SMITH & NEPHEW PLC 20-F 2011
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the fiscal year ended December 31, 2010
Commission file number 1-14978
Smith & Nephew plc
(Exact name of Registrant as specified in its charter)
England and Wales
(Jurisdiction of incorporation or organization)
15 Adam Street, London WC2N 6LA
(Address of principal executive offices)
Securities registered or to be registered pursuant to Section 12(b) of the Act:
Securities registered or to be registered pursuant to Section 12(g) of the Act: None.
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act: None.
Indicate the number of outstanding shares of each of the issuers classes of capital or common stock as of the close of the period covered by the annual report: 951,021,116 Ordinary Shares of 20¢ each
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act Yes x No ¨
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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes x No ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No ¨
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If this is an annual report, indicated by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
INTRODUCTION AND FINANCIAL SUMMARY
The Smith & Nephew Group (the Group) is a global medical devices business operating in the markets for orthopaedic reconstruction and trauma, endoscopy (which includes arthroscopic procedures referred to as sports medicine) and advanced wound management, with revenue of approximately $4 billion in 2010. Smith & Nephew plc (the Company) is the parent company of the Group. It is an English public limited company with its shares listed on the premium list of the UK Listing Authority and traded on the London Stock Exchange. Shares are also traded on the New York Stock Exchange in the form of American Depositary Shares (ADSs).
This is the Annual Report of Smith & Nephew plc for the year ended 31 December 2010. It comprises, in a single document, the Annual Report and Accounts of the company in accordance with UK requirements and the Annual Report on Form 20-F in accordance with the regulations of the United States Securities and Exchange Commission (SEC).
Smith & Nephews corporate website, www.smith-nephew.com, gives additional information on the Group, including an electronic version of this Annual Report. Information made available on this website, or other websites mentioned in this Annual Report, are not, and should not be regarded as being, part of or incorporated into this Annual Report.
For the convenience of the reader, a Glossary of technical and financial terms used in this document is included on page 152. The product names referred to in this document are identified by use of capital letters and are trademarks owned by or licensed to members of the Group.
Key Performance Indicators
The Directors Report includes a number of measures that management use as key performance indicators including those financial performance indicators set out in the Financial Summary above. A discussion of the reasons for, calculation and limitations of the key financial performance indicators is set out below.
The Group is focused on continued delivery of sustainable profitable growth through four strategic pillars Customer led, Efficient, Investing for growth and Aligned as explained on page 4 of this document.
From these four strategic pillars, a scorecard has been developed which identifies the specific functional strategic imperatives for each part of the Group. The performance against the scorecard is evaluated against a series of financial and non-financial indicators and measures.
The principal key financial performance indicators used in the scorecard, which measure performance against the Groups strategic pillars, are:
(i) Underlying growth in revenue
Underlying growth in revenue is used to compare the revenue in a given year to the previous year on a like-for-like basis. This is achieved by adjusting for the impact of sales of products acquired in material business combinations and for movements in exchange rates. Underlying growth in revenue is not presented in the accounts prepared in accordance with International Financial Reporting Standards (IFRS) and is therefore not a Generally Accepted Accounting Principle (a non-GAAP measure). An explanation of how this non-GAAP measure is calculated is presented in the Business Overview on page 24.
The Group believes that the tabular presentation and reconciliation of reported revenue growth to underlying revenue growth assists investors in their assessment of the Groups performance in each business segment and for the Group as a whole.
Underlying growth in revenue is considered by the Group to be an important measure of performance in terms of local functional currency since it excludes those items considered to be outside the influence of local management. The Groups management uses this non-GAAP measure in its internal financial reporting, budgeting and planning to assess performance on both a business segment and a consolidated Group basis. Revenue growth at constant currency is important in measuring business performance compared to competitors and compared to the growth of the market itself.
The Group considers that revenue from sales of products acquired in material business combinations results in a step-up in growth in revenue in the year of acquisition that cannot be wholly attributed to local managements efforts with respect to the business in the year of acquisition. Depending on the timing of the acquisition, there will usually be a further step change in the following year. A measure of growth excluding the effects of business combinations also allows senior management to evaluate the performance and relative impact of growth from the existing business and growth from acquisitions. The process of making business acquisitions is directed, approved and funded from the Group corporate centre in line with strategic objectives.
The material limitation of the underlying growth in revenue measure is that it excludes certain factors, described above, which ultimately have a significant impact on total revenues. The Group compensates for this limitation by taking into account relative movements in exchange rates in its investment, strategic planning and resource allocation. In addition, as the evaluation and assessment of business acquisitions is not within the control of local management, performance of acquisitions is monitored centrally until the business is integrated. The Groups management considers that the non-GAAP measure of underlying growth in revenue and the GAAP measure of growth in revenue are complementary measures, neither of which management uses exclusively.
(ii) Trading profit and trading profit margin
Growth in trading profit and trading profit margin (trading profit expressed as a percentage of revenue) are measures which present the growth trend in the long-term profitability of the Group excluding the impact of specific transactions or events that management considers affect the Groups short-term profitability. The Group presents these measures to assist investors in their understanding of trends. The Groups internal financial reporting (budgets, monthly reporting, forecasts, long-term planning and incentive plans), focuses primarily on profit and earnings before these items. Trading profit and trading profit margin are not recognised measures under IFRS and are therefore non-GAAP financial measures.
