaffected by selling days. With the effect of two fewer selling days in the Other Established Markets, the Other Established Markets declined 1%. In contrast, our emerging markets drove another quarter of double-digit growth. And within this, China continued the positive trend with all franchises posting positive growth. We also benefited from the small tender order in the Gulf States. I will talk more about the emerging markets later in my presentation. And now, turning to our individual franchise in more details. In Sports Med Joint Repair, we grew 5%. We drove good performance with recently launched products as Q-FIX for shoulder and ULTRABUTTON for knee repair. Our enabling technologies business declined by 4% with continued softness in our resection portfolio, overshadowing a good uptake of our new LENS visualization system. Meanwhile, the ramp up in production of our next-generation COBLATION system WEREWOLF was a bit slower than expected. It's now behind us and we expect growth from these new products to increasingly offset the drag from our legacy resection portfolio. Our Trauma & Extremities revenue grew 7% globally, benefiting from the small tender order in the Gulf States I mentioned earlier. In addition, our INTERTAN nail for hip fracture continued its strong growth supported by recent clinical evidence. Our Other Surgical Businesses delivered underlying growth of 11%. In particular, robotics grew strongly in the quarter. I'm turning now to Recon. Globally our Recon revenue was up 2%. We grew our global knee franchise by 4%. Growth in the U.S. was 5%. This is driven by a continued strong uptake of JOURNEY II, our kinematic knee platform. And we also launched an addition to our LEGION revision platform, which is receiving keen customer interest. Global hips was down 1%. The addition to our REDAPT Revision hip family, both the acetabular cup and the stem are receiving very positive customer feedback, and we launched a further product in the family in Q2 with the REDAPT mono sleeve stem. We expect a gradual improvement in hip growth trend in the second half of the year. And turning now to wound management. Wound management is made up of wound care, bioactives and wound devices, and overall growth was up 3% in the quarter. Advanced Wound Care revenue improved sequentially to 2% growth. The improvement is driven by continued strong growth in the U.S. and return to positive growth in China. I am particularly pleased to see the growth in the U.S., a market where some years ago, we took steps to improve the execution. We've put resources behind our ALLEVYN brand and our disease focus strategy. And today, we are one of the fastest-growing wound businesses in the U.S. with 16% growth in the quarter. Advanced Wound Bioactives was flat, representing an improvement in Q1 expected. OASIS remained a headwind. SANTYL growth kicked back into positive territory in the quarter and we expect this to improve further in the second half of the year. In Advanced Wound Devices, we had another good quarter of 14% growth with PICO performing strongly and all across. And I will now hand over to Graham.

