Elastoplast to skin graft

Smith & Nephew, the Elastoplast to Simple Soap medical products group, has been rather bypassed in the return to favour of health and pharmaceuticals stocks over the past year or so. Although the shares are up 29 per cent since the beginning of 1995, they have underperformed both the healthcare and pharmaceutical sectors and only barely outperformed the growth in the general market.

But all that could be about to change. This week Smith & Nephew's shares caught a whiff of the boom in fledgling biotech companies when it signed a deal with Advanced Tissue Sciences, a California-based bio-tech group which is developing what is claimed to be world's first "off the shelf" artificial skin. Since the announcement of the link-up, the share price has risen 6 per cent to 196p as the market has woken up to the possibilities of the deal.

That was an eye-catching transaction - not just because the prime source of the raw material is babies' foreskins, one of which can provide the basis for enough skin to cover six football pitches. The skin replacement, trade-named Dermagraft, is initially targeted at the $2.5bn market for the treatment of chronic diabetic foot ulcers.

Dermagraft could provide relief to a substantial part of that market. After eight weeks, the skin is said to be indistinguishable from the original, providing a more cost-effective and successful substitute for existing methods of treatment. Smith & Nephew chief executive John Robinson believes sales could be $500m, but cautiously suggests, based on past experience, that it could take 10 years to get there.

Even so, Stephen Putnam of the group's brokers Kleinwort Benson suggests sales could be breaking through the pounds 100m mark by the year 2000, with margins well over 20 per cent. He believes the potential of Dermagraft could be worth up to an extra 2 per cent to the group's growth rate over time. Smith & Nephew will share the profits with ATS, but its capital payments to the Californian group are limited to a maximum of $70m and even that is dependent on sales targets being achieved.

The Dermagraft deal is just the latest manifestation of Smith & Nephew's attempt to cast off its "dull-but-worthy" image. It follows an earlier development joint venture with ATS, signed nearly two years ago, for artificial cartilage for knee and, possibly, spine injuries. That project involves greater risks. Cartilage is still 10 years away, whereas Dermagraft could be available for use at the end of next year. But the prize is glittering none the less: the knee-injury market alone is worth $1bn.

All this is not just science fiction. Smith & Nephew has already launched an artificial bone material in the US which will initially be used for repairs to the middle ear, but could eventually provide more durable hip joints, opening up a substantial market.

Such moves are helping to change the market's perception of the group. Smith & Nephew is not a drugs company, so apart from speculation last summer when Johnson & Johnson were touted as showing interest, it has not really participated in the frenzy surrounding pharmaceuticals over the past 18 months.

At the same time, many of the group's businesses have been hard hit by the pressure on healthcare budgets which has emerged this decade in reaction to the freewheeling 1980s, when drug companies' sales expanded on the back of apparently limitless expenditure on health. Growth has been further diluted by less hi-tech, "commodity" businesses, including the manufacture of surgeons' gloves. So, while respectable, recent sales growth has been no match for that of the of the big drugs groups which have been less affected by the spending squeeze.

But Mr Robinson has been slowly and determinedly refocusing the group on higher-margin areas where it has strong positions. Last year the group walked away from the last of its pharmaceuticals businesses and also got out of surgeons' gloves. At the same time, acquisitions last year strengthened the group's already powerful position in equipment for keyhole surgery and therapeutic and rehabilitation devices.

Despite these signs, there remains a degree of scepticism. Its record on acquisitions is still coloured by the huge pounds 148m write off it took last year on the disposal of Ioptex, the eye implant business, bought in 1988 just before the market peaked.

If profits hit pounds 190m this year, rising to around pounds 205m in 1997, the forward price/earnings multiple falls from 17 to 16 over the next couple of accounting periods. Given the pressures still surrounding the group, that probably represents fair value.

Smith & Nephew

Share price 197.5p

Prospective p/e* 17

Gross dividend yield 3.8%

Year to 31 July

1993 1994 1995 1996* 1997*

Turnover pounds 949m pounds 965m pounds 1.026bn pounds 1.1bn pounds 1.17bn

Pre-tax profit/(loss) pounds 165m (pounds 5.5m) pounds 177m pounds 190m pounds 205m

Earnings per share 10.6p (4.96p) 10.3p 11.6p 12.5p

Dividend per share 4.91p 5.28p 5.65p 6.05p 6.50p

* Kleinwort Benson Securities forecast