The Group has identified the following items, where material, as those to be adjusted and identified separately: acquisition and disposal related items including amortisation of acquisition intangible assets and impairments; significant restructuring events; gains and losses arising from legal disputes and uninsured losses; and taxation thereon. An explanation of how trading profit is calculated is presented in Business Overview on page 25.
The material limitation of these measures is that they exclude significant income and costs that have a direct impact on current and prior years profit attributable to shareholders. They do not, therefore, measure the overall performance of the Group presented by the GAAP measures of earnings per share and operating profit. The Group considers that no single measure enables it to assess overall performance and therefore it compensates for the limitation of the adjusted earnings per share and trading profit measures by considering them in conjunction with their GAAP equivalents. The gains or losses which are identified separately arise from irregular events or transactions. Such events or transactions are authorised centrally and require a strategic assessment which includes consideration of financial returns and generation of shareholder value. Amortisation of acquisition intangibles will occur each year, whilst other excluded items arise irregularly depending on the events that give rise to such items.
(iii) Adjusted earnings per ordinary share
Growth in adjusted earnings per ordinary shares (EPSA) is another measure which presents the trend growth in the long-term profitability of the Group. EPSA is not a recognised measure under IFRS and is therefore a non-GAAP financial measure.
EPSA excludes the same impact of specific transactions or events that management considers affect the Groups short-term profitability as set out and discussed in the section on trading profit above, including the material limitations of such measures. A reconciliation of adjusted attributable profit, which represents the numerator used in the EPSA calculation, to attributable profit is presented in Business Overview on page 26.
(iv) Trading cash flow and trading profit to cash conversion ratio
Growth in trading cash flow and improvement in the trading profit to cash conversion ratio are measures which present the trend growth in the long-term cash generation of the Group excluding the impact of specific transactions or events that management considers affect the Groups short-term performance.
Trading cash flow is defined as cash generated from operations less net capital expenditure but before acquisition related cash flows, restructuring and rationalisation cash flows and cash flows arising from legal disputes and uninsured losses. Trading profit to cash conversion ratio is trading cash flow expressed as a percentage of trading profit. The nature and material limitations of these adjusting items are discussed in the sections above.
The Group presents these measures to assist investors in their understanding of trends. The Groups internal financial reporting (budgets, monthly reporting, forecasts, long-term planning and incentive plans) focuses on cash generation before these items. Trading cash flow and trading profit to cash conversion ratio are not recognised measures under IFRS and are therefore considered non-GAAP financial measures. A reconciliation of trading cash flow to cash generated from operations is presented in Business Overview on page 27.
The material limitation of this measure is that it could exclude significant cash flows that have had a direct impact on the current and prior years financial performance of the Group. It does not, therefore, measure the financial performance of the Group presented by the GAAP measure of cash generated from operations. The Group considers that no single measure enables it to assess financial performance and therefore it compensates for the limitation of the trading cash flow measure by considering it in conjunction with the GAAP equivalents. Cash flows excluded relate to irregular events or transactions including acquisition related costs, restructuring and rationalisation costs and cash flows arising from legal disputes and uninsured losses.
The Groups fiscal year end is 31 December. References in this Annual Report to a particular year are to the fiscal year unless otherwise indicated. Except as the context otherwise requires, Ordinary Share or share refer to the Ordinary Shares of Smith & Nephew plc of 20 US cents each.
The results of the Group, as reported in US Dollars, are affected by movements in exchange rates between US Dollars and other currencies. The Group applied the average exchange rates prevailing during the year to translate the results of companies with functional currency other than US Dollars. The currencies which most influenced these translations in the years covered by this report were Sterling, Swiss Franc and the Euro.
The Group Accounts of Smith & Nephew in this Annual Report are presented in US Dollars. Solely for the convenience of the reader, certain parts of this Annual Report contain translations of amounts in US Dollars into Sterling at specified rates. These translations should not be construed as representations that the US Dollar amounts actually represent such Sterling amounts or could be converted into Sterling at the rate indicated. Except as where stated otherwise, the translation of US Dollars and cents to Sterling and pence appearing in this Annual Report has been made at the Bank of England exchange rate on the date indicated. On 23 February 2011, the Bank of England rate was US$1.6238 per £1.
The Accounts of the Group in this Annual Report are presented in millions (m) unless otherwise indicated.