That's you? Thanks, Olivier. Good morning, everyone. I'm delighted to be here with you in person, with apologies to those I've met already. It was positively my last introduction. I joined Smith & Nephew on the 1 March this year from Alvogen, a private generic pharmaceutical company where I was CFO. And before that, AstraZeneca, where I worked for around 20 years in a broad range of finance roles around the world, topical this morning, I guess. Today, I'll focus on Smith & Nephew and running through the first half financial performance and outlook before returning to give you a few brief observations from my first full quarter. As Olivier mentioned, sales grew 3% on an underlying basis, excluding the impact of foreign exchange and disposals, and we're flat on a reported basis. Trading profit grew by 2% to $493 million, and the trading profit margin in the first half was 21.1%, an improvement of 30 basis points. Within this, gross margin improved by 140 basis points, largely offset by movements in SG&A. I'll provide more detail on both in a moment. R&D investment remained at around 5% of revenue, in line with expectations. So looking at trading margin in more detail. The year-on-year improvement of 30 basis points breaks down, as I said, into 140 basis points improvement in gross margin and 110 basis points of adverse moment on operating expenses. As shown on the slide, the largest movements on both sides of the equation are items in the prior year that are not recurring in nature. And broadly, the favorable movements in COGS are offset by items going the other way in SG&A. So while optically we're seeing quite large movements in gross margin and in SG&A in the first half this year, favorable on the gross margin side and unfavorable on the SG&A side, I'd focus really on the underlying 30 basis points of improvement in the trading margin, which is in line with our full year guidance. Putting aside the nonrecurring movements, this 30 basis points trading margin improvement was driven by a modest improvement in underlying gross margin and a broadly stable underlying SG&A ratio. I'll now briefly touch on differences between our non-GAAP trading profit measure and IFRS. IFRS operating profit grew at 16% a 240 basis points margin improvement. The stronger uplift in IFRS profits and margins stems from the absence of any restructuring charges which is outside trading profit in the first half this year. Charges in the prior year period related to the now complete Group Optimization program. Moving on to the bottom line. EPSA growth, as Olivier mentioned, of 15% in the first half was substantially higher than growth in trading profit and profit before tax. This was because of favorable movement in the tax rate. This in turn was driven by two factors: First and foremost, a one-off provision release following successful conclusion of a U.S. tax audit, which reduced the half year tax rate by around 6%; secondly, a modest 1% improvement in our tax rate on trading to around 25%. We expect this to continue throughout this year and into the medium term. In addition, the average number of shares is 2% lower following the buyback program in the second half of 2016, excluding the one-off tax benefit, EPSA improved by 6%. IFRS EPS benefited from the same favorable tax movements, of course and also the absence of the restructuring charges just mentioned, so it grew by 37% in the first half. Now turning to cash. Trading cash flow of $327 million was generated in the first half, a 28% increase on the same period in 2016. This was driven by improvement in the cash conversion ratio to 66% well above the 53% we realized in the prior year. Improvement in cash conversion principally reflect lower working capital outflows of $157 million, mainly from an improved inventory trajectory. As usual, we expect a higher cash conversion in the second half and in the first half, reflecting the [indiscernible] cycle of the business. The restructuring, legal, acquisition and other costs of $67 million include cash outflows from going metal-on-metal hip claims, patent litigation with Arthrex and the utilization of the restructuring provisions related to the Group Optimization plan which ended in 2016. At the bottom line, including low working capital and tax payments, free cash flow in the first half was $78 million higher than the prior year at $173 million. Now turning to our capital allocation policy which is unchanged and net debt. We started the year with net debt of $1.6 billion and generated free cash flow of $351 million before CapEx. Capital expenditure was $178 million, reflecting investment in instruments and continued investments in manufacturing capacity. Dividends were $162 million, being the cash payment of our final dividend for 2016. On acquisitions, the net cash spend of $32 million relates principally to the expected deferred consideration payments for Blue Belt and a few other smaller acquisitions. Finally, within other, we include the repurchase of own shares equivalent to shares issued under employee schemes, effectively neutralizing the dilutive effect of our employee share schemes. So we closed with net debt of $1.6 billion. Finally, I close on our guidance and a few initial reflections. To summarize on the guidance, the guidance and outlook for 2017 is unchanged with the exception of a modest improvement in our tax rate. On revenue, we continue to expect 3% to 4% underlying growth with the momentum we've built in the first half continuing. On a reported basis, we expect 2.5% to 3.5% revenue growth based on prevailing exchange rates on the 21 July, and reflecting the 80 basis point impact from the disposal of the gynecology business. On margin, the guidance for 2017 remains unchanged, a 20 to 70 basis points improvement. Taking the one-off tax benefit we've seen in the first half and the improved tax rate of around 25%, we expect the 2017 full year tax rate on trading results to be around 22%, barring any changes to tax legislation or other one-off items. The only change to our medium-term guidance is that we now expect our ongoing tax rate on trading results to reduce to around 25%, again, barring any changes to tax legislation or other one-offs. And finally, a few words about my first month at Smith & Nephew. Since joining, I've spent much of my time meeting senior leaders and as many employees and customers as possible. I found the people rightly passionate about what they do and I found a strong culture. Smith & Nephew has a history of developing pioneering technologies, something I can see in our strong product portfolio and our new R&D organization. I'm also happy to see the significant restructuring work that's been done under Olivier's leadership, which has resulted in a much more agile structure, which is much better able to execute the strategy. I think we're just starting to see the benefits of those changes and agree with Olivier that we must maintain our focus on improving our execution in the near term. With this focus, we also both see opportunities for the business to do better than we're doing today, better performance in the market and more efficiency in all parts of our operations. I'm very much looking forward to working with Olivier and the rest of the team to shape and realize those opportunities over the coming months and years ahead. With that, back to you, Olivier.

Thank you, Graham. Take my slide if you want. So now turning to the strategic update. Here's a remainder of our strategic priorities, and in the following slide that we talk about, important updates again, each priorities, starting with the Established Markets. So to win in the Established Markets, we need to stay, as you've said, very focused on commercial execution. I talked to you about several of our initiatives in the full year results in February, and we have made very good progress since then. We have a simpler, more agile commercial structure in each country supported by global functions. In many countries, we have only been operating in this way for just over a year. With the new structure in place, it is becoming clear that this will enable us to drive improved performance and much greater efficiency. Our Sales Force Excellence initiative is something I am myself very hands on with, and we have sharpened the focus on both health economics and clinical evidence to support our products. I talked earlier about the effect this can have on a product like INTERTAN. Improving execution is not only about the customer-facing organization. For example, to support the acceleration in our sales growth, we also need seamless and responsive supply where it's not sacrificing inventory efficiency. Our global operation function is driving initiatives to make these world-class functions. In the Established Markets, better execution is also about taking advantage of changes in the market. In the U.S. and other countries, we're seeing a shift towards day-care surgery, also for total joints starting to take place. Two weeks ago, CMS in the U.S. announced a proposed change in its reimbursement for total knee replacement and moving it from the inpatient-only list from 2018 and seeking comments on reimbursing total joints in the ambulatory surgery centers, the ASCs, setting the future. This highlights the trend towards more of U.S. knee procedures shifting to the outpatient and ASC settings. We're excited about this market shift, which recently is uniquely positioned to benefit from. Our leading sports medicine franchise means that we already are partnered to a large proportion of the ASC market. In fact, we are [indiscernible] the strongest sports medicine at present. In addition, most of our ENT products are also used by our ASC customers. We believe we can leverage this deep customer knowledge in our relationship to capture a larger share of the knee business. Our strong knee portfolio, as evidenced by our growth is well suited to an outpatient setting where early mobility and efficiency are key criteria. We also believe NAVIO is the robotics system of choice for ASCs due to its small footprint, portability and cost. In addition, our own products, such as PICO and ACTICOAT when used in incisions offer advantages to patients when discharged home earlier. Now I don't want you to be overexcited. Changes in clinical practice tend to happen gradually in our market, but I truly believe we're very well positioned for this. So turning now to the emerging markets. We had a challenging year in the emerging markets in 2016, you remember that? But this did not change our view that the emerging market is one of our pillars for higher growth. As expected, we have now returned our emerging markets business to sustainable double-digit growth. China is our largest country within this region. We faced a restocking cycle last year as the market growth slowed down and our distributors had a higher stock than needed. We have improved our management of an involvement in channel inventory, and we have seen a return to double-digit growth in this attractive Chinese market in the first half of 2017. The Other Emerging Markets continued to do well. We have been early investors in many of these markets and we see the benefits of this coming through. There are always going to be quarterly fluctuation in the growth rate and differences in performance within country, so we look at the longer-term secular trend when making decisions and those are very favorable. Finally, we see the next wave of sustained growth coming from the mid-tier, essentially growth from widening access to a greater proportion of the relation in these countries. We are addressing these by steadily building a dedicated product portfolio and specific distribution model, as you know. So turning to robotics and our third strategic pillar of innovation. We did acquire NAVIO platform at the beginning of 2016. And in a short period of time, we have developed and achieved approval for our 3 major knee platforms on the system JOURNEY II, GENESIS II and LEGION. NAVIO is an exceptionally diverse robotic platform and we have full pipeline of further indication expansions. We track a multitude of metrics, not only sales. And particularly important to me is a trend that we're seeing of greater utilization, essentially how often the robot is used. And this confirms my view that robotics will become increasingly important and mainstream in the future. Another highlight for me has been interest from other countries outside of the U.S. We have now sold multiple units in India, for example. We are on track to meet our 3-year target of more than 50% compound annual growth rate from the combination of capital sales and increased pull-through of implants, and I believe this will turn out to be one of our most important strategic acquisitions. And turning to the fifth pillar of the strategy. And it has been now exactly 3 years since we acquired ArthroCare, and I thought it was appropriate to review its performance. I have said before that this was a perfect acquisition for us. It reinforced our Sports Medicine business with complementary product portfolios and customer relationships. ArthroCare also had a strong pipeline of innovations, many of which have been launched since the acquisition. When making acquisitions, this is not just about strategic fit, customer and products, it's also about creating value, obviously, for our shareholders, and ArthroCare has met all of the 3 years target that we've set mainly ahead of time. We have achieved both the cost and revenue synergies, totaling $85 million in trading profit level and the return on invested capital in year 3 exceeded our target. In conclusion, we had a good start to the year. Our focus on better execution is driving greater consistency in our performance. I also believe we have the strongest portfolio of products we have ever had, many of which are only at the start of their rollout. Our first half results underpin our full year guidance, which is unchanged. We're taking good momentum to the second half and continue to expect underlying revenue growth in the 3% to 4% range and 20 to 70 basis point improvement in trading profit margin for the full year. Creating long-term value is not only about our performance today. It's about enhancing the company and making it more fit for the future. As I look to the medium and long term, we have strong market positions and we have invested in platforms which will enable us to achieve our ambition to consistently outgrow our market whilst improving our profitability. I continue to believe that there are further opportunities to drive better performance. These include maximizing the benefits from our multiple growth driver and further increasing efficiencies through more effective use of our commercial, R&D, global operations and supporting function resources. I'm delighted to have Graham join my team, and I'm certain he will play a very key role in identifying and delivering these further opportunities. So thank you, and that ends the formal presentation. We'll now take the questions.