Special Note Regarding Forward-Looking Statements
The Groups reports filed with, or furnished to, the US Securities and Exchange Commission (SEC), including this document and written information released, or oral statements made, to the public in the future by or on behalf of the Group, contain forward-looking statements within the meaning of the US Private Securities Litigation Reform Act of 1995, that may or may not prove accurate. In particular, statements regarding expected revenue growth and trading margins discussed under Outlook and Trend Information, market trends and our product pipeline are forward-looking statements. Phrases such as aim, plan, intend, anticipate, well-placed, believe, estimate, expect, target, consider and similar expressions are generally intended to identify forward-looking statements. Forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause actual results, to differ materially from what is expressed or implied by the statements. For Smith & Nephew, these factors include: economic and financial conditions in the markets we serve, especially those affecting health care providers, payors and customers; price levels for established and innovative medical devices; developments in medical technology; regulatory approvals, reimbursement decisions or other government actions; product defects or recalls; litigation relating to patent or other claims; legal compliance risks and related investigative, remedial or enforcement actions; strategic actions, including acquisitions and dispositions and our success in integrating acquired businesses; and numerous other matters that affect us or our markets, including those of a political, economic, business or competitive nature. Specific risks faced by the Group are described under Risk Factors on page 18 of this Annual Report. Any forward-looking statement is based on information available to Smith & Nephew as of the date of the statement. All written or oral forward-looking statements attributable to Smith & Nephew are qualified by this caution. Smith & Nephew does not undertake any obligation to update or revise any forward-looking statement to reflect any change in circumstances or in Smith & Nephews expectations.
Market data and market share estimates throughout this report are derived from a variety of sources including publicly available competitors information, internal management information and independent market research reports.
Documents on Display
It is possible to read and copy documents referred to in this Annual Report at the Registered Office of the Company. Documents referred to in this Annual Report that have been filed with the Securities and Exchange Commission in the US may be read and copied at the SECs public reference room located at 450 Fifth Street, NW, Washington DC 20549. Please call the SEC at 1-800-SEC-0330 for further information on the public reference rooms and their copy charges. The SEC also maintains a web site at www.sec.gov that contains reports and other information regarding registrants that file electronically with the SEC. This Annual Report and some of the other information submitted by the Group to the SEC may be accessed through the SEC website.
Description of the Group
Business Review, Liquidity and Prospects
Corporate Governance Statement
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DESCRIPTION OF THE GROUP
This section discusses the activities, resources and operating environment of the business under the following headings:
Discussion of the Groups operating and financial performance, liquidity and financial resources for 2010 and 2009 is given in the Business Review, Liquidity and Prospects section (pages 23 to 44).
Discussion of the Groups management structure and corporate governance procedures is set out in the Corporate Governance Statement section (pages 45 to 57).
The Directors Remuneration Report gives details of the Groups policies on senior managements remuneration in 2010 (pages 59 to 71).
Details of the structure of the Companys share capital and securities, persons with significant shareholdings in the Company and a summary of the articles of association are incorporated into the Directors Report and are given in Investor Information (pages 135 to 149).
Smith & Nephews overall vision is to help improve people's lives by repairing and healing the human body. To achieve this, the Group is focused on continued delivery of sustainable profitable growth, through four strategic pillars:
The Group has a history dating back over 150 years to the family enterprise of Thomas James Smith who opened a small pharmacy in Hull, England in 1856. On his death in 1896, his nephew Horatio Nelson Smith took over the management of the business.
By the late 1990s, Smith & Nephew had expanded into being a diverse healthcare conglomerate with operations across the globe, including various medical devices, personal care products and traditional and advanced woundcare treatments. In 1998, Smith & Nephew announced a major restructuring to focus management attention and investment on three global business units advanced wound management, endoscopy and orthopaedics which offered high growth and margin opportunities.
Smith & Nephew was incorporated and listed on the London Stock Exchange in 1937 and in 1999 the Group was also listed on the New York Stock Exchange. In 2001, Smith & Nephew became a constituent member of the FTSE-100 index in the UK. This means that Smith & Nephew is included in the top 100 companies traded on the London Stock Exchange measured in terms of market capitalisation.
Today, Smith & Nephew is a public limited company incorporated and headquartered in the UK and carries out business around the world.
On 10 February 2011, the Group announced that David Illingworth will retire from the Board and as Chief Executive, at the Annual General Meeting on 14 April 2011. It was also announced that Olivier Bohuon will join the Board as an executive director on 1 April 2011. He will offer himself for re-election by the shareholders at the Annual General Meeting and, subject to his re-appointment, shall assume the position of Chief Executive Officer at the conclusion of the Annual General Meeting on 14 April 2011.
In December 2010, the Group reviewed and replaced its principal banking facilities ahead of their maturity in May 2012. The Group has reduced its $1 billion 5 year term loan to $500 million with effect from 20 December 2010. Smith & Nephew has also cancelled its $1.5 billion multi-currency revolving loan facility and replaced it with a new 5-year $1 billion multi-currency revolving loan facility.
Smith & Nephew is organised into three primary Global Business Units (GBUs), which are also our reporting segments: Orthopaedics, Endoscopy and Advanced Wound Management. Included within the Orthopaedics segment are our biologics activities, which comprise research and development projects under the direction of a Committee representing all GBUs.
Smith & Nephew operates on a worldwide basis and has distribution channels in over 90 countries. In the more established countries by revenue, the Groups business operations are organised by GBU. In the majority of the remaining markets, operations are managed by country managers who are responsible for sales and distribution of the Groups product range. These comprise the emerging markets unit.