It's Yi-Dan from Deutsche Bank. So first question to Olivier. Just a quick question on Syncera. [Technical Difficulty].

Okay. Well, let me start with Syncera. I mean, first of all, it's not a large investment. It has always been a low-cost investment for us. So we have not put a lot of resources in this one. We still believe Syncera has a future in the company. Now it is behind our expectation. I'm not going to tell you that we are just on track. I think it starts slowly and slowly. It's complex things for people to do. I think it was truly appropriate in the context of the CJR to see Syncera, but we don't see any impact of CJR for the moment. So we don't see the ramp-up that we're expecting in Syncera. So talking about reallocating the resources, I think, would be wrong: A, because it's a small amount of money; and B, because we still believe in Syncera in the future. We are actually fine-tuning the Syncera model there recently to make it more easy and to try to have a wider scope for Syncera. Well, that's what I can tell you. So since you left...

[Technical Difficulty]

It's not a no go. No, it's not a no go. We have very few people dedicated to Syncera. So it's not a no go. I think it's a test that we do because we believe that these are the future as we did for the mid-tier. You remember, I said that Smith & Nephew is -- want to be disruptive, in disruptive technologies, products, new platform and the robotics and those things, but also in disruptive models. I believe the mid-tier was mentioned in the mid-tier in my presentation. Syncera is also a part of it, so we try it. I think it has a potential. Now is it a huge potential? I don't know. Frankly, I don't know. But we are -- because of the small amount of resources dedicated to Syncera, we want to continue. So we try to fine-tune it and that's what we are doing. On the G&As, I mean, Graham will answer. But don't forget that we have built GBS, which is the Global Business Services, which is extremely important, where we dedicate a lot of -- we put a lot of resources actually which were local resources in specific centers. So Graham?

Sure, yes. I mean, in addition to that, there have been a number of outsourcing initiatives over the last few years that have gone through the organization. So if you think about the total G&A resource, you have to think about both what's inside the company and outside already. I think overall, what I see, and as I've spent 20 years in the G&A space, more than 20 years, there's no perfect way to do those things. And so I think you always have to bring a mindset of continuous improvement to that. And therefore, there probably are things around the edges that can be done to further enhance what we've done already. But on the other hand, the business is developing. We're growing further in emerging markets. Those markets have different requirements and needs from the developed markets that we've got. So evaluating exactly what the right model for us to have going forward to make changes to the existing model. It takes a little bit of time to work through all that.

[Technical Difficulty]

No, we don't. We don't disclose that separately.

[Technical Difficulty]

No. I mean, the annual reports got the full G&A administrative expenses, but that includes restructuring costs as well. So I'm not putting a percentage out there at this particular point.

I can tell you and -- because I know you will not stop biting on this one. It is competitive and it is improving the rest of the year. Veronika?

Two questions for me. The first one is on the guidance. Obviously, you have half the year behind you. Can you give us a sense, as you look into the second half of the year, whether you feel you're tracking in the upper or the lower half of that range? And maybe what are the major risks or variables you see to that? And then my second question is a revisit of capital allocation in M&A, Graham, now with you on board. I wonder if we are likely to see any changes to your capital allocation strategy. I noticed there was a comment, Olivier, in the press release this morning that you are looking for more bolt-on acquisitions on the technology and EM space. Does that mean you're rolling out larger deals at this stage? And if we are not going to see any larger deals, why don't we see [Technical Difficulty]?

Graham, do you want to do that? The guidance, I can take guidance and you can hop into -- again, I've said that we are confirming the guidance, which is 3% to 4%, 20 to 70 basis points of profit. And why, because you can tell me, well, you know what, you were growing at 3%, Q1. Adjusted for the number of days in Q2, actually, it's better than 3%. So why don't you expect to be? Because we are operating in a market which is complex. We have risks. The risks are: the volatility of the Emerging Markets is one of them, for example. We have identified few risks or so here and there that we can have. So we believe that staying at between 3% and 4% is the right thing to do and we do not expect much more. Between 20 and 70 basis points, again, why the range, because again of the variation of the top line plus the fact that we always want to keep some opportunities to invest in a few areas. So that's what -- and I don't think there is much to say than we want to be clear. If I gave this guidance in Q4, actually, in the full year, saying that -- the first time Smith & Nephew was giving that because I want to achieve this guidance. And I saw that the structure we put in place in the past years is ready to be able to make the implementation of the strategy happen and improving the execution, commercial execution. So I'm very comfortable with this 3% to 4%.

Yes. I think the only thing I'd add to Olivier is that it's actually quite a tight guidance range already, actually. So tightening it further at this point, I think, possibly would be getting a little bit ahead of ourselves. In terms of revisiting the capital allocation policy, I think the framework itself is absolutely the right framework. 1, 2, 3, 4, in that order, makes complete sense to me, and we remain committed to our investment grade credit rating. On the other hand, right now we're focused on execution with what we've got, and we're almost religious in that focus. I think we need to sustain that all the way through the year. But this is clearly an industry where there are still good opportunities. Not all the best technologies sit in our own laboratories and engineering facilities. So continuing to look around to see opportunities at sensible prices, within the strategy and the businesses that we operate or very close to them, continues to be a priority for us. And whether those are small things or a succession of small things or larger things and that's partly opportunity driven, but I'm absolutely committed to being competitive in that space, at the same time as being disciplined in the prices that we pay. So we have to, I think, keep a little bit of flexibility to make sure we don't miss out on the good opportunities.

But execution -- just to rebound on the execution, it's not only, I mean, selling better with -- of people. It's also improving our efficiency, I mean, our return on investment, trying to improve what we can generate with $1 invested in marketing. So we work a lot on these actions. So we have a lot of actions to improve everything we can, not only sales work but the marketing also. And bolt-on, yes, I mean, you will see bolt-on acquisitions here and there. We have some gaps in our portfolios. So we always find some good things to do. You remember we did UNI knee the year before last which was extremely good for us. I mean, we can find many also like this. Tom?

Tom Jones from Berenberg. One for Olivier and one for you. Olivier, massively relevant to this particular quarter, but I just wonder what your current thoughts around the Bioventus JV are. I assume it hasn't got worth any less than when you did the initial deal. There's quite a big chunk of value that's sitting there, not doing a great deal for your P&L. So when would you expect that to start contributing? And if it is not in the near term, why continue to hold that asset? Why not [Technical Difficulty] and if we have that capital for some other use and or get it back to shareholders? And then for you, Graham, a tricky question, I'd like to give this earlier [Technical Difficulty] but FX was into fairly significant moves in your key trading currencies in the last few [Technical Difficulty]. I just wondered if you could give us some steer on how FX is likely to impact the business over the next 12 to 18 months. I picked that time frame because I know you like to hedge stuff quite a long way forward. So maybe some indication of kind of how your [Technical Difficulty] hedges unwinding is helping or hindering initiatives margin and how your current hedging position may affect the trading margin [Technical Difficulty] interest in the margin side. We tend do have a pretty handle on the revenue side, but margin impact is a bit of a black box for us [Technical Difficulty]

Okay. On Bioventus, I will give you the answer and we will feel -- the board of Bioventus will give you some insight also. Bioventus, for the ones who were not there at this time, was the biologic arm of Smith & Nephew. And in 2012 we decided to do a spinoff for very simple reason. The level of R&D that we're putting in this business, we're -- I'm making it possible. The fact that we could program and form the right program for the knee, actually, the JOURNEY II, for Sports Medicine and for Wound Management. So we said, Well, that is not our business. It's too expensive and it's too risky. So let's do a spinoff. So we did a spinoff with a company called Essex in the U.S. which is a private company and they took 51% of the share and as you say, we have 49% of the share. So now it's a company and they have grown, actually. It's now a company which have about $300 million of sales roughly. So we have the stake. Now can we sell it? Well, we believe it's a potential thing to do. I mean, we always have the opportunity to sell. Now can we wait more and expect to do more with that? Yes, certainly. That's our philosophy today. So Phil, if you want to give some insight on Bioventus.

Yes. I mean, Bioventus has made very good progress over the last few years. It's been a number of acquisitions. It's built an orthobiologics business. It's added to its HA business and progressed its BMP R&D program. We did consider with our partner, floating it last year and certainly, the indicative valuation was ahead of the original one a few years ago. So very good progress.

[Technical Difficulty] it's private. When would you start contributing [Technical Difficulty] benefit to your P&L as Smith & Nephew can [Technical Difficulty]?

Yes. It has a big R&D program. So it's the balance of the profitability it's generating on the revenue pieces and how much we put into R&D. And it's really a choice around the management team.

But I mean, financially, again, strategically, it's the best deal we have ever done for a while. I mean, the return is good. We have been reimbursed, part of it. We expect that good things come in the future. So yes, I think it's a very good deal. And actually, it shows you that we can do also allocation -- portfolio allocation when it's necessary because frankly, I think it was not good for us to keep this business at this time.