A head office team in London, England directs the overall business and supports the business units, primarily in the areas of business development, legal, company secretarial, finance, human resources and investor relations.
Orthopaedics comprises reconstruction, trauma and clinical therapies products.
The Orthopaedics business is managed worldwide from Memphis, Tennessee, the site of its main development and manufacturing facility, with a European headquarters in Baar, Switzerland. Products are also manufactured at smaller facilities in Switzerland, Germany, and the UK as well as by third-party manufacturers. A new facility has been constructed in Beijing, China.
Orthopaedic reconstruction implants include hip, knee and shoulder joints as well as ancillary products such as bone cement. Orthopaedic trauma fixation products consist of internal and external devices and other products, including shoulder fixation and orthobiological materials used in the stabilisation of severe fractures and deformity correction procedures. Clinical therapies products are those that are applied in an orthopaedic office or a clinic setting and include bone growth stimulation and joint fluid therapies.
Knee Implant Systems The Orthopaedics business offers a range of products for specialised knee procedures. The LEGION/GENESIS II Total Knee System is a comprehensive system designed to allow surgeons to address a wide range of knee procedures from primary to revision. LEGION TKS features VERILAST Technology, an advanced bearing surface. The JOURNEY Active Knee Solutions, a family of advanced, customised products designed to treat early to mid-stage osteoarthritis patients, provides more normal feeling and motion through bone ligament preservation and anatomic replication. Other knee systems include the PLUS Solution Knee Family and PROFIX Knee. Our LEGION/GENESIS II and JOURNEY also utilise VISONAIRE Patient-Matched Instrumentation, a new technology platform of patient-matched cutting blocks for total knee procedures.
Hip Implant Systems The Orthopaedics business offers a broad range of hip replacement systems. In particular, the R3 Acetabular System includes a modular acetabular cup that provides a variety of advanced bearings within a single system. The BIRMINGHAM HIP Resurfacing System is a system for hip resurfacing, a bone conserving approach, which utilises proven low wear metal-on-metal bearing surface technology. Other hip systems include the SYNERGY Hip System, ANTHOLOGY Hip System and the SL-PLUS Hip Family System.
Bearing surfaces The Orthopaedics business utilises a range of bearing surfaces in its implant systems, including its proprietary OXINIUM Technology. Oxidised zirconium, branded OXINIUM, combines the enhanced wear resistance of a ceramic bearing with the superior durability of a metallic bearing. When combined with highly cross-linked polyethylene (XLPE) it results in our VERILAST Technology. LEGION Primary Knee, with VERILAST Technology, is the only knee system with a 30 year wear performance claim approved by the United States Food and Drug Administration (FDA) more than double the performance expectation for wear compared to conventional technologies.
Trauma Implant Systems The principal fixation products are the TRIGEN Intramedullary Nailing system, TRIGEN Meta Nail with expanded fixation and technique options, TRIGEN INTERTAN Intertrochanteric Antegrade nails for hip fractures, TRIGEN SURESHOT Distal Targeting System for Intramedullary Nailing and PERI-LOC Periarticular Locked Plating system which offers a comprehensive family of fracture specific plate and screw products for the upper and lower extremity.
For external fixation and limb restoration, Orthopaedics offers the TAYLOR SPATIAL FRAME Circular Fixation System and JET-X Unilateral Fixator.
Clinical therapies The principal clinical therapies products offered include the EXOGEN Ultrasound Bone Healing System which utilises low-intensity pulsed ultrasound to accelerate the healing of fresh fractures and to heal non unions. DUROLANE Joint Fluid Therapy and SUPARTZ Joint Fluid Therapy are non-surgical, non-pharmacological pain-relieving therapies for osteoarthritis of the knee.
Orthopaedics maintains its commitment to being customer-led by focusing on product innovation, sales excellence and physician education. Whether through extending the life of implants, improving operating room efficiency, or promoting faster healing, Smith & Nephews innovations differentiate it and provide solutions to active patients seeking to regain quality of life while enhancing economic value for customers. Orthopaedics provides peer-to-peer medical education, through KLEOS, tailored to individual surgeon needs utilising the worlds top orthopaedic specialists and key opinion leaders. KLEOS is a medical education platform which offers seminars, fellowships, instructional videos and literature reviews.
The Orthopaedics business efficiency programmes continue to deliver savings to the business. The current programmes are focused on improving inventory utilisation, reducing sourcing costs, improving manufacturing efficiency, reducing overhead costs and ensuring continual efficiency improvement.
The emerging markets continue to be an important component of investing for growth, China in particular remains a focus with several milestones achieved in 2010 including opening a new manufacturing facility near Beijing, integration of product development teams into the franchises, and opening of three surgical training centres. Outside China, Orthopaedics is investing in sales teams in other emerging markets, extending physician training via KLEOS, developing tailored products to meet local needs and improving local infrastructure and logistics.
The Orthopaedics business aligns its organisation and develops its talent for consistent execution on the Groups plans. Compensation for executives, managers and staff are carefully aligned to the execution of their objectives.