Yes. So it is a complicated question, Tom. Let me have a go at it. But I've got my Treasurer in the room. So I'm under supervision and he can help me out if I'm going astray a little bit. I think you're right to pull out that we're hedged, so any effects in the current year are muted by that hedging and the net pluses and minuses are pretty small on a transactional basis. If you think out beyond the playout of those hedges, we've basically got a business that's very -- in very crude terms, sort of 50% of its sales are in U.S. dollars and 75% of the costs of the custom goods at least, are in U.S. dollars. And that means that, therefore, 25% of our cost of goods is in non-U.S. dollar. Therefore, if the dollar appreciates, we tend to get a suppression of our sales, on 50% of our sales line, and we get a suppression of costs and cost of goods on only about 25% of the cost of goods and therefore, that's a net compressor on gross margins. Clearly, our hedges operate over about a 12-month period. And so we tend to get to a place where year-over-year, once you go past that 12-month horizon, if you see sustained appreciation of the U.S. dollar against the large basket of currencies, then that will tend to be a suppressor on that margin. As of today, I don't think we've seen any of those large secular movements in FX. But I'm certainly not going to become -- somebody's got a crystal ball about what's going to happen to the dollar. Of course, within that, there are particular currency pairs that are particularly important to us. The euro is probably the biggest of those. But we also have reasonably big exposure to the markets where we make a reasonably large amount of sales. And beyond that, I can't give you really any more clues because it's really actually speculating about exactly where those secular movements on the dollar are moved. But it means that we're not quite the same place as an organization that's got the sort of the simple natural hedge of a large amount of non-U.S. dollar denominated costs sitting to offset in margins. We are a little bit exposed to that.

Given the dollar weaknesses, I'm assuming on a kind of like-for-like basis [Technical Difficulty] 12 months when your hedge has rolled off, there should be some modest tailwinds into margin? [Technical Difficulty] sort of that guidance for next year. Do you actually [Technical Difficulty] I'm not Michael, so I won't push on margins anymore.

Okay. Let's -- sorry. One question for the phone and then I go to you, please. Any questions from the phone?

[Operator Instructions]. We have one question. It is Ian Douglas-Pennant from UBS. Please go ahead.

Hi, thanks for taking my questions. On the tax rate, it's great to see further upgrades coming through there. Could you give any kind of indication? Is 25% the endgame or are you still making -- I can't remember what the politically acceptable phrases there. But are you still making changes that might result in the tax rate coming down there beyond that 25% as well in an upside scenario. And in Wound Care, you mentioned some weakness in Europe. Is that just France or are you talking about other territories as well as France?

Okay. Let me start with the Wound Care and then we go to tax rate. By the way, tax rate, don't forget, the tax rate was 32%. So we have been able to go from 32% to 25% -- 26% actually and 25% guideline and this without increasing the risk because that's also very important. The board is really focused on no risk which makes sense. And so I think the improvement during the last years have been pretty significant. And then Graham will give you his vision of tax. But regarding the Wound Care, France is not concerned actually. I mean, we have some issues in Q1 in France due to prices in Wound Care. We have not seen any more impact. And actually, the volume in France of Wound Care is recovering. The main issue in Wound Care in Europe is in the UK and to a lesser extent, in Germany which by the way is also improving through our execution -- improvement in execution of programs. So most of it is Wound Care UK, which is a place where we are struggling but we have plans also to make it better.

And I'm sorry, on the UK, I'm not up to speed on that story. Is that a Smith & Nephew specific issue or a market issue?

No, it's -- the market is not really good and Smith & Nephew is not very good either. So I think it's a combination of 2 things. The good news that we have identified the reason and you know that last year was not really a good year in many aspects. And I think that the disruption that we have generated in the market which was necessary by the way, in putting together all the commercial businesses from health commercial or your commercial got Manchester to what further has created that I said, the disruption that was essential. And now we have place which everyone is operating together and things will improve, believe me, in the UK

On the tax, I think the simple message is that yes, 25% does reflect what I think is the -- a reasonable assumption going forward in the business, barring any significant changes in legislation, particularly in the United States or in any other major one-offs coming through. The tax structure of the group reflects principally the operations and the intellectual property of the organization and a lot of the heritage of this company sits in the United States. Making some sort of radical move on that would probably incur a very large one-off tax bill and I'm not sure that, that would actually make sense, frankly. So I think the 25% does reflect a sensible assumption going forward for the business. Of course, as we run and operate the business going forward, we're mindful of that tax structure. And further intellectual property, further operations of the business will principally reflect the operational decisions and drivers for those choices. But we, of course, will bear in mind tax as part of the decision-making which means we may evolve over time, but I don't expect any big discontinuities.

I think we can say that the focus on the company -- of the company on tax is much higher than what it was, I mean, whether it's IP or localization or -- again, this should be driven by, first of all, business reasons. And we will look at tax also as an important part of the consequence of our choices.

I originally trained in tax, but I don't fancy myself as an amateur. I'm rather out of touch. I am reassured though we've got very good quality tax team and they were very mindful of the business challenges...

But that wasn't why you were hired, of course.

Yes, obviously.

Thank you very much. Patrick at Citi. Just 2 for me, if I can, please. The first would be -- I appreciate it's very difficult. But over the long, long term, assuming Total Knee in ASCs got proper reimbursement, where would you think long, long term the natural level of ASCs that knees is relative to the more traditional sort of setting? I would say, are we talking 20%, 30%, 40%? I mean, where would you imagine that might come out of?

It's a difficult question. I mean, it's -- crystal ball, if I tell you that it's maybe 40-60, that would be my guess, but I may be totally wrong on this one.

Of course. I mean, best guess, but the second one is on...

But -- sorry. But definitely, I mean, ASC is an opportunity for us on a long-term basis because again, as I said, our footprint both in Sports Medicine and in Wound Management. It's such that this gives us a large number of opportunities. And as I said, robots also, because of the price, because of facility of moving the robot, I think, that will be also another plus.

The second one is more on the wound side of things. For a while, you guys have historically looked at doing M&A in this space as have a number of your competitors, and no one's really managed it yet. Has that been more of a difficulty in terms of finding the correct assets? Is it more that they are not available for sale, [Technical Difficulty] problem or just the asking prices are unreasonable [Technical Difficulty]

That's not a price issue. It's a fact that if you really want to be specific on wound, you don't find many players. Look at them. The good players, who are they? Coloplast, but it's a mix and they're not for sale. Mölnlycke is a good company also. They are not for sale. ConvaTec is now what it is, and it was not only wound, as you know, but a number of things. So -- and then, you have tiny players which will not move the needle, and so that is the point. And for -- and that's for us. Now a smaller player are always complaining of the fact that they do not have the right size and the critical mass to be efficient, but the problem is then if you want to buy something, it's so expensive for them that they don't do it or they don't find the bride.

Alex Gibson from Morgan Stanley. Just one on the Wound Devices segment. Could you give us a bit more granularity on where the growth has come from in there? Is it particularly the PICO device? Has RENASYS TOUCH come back into play and has that helped you drive share, if -- maybe a bit of growth on how that [Technical Difficulty]?

Okay. On -- again, the philosophy of Smith & Nephew is that we believe that the portable negative pressure, PICO, is a feature of negative pressure. Having said that, we also believe that it's important to have both [indiscernible] negative pressure and portable negative pressure, that's what we do. We sell big ambitions in RENASYS because we have the reiteration of RENASYS TOUCH and RENASYS GO. And both in the U.S. and in Europe, we use it as a tool to make better sales of PICO basically. Why? Because opinion leaders are talking about negative pressure, hospital leaders. And so, it helps us to be strong. I believe we have a superior product than all the competitors in PICO. And actually, the results in percent worldwide are showing that this is a great dynamic. We expect this to be sustainable which we believe that it will be this type of growth for the years to come and we're extremely optimistic. Now we have -- also optimistic not because we only have the PICO we have today, but we have life cycle management, which is extremely ambitious and extremely good. So we have many products to come to enforce the line of PICO that we have today, which is at 1.6, then 2.0, then 7.0 and so on. So we have really a superb portfolio to launch in the future with positive, negative pressure.

[Technical Difficulty]

We are three years, actually. I think the first JOURNEY II was -- explained the [Technical Difficulty] three years ago.

[Technical Difficulty]

Well, I think that it's a mix of many things. I think that JOURNEY II is certainly a driver. And as you know, when you have some drivers like this, this has an effect, the snowball effect on the rest of the business. So we are better known by the fact that we are innovative, that we bring things which are different. I do believe that we have certainly also taken advantage of the issue with our competitors here and there which is important. We have this UNI knee, which was important for us also at this stage. We now have the robot, which I believe will be a game changer for us, not only for the robot itself, but the impact on the knee platform of Smith & Nephew. So again, we have said that when we launched, and I remember many people were skeptical about the ability of Smith & Nephew as a number four player in the market to be able to grow above the market with one of our businesses. It shows you that disruption is important. Then this is something -- because -- why it's important? A, it gives you a premium price, which is important; B, it avoids price erosion; C, it's not the payer who is deciding because when you have in front of you three hips which are equivalent, yes, the payer can say, Well, I take the cheaper one. When you have such a difference in terms of product, surgeon is leading the choice. So I think it's a very important thing for us to have this JOURNEY II, but again, we have launched other things. And also, maybe the OXINIUM is also an important part of this. We are the only one to have this. So I mean, I think a number of things there. And also, I don't want to say it's just a product. It's also the fact that we are improving. We're improving our ability to sell. I think our marketing efforts are better and they will become better and better, and our reps are also better.