In Trauma, Orthopaedics launched the TRIGEN SURESHOT Distal Targeting System for Intramedullary Nailing which simplifies the surgical technique, reducing surgery time and fluoroscopic X-ray exposure. The VLP Foot and Ankle plating system, a comprehensive plate and screw system to manage fractures in the foot and ankle was also launched in the year bringing the advantages of variable angle plating to a rapidly growing segment of the market.
Reconstructive Orthopaedics continued the commercialisation of its VISIONAIRE Patient-Matched Instrumentation. With VISIONAIRE, the patients MRI and X-rays are used to create customised cutting blocks that allow the surgeon to achieve optimal mechanical axis alignment as well as saving time and reducing instruments in the operating room.
In 2010, several significant regulatory product and claims approvals were obtained around the globe.
In the US the SURESHOT Distal Targeting System for TAN Intramedullary Nails and accessories was approved. In Japan, the LEGION TKS Posterior Stabilized and Revision Systems, 12/14 Taper OXINIUM Femoral Heads, the PERI-LOC Titanium Plating System, and ECHELON Titanium Hip Stems were all approved. In the EU, we also received approval for the SURESHOT Distal Targeting System and VISIONAIRE Patient Matched Cutting Blocks. Also, in the EU, DUROLANE was approved for treatment of mild to moderate osteoarthritis in a broader range of joints and following joint arthroscopy.
In the US, the Orthopaedics business received 510(k) clearance from the FDA for VERILAST Technology wear claims for an estimated 30 years of normal use for the LEGION Primary Knee system.
Around the globe, 20 additional approvals and clearances were obtained, including amongst others: BHR instrument upgrades, R3 Acetabular system additions, VLP FOOT Plating Screw System and accessories, the JOURNEY Select Knee System and LEGION Porous Plus HA primary Femoral Components.
In Europe, regulatory approval was secured for EXOGEN for use on all osseous defects and DUROLANE for osteoarthritis pain relief in all synovial joints and for pain relief post arthroscopic surgery.
Orthopaedic reconstruction revenues are lower in the third quarter of any year due to fewer elective surgeries in the summer and higher in the fourth quarter as elective surgeries increase. Reconstructive trauma revenues are generally highest in the fourth quarter caused to a large extent by the relatively high number of accidents and sports related injuries which occur in the autumn and winter seasons in North America and Europe.
Market and Competition
Smith & Nephew estimates that the worldwide orthopaedic market, excluding clinical therapies, served by the Group grew by approximately 4% in 2010 and is currently worth approximately $17 billion per annum worldwide. Management believes that the Smith & Nephew Orthopaedics business holds an 11% share of this market by value. Principal global competitors in orthopaedics are Zimmer, Stryker, DePuy/Johnson & Johnson, Synthes and Biomet.
In 2010, weaker economic conditions worldwide continued to create several challenges for the overall orthopaedic market, including increased deferrals of joint replacement procedures and heightened pricing pressures. These factors contributed to the lower overall growth of the worldwide orthopaedic market compared to historic comparables. However, over the medium-term, several catalysts are expected to continue to drive sustainable growth in orthopaedic device sales, including the growing, ageing population, rising rates of co-morbidities such as obesity and diabetes, technology improvements allowing surgeons to treat younger, more active patients, and the increasing
strength of the demand for healthcare in emerging markets. Both the orthopaedic trauma and clinical therapies markets are expected to continue to grow due to a global population increasingly at risk from fractures due to age, osteoporosis, obesity and diabetes and also due to continuous advancements in the surgical treatment of fractures, and the need to manage pain in younger, more active patients.
Management estimates that the worldwide market for clinical therapies increased by 6% in 2010 and is currently worth more than $1.7 billion per annum. Smith & Nephews primary market for clinical therapies is in the US. In the US long bone stimulation market management estimates Smith & Nephews share to be 40%. Principal competitors are Biomet, DJ Ortho and Orthofix. In the US joint fluid therapies market, management estimates that Smith & Nephew maintains a share of 14%. The principal competitors are Genzyme, Sanofi Aventis, DePuy/Johnson & Johnson and Ferring Pharmaceuticals.
Smith & Nephews Endoscopy business develops and commercialises endoscopic (minimally invasive surgery) techniques, educational programmes and value-added services for surgeons to treat and repair soft tissue and articulating joints. The business focuses on the arthroscopy or sports medicine sector of the endoscopy market. Arthroscopy is the minimally invasive surgery of joints, in particular the knee, shoulder and hip.
The Endoscopy business is headquartered in Andover, Massachusetts and manufacturing facilities are currently located in Mansfield, Massachusetts, and Oklahoma City, Oklahoma. Major service centres are located in the US, the UK, Germany, Japan and Australia.
The Endoscopy business offers surgeons endoscopic technologies for surgery of the joints and ligament repair, including: specialised devices and fixation systems to repair damaged tissue; fluid management equipment for surgical access; digital cameras, digital image capture, scopes, light sources and monitors to assist with visualisation; radiofrequency wands, electromechanical and mechanical blades, and hand instruments for resecting damaged tissue.
Key products in repair are FAST-FIX for meniscal repair, ENDOBUTTON for cruciate fixation, and the FOOTPRINT Suture Anchor for rotator cuff repair. Key products in resection are the wide range of DYONICS shaver blades, ACUFEX handheld instruments, and a range of radiofrequency probes. The key product in Visualisation is the DYONICS 560 HD camera.
Smith & Nephews strategic intent is to grow the business as the leading provider of endoscopic techniques and technologies for joint and ligament repair. Management believes that the business capitalises on the growing acceptance of endoscopy as a preferred surgical choice among physicians, patients and payors, enhanced by a customer-led approach to growing the arthroscopy market.
To sustain growth and enhance its market position, the Endoscopy business supports its strategy with investment in surgeon education programmes, global fellowship support initiatives, partnerships with professional associations and surgeon advisory boards. The emerging markets, especially China, are expected to be a major driver of growth in future, and the business is also investing funds to accelerate this growth.
The business has a commitment to, and track record of, driving efficiencies, through a formal operational excellence programme as well as a culture of continuous process improvement.
The Endoscopy business aligns its organisation to ensure all employees are working on common objectives, and to ensure consistent execution against the Groups wider objectives.
In 2010, Smith & Nephew continued to expand its arthroscopic sports medicine portfolio with the launch of several new repair and resection products.
The BIORAPTOR Knotless Suture Anchor is a device used to repair a torn labrum in the hip and shoulder. The ease of use provided by this knotless arthroscopic device provides surgeons with full control over suture tension a critical element in the procedure.
BIOSURE SYNC Tibial Fixation System is designed to address the need for strong fixation on the tibial side of ACL reconstruction. It employs a sheath and screw to achieve a 360° graft-to-bone contact throughout the tibial tunnel and can accommodate a variety of arthroscopic ligament reconstruction techniques.
The TWINFIX and FOOTPRINT suture anchor product lines were enhanced through the incorporation of ULTRABRAID suture, which provides stronger knot strength and a low profile knot stack. Both are designed to provide easy, secure and strong repairs with precise control over final tensioning and are available in a wide variety of materials and sizes.
Recent Regulatory Approvals
During 2010, the Endoscopy business obtained regulatory clearances for the following products in most major markets, except Japan where the approval process is more lengthy: FOOTPRINT Ultra PK, BIOSURE SYNC, TWINFIX Ultra HA, and TWINFIX Ultra Ti, all designed for the reattachment of ligaments, tendons or soft tissues to bone in knees, shoulders or other articulating joints; and various other arthroscopy instruments, devices and sterilisation trays. In Japan, regulatory approvals included ENDOBUTTON CL Ultra, Ultra FAST-FIX KINSA RC and various TWINFIX suture anchors.
Smith & Nephews Endoscopy revenues are generally at their highest in the fourth quarter of any year. This is caused to a large extent by the relatively high number of accidents and sports related injuries which occur in the autumn and winter seasons in North America and Europe.
Market and Competition
Management estimates that the global arthroscopy market in which the business principally participates is worth more than $3 billion a year and has recently been growing between 8% and 12% annually. Arthroscopy growth rates are driven by increasing numbers of sports injuries, longer and more active lifestyles, patient desire for minimally invasive procedures, innovative technological developments and a need for cost-effective procedures. The arthroscopy market has a particular focus on arthroscopic repair of the knee and shoulder using a broad range of technology. The Group also expects to benefit from the demand for less invasive approaches to arthroscopic hip repair.
Management believes that Smith & Nephew has a 22% share of the global arthroscopy market as at 31 December 2010. Smith & Nephews main competitors in the global arthroscopy market in 2010 were Arthrex, Mitek/Johnson & Johnson, Stryker, Arthrocare and Linvatec/Conmed.
Advanced Wound Management
Smith & Nephews Advanced Wound Management business offers a range of products from initial wound bed preparation through to full wound closure. These products are targeted at chronic wounds associated with the older population, such as pressure sores and venous leg ulcers. There are also products for the treatment of wounds such as burns and invasive surgery that impact the wider population.
The Advanced Wound Management business has its global headquarters in Hull, England and its North American headquarters in St Petersburg, Florida. The products are manufactured at facilities in Hull and Gilberdyke, England, Suzhou in China, and also by third party manufacturers around the world.
The main products within the Advanced Wound Management business are for exudate management, predominantly the ALLEVYN brand, infection management, including the ACTICOAT brand and Negative Pressure Wound Therapy (NPWT).
The ALLEVYN hydrocellular dressings range has been considerably enhanced by new versions, introduced in recent years, which management believes provide efficient fluid management and an optimal moist wound environment that promotes faster healing of the wound, reduced risk of maceration and protection from infection. The range includes ALLEVYN Ag, a range of dressings combining the infection management capabilities of silver with ALLEVYN.
The ACTICOAT range incorporates the smallest crystallised silver used in the treatment of wounds and burns. The silver reduces the risk of bacterial colonisation and acts to kill micro-organisms that can cause infection and prevent or delay healing.
NPWT delivers vacuum-assisted pressure to help promote healing. NPWT consists of a wound dressing, a drainage tube, and a transparent film that is connected to a suction device. Smith & Nephew offers the RENASYS EZ and RENASYS GO pump systems together with a range of foam and gauze dressing kits.