[Technical Difficulty]

Well, other business is what, is hip? As I said, we have now three new REDAPT Revision System portfolios. So I think this will help us not to go above market because it doesn't change, really, the game but will be at market. So that's the idea. And that has been said also in the past. On the Trauma business, which is not [Technical Difficulty] but which is also close to these, 7% growth that we have had this quarter is above our expectations because we have, as I said, a small tender in the Gulf, which has helped us to get this growth. But having said that, the portfolio is good. We are improving, we plan to do better next year. So I think in China, things are back on track also in Trauma. So we're pretty optimistic with this business also.

[Technical Difficulty]

Do you want to answer?

I wasn't around in 2015, so I can't comment on that. I can -- I mean, I'll certainly comment on -- I think that there are a number of valuable opportunities for us to continue investing in R&D. Olivier has already touched on one of them, around the PICO platform. There is a significant life cycle management program around that that I think is a valuable investment for us in the business. It's not just there, both in evolution of the product itself and in building clinical evidence around the product to drive utilization. So I think we've roughly been in the same place on R&D at 5% of sales [Technical Difficulty] go forwards, but...

But on NAVIO specifically, we said when we did a pilot of the product that we had delusion during a couple of years due to the R&D at force to get primarily the Total Knee indication, which we didn't have when we got the product, it's just partially knee indication, so we've got it. We now have also a lot of ambitions on doing other things with the robot. So we plan to invest some money in R&D, in other fields like hip, for example, Sports Medicine. So we are working on this. Having said that, I just would like to take the opportunity of the R&D discussion to tell you that it's the first time I'm really proud of what we have in R&D, I mean, both in terms of structure, which is now super simple. It has been centralized the end of last year. I wanted to have a single R&D, which I couldn't get before because of the division structure and so on. So we now have a single R&D overlooking all the businesses of the company with one head, with very straight, good processes. I mean, I chair the product admission board that is meeting on a regular basis, actually, every quarter. It's a long board. We decide what to do and not only we decide what to do, but we also check very carefully on the development stage of the product. And so I'm very confident that this will help us to make the right choices in the future in terms of what to do for the new products.

One of the specifics I had in mind when I was talking about we're just at the beginning of seeing some of the benefits of the restructuring changes that Olivier has made coming through in the business.

Hi, David Adlington, JP Morgan. A couple of questions. So just on WEREWOLF, it sounded like you had some teething problems on WEREWOLF...

On WEREWOLF? Is that -- yes.

Yes, some teething problems. Just maybe if you could give us some further color on that and whether that's consigned to history? And secondly, just on the Middle East tenders, you have obviously the first one you've had for a while. Just wanted to know what visibility you had on further tenders coming through. It doesn't sound like that much in the second half.

Okay. Well, on the second part of your question, we -- first of all, it was more tender, a single digit. And so it was not the big tender like the one we're used to having in the future -- sorry, in the past. Sorry. I wish in the future [Technical Difficulty]. Anyway, in the -- for the rest of the year, we don't expect this to happen. And by the way, that's also coming back to Veronika's point. The guidance, we're expecting this to happen potentially in the second half. So it came in the first half, so that's also something which has to be kept in mind. On WEREWOLF, yes, we are at the start, a long, difficult start in production. And this is why we have not been able to compensate the issues of the blades with the development and ramp up of WEREWOLF. Now it's behind us, as I said, so we expect to see WEREWOLF, which is super technology. That's a really game changer, especially on the knee, actually, which is a gap that we had in COBLATION in the past. So we'll see a ramp-up of this, and that will help us to come back on track with the [Technical Difficulty] technologies.

Just speaking on the resection issue. Resection has been an issue for seven or eight years, right? So has it got materially worse that we're seeing it more evident now or...

Well, the blades is more, I would say, the past. And if you'll correct me if you think I'm wrong on this one, but we still have blades used. But the use of blades is not as much important as what it was because the new COBLATION system that we have. So, I think the blades is something which will become less and less important and more and more you'll see it. High-tech COBLATION are F type of things called COBLATIONS to place in this business. And that is one of the reasons why I was very happy to do the ArthroCare acquisition because it was, for us, the only way to bring us also this new COBLATION system that we didn't have in-house. It's actually also interesting for the ENT business. And we have a number of things into COBLATION that's pretty exciting.