Advanced Wound Management also offers a range of other advanced products including films, such as OPSITE and IV3000, skin care treatments and gels.
Advanced Wound Managements strategy is to be customer-led and invest for growth by focusing on high growth, high value segments, in particular exudate and infection management, through improved wound bed preparation, moist and active healing and penetration of the NPWT market.
There has been a continued focus on operational efficiency and excellence. Since 2007, efficiency improvements have been delivered through various projects including support function consolidation, outsourcing of manufacturing to low cost suppliers, distribution rationalisation projects and the start of manufacturing in Suzhou, China.
An aligned approach across the GBU is designed to ensure that our employees are developed and work on common objectives to deliver consistent execution of the Groups plan.
During 2010, the ALLEVYN hydrocellular dressings range was extended further, reinforcing our position as the company offering what we believe is the most comprehensive foam dressing solutions with the addition of ALLEVYN Lite. This new addition has the efficient fluid management properties of the existing ALLEVYN dressings and reduces pain on dressing removal for the patient, whilst improving comfort and wear through anatomical design.
The infection management portfolio was expanded in Japan in 2010, with further improvements to the already successful CADEX product and our first silver dressing entry in the market with ALGISITE Ag, giving a strong portfolio for future growth in the region.
Recent Regulatory Approvals
During 2010, Advanced Wound Management secured approval for a new formulation of No Sting SKIN PREP, ALGISITE Ag in Japan, OPSITE Visible Drain dressing and NPWT dressing kits with ports in the EU and US. A new more conformable version of ALLEVYN Gentle Border, ALLEVYN Gentle Border Lite, was also approved in the EU and the US.
Approval was obtained in the EU and US for the manufacture of the complete range of ACTICOAT dressings at Advanced Wound Managements Hull facility following transfer of conversion and packaging from Alberta and for the manufacture of OPSITE Post Op Visible in Suzhou.
We secured our first licence to sell domestically manufactured products in China following the transfer of ALLEVYN Adhesive manufacture to the Suzhou facility.
Due to the nature of its product range there is little seasonal impact on the Advanced Wound Management business.
Market and Competition
Management estimates that the sales value of the advanced wound management market worldwide was $5.2 billion in 2010, an underlying increase of just under 4% from 2009. During 2010, the market growth rate slowed slightly due to the weaker economic conditions. The advanced wound management market is focused on the treatment of chronic wounds of the older population and other hard-to-heal wounds such as burns and certain surgical wounds and is therefore also expected to benefit from demographic trends. Growth is driven by an ageing population and by a steady advance in technology and products that are more clinically efficient and cost effective than their conventional counterparts. The market for advanced wound treatments is relatively unpenetrated and it is estimated that the potential market is significantly larger than the current market. Management believes that the market will continue the trend towards advanced wound products with its ability to accelerate healing rates, reduce hospital stay times and cut the cost of clinician and nursing time as well as aftercare in the home.
Management estimates that Smith & Nephew had a 18% share of the advanced wound management market as at 31 December 2010. Worldwide competitors in advanced wound management in 2010 include Convatec, Mölnlycke, Systagenix and Kinetic Concepts, who are active exclusively in the NPWT market.
SALES AND MARKETING
Smith & Nephews customers are the providers of medical and surgical services worldwide. In certain parts of the world, including the UK, much of Continental Europe, Canada and Japan, these are largely government organisations funded by tax revenues. In the US, the Groups major customers are public and private hospitals, which receive revenue from private health insurance and government reimbursement programmes. Medicare is the major source of reimbursement in the US, for knee and hip reconstruction procedures and for wound healing treatment regimes.
Competition exists among healthcare providers to gain patients on the basis of quality, service and price. Providers are under pressure to reduce the total cost of healthcare delivery. There has been some consolidation in the Groups customer base, as well as amongst the Groups competitors, and these trends are expected to continue in the long term. Smith & Nephew competes against both specialised and multinational corporations, including some with greater financial, marketing and other resources.
The Groups customers reflect the wide range of distribution channels, purchasing agents and buying entities in over 90 countries worldwide. The largest single customers worldwide are the National Health Service in the UK and the Heath Trust Purchasing Group in the US. These represented 6% and 5% respectively of the Groups worldwide revenue in 2010.
In the US, the Groups products are marketed directly to care givers, hospitals and other healthcare facilities with each business unit operating a separate specialised sales force. The US sales forces consist of a mixture of independent commissioned sales agents and direct employees. The independent agents are contractually not permitted to sell products that compete with Smith & Nephews. Orthopaedics and Endoscopy products are principally shipped and invoiced directly to the ultimate customer. Advanced Wound Management products are marketed directly to the ultimate customer. The products are shipped and invoiced to a number of wholesale distributors. In most other direct markets, the business units typically manage employee sales forces directly, and also ship and invoice products both directly to the ultimate customer and to wholesale distributors.
The emerging markets unit comprises direct selling and marketing operations, directly and through distributors, in India, China, Hong Kong, South Korea, Malaysia, Singapore, Thailand, the United Arab Emirates and South Africa. In these markets, Orthopaedics and Endoscopy frequently share sales resources. The Advanced Wound Management sales force may be separate where it calls on different customers. In countries not covered by the emerging markets unit, Smith & Nephew typically sells to third party distributors which market the Groups products locally.
MANUFACTURING, SUPPLY AND DISTRIBUTION
The Group has a central Global Operations function which continues to implement Lean manufacturing throughout the factories and the supply chain which is designed to improve and sustain higher levels of productivity, quality, service and efficiency. Core competencies include: materials technology; high precision machining in Orthopaedics and Endoscopy; and high-volume, automated manufacturing in Advanced Wound Management.
Each business unit purchases raw materials, components, finished products and packaging materials from certain key suppliers. These principally include metal forgings and stampings for Orthopaedics, optical and electronic sub-components and finished goods for Endoscopy, active ingredients and finished goods for Advanced Wound Management and packaging materials across all businesses. Suppliers are selected, and contracts negotiated, by a centralised Group procurement team wherever possible, with a view to ensure value for money based on the total spending across the Group.
The Group outsources manufacturing where necessary to obtain specialised expertise or where it is possible to gain lower cost without risk to intellectual property. Suppliers of outsourced products and services are selected based on their ability to deliver products and services to specification, and establish and maintain a quality system. Suppliers are trained and are monitored through on-site assessments and performance audits that include quality, service and delivery. Finished goods purchased for resale include SUPARTZ and DUROLANE joint fluid therapy products in the Orthopaedics business and screen displays, optical and electrical devices in the Endoscopy business.
The Group operates a number of central distribution facilities in the key geographical areas in which it operates. Orthopaedics and Endoscopy operate a facility in Baar, Switzerland which acts as the main holding and consolidation point for markets in Europe. Hubs serving the US are located in Memphis, US for Orthopaedics and Oklahoma City, US for Endoscopy. Products are shipped to Group companies who hold small amounts of inventory locally for immediate or urgent customer requirements. Advanced Wound Management distribution hubs include: Neunkirchen, Germany; Nottingham, England; and Atlanta, US.
PROPERTY, PLANT AND EQUIPMENT
The table below summarises the main properties which the Group uses and their approximate areas.
The Group Global Operations strategy includes ongoing assessment of the optimal facility footprint. The Orthopaedics headquarters and manufacturing facilities in Memphis, Tennessee are largely freehold, a portion of Tuttlingen and the Advanced Wound Management facilities in Hull and Gilberdyke are freehold while other principal locations are leasehold. The Group has freehold and leasehold interests in real estate in other countries throughout the world, but no other is individually significant to the Group. Where required, the appropriate governmental authorities have approved the facilities.
In 2010, Orthopaedics purchased a building in Cordova, Tennessee which will be its new headquarters and sales training building, and is exiting a smaller leasehold office facility in 2011. The Group closed the manufacturing facility in Largo, Florida during 2009 and outsourced or relocated its manufacturing output the building was sold in 2010. The Orthopaedics business has opened the new factory in Beijing, China, and the facility in Linhe is expected to close at the end of 2011. The Beijing factory will supply implants to the local market and orthopaedic instruments for export.
RESEARCH AND DEVELOPMENT
The global business units each manage a portfolio of short and long-term product development projects designed to meet the future needs of customers and continue to provide growth opportunities for the business. The Groups research and development is directed towards all three operating segments. Expenditure on research and development amounted to $151m in 2010 (2009 $155m, 2008 $152m), representing approximately 4% of Group revenue (2009 4%, 2008 4%).
The Group continues to invest in future technology opportunities for clinical needs identified from across the Smith & Nephew businesses.
The Groups principal research facility located in York, England is now managed in conjunction with the Groups research facility in Durham, North Carolina, to provide research programmes that seek to underpin the longer-term technology requirements for its businesses and to provide a flow of innovative products. In-house research is supplemented by work performed by academic institutions and other external research organisations in Europe, America and Asia.
Product development is primarily carried out at the Groups principal locations, notably in Memphis, Tennessee and Aarau, Switzerland (Orthopaedics), Mansfield, Massachusetts (Endoscopy) and Hull, England (Advanced Wound Management).
Smith & Nephew has a policy of protecting, with patents, the results of research and development carried out by the Group. Patents have been obtained in a wide range of fields, including Orthopaedic reconstruction and trauma, clinical therapies, Endoscopy and Advanced Wound Management. Patent protection for Group products is sought routinely in the Groups principal markets. Currently, the Groups patent portfolio stands at approximately 4,000 patents in force and patent applications pending.
Smith & Nephew also has a policy of protecting the Groups products by registering trademarks under local laws of markets in which such products are sold. The Group vigorously protects its trademarks against infringement. Currently, the Groups trademark portfolio consists of approximately 4,000 trademarks, trademark applications and design rights.
For each major product, Smith & Nephews goal is to provide a collection of intellectual property, which may include patents, trade secrets and licences, that reduces the risk associated with failure of any individual piece of intellectual property. Most individual pieces of intellectual property protect a relatively small proportion of the Groups annual revenue. As a result, the Group tries to ensure that its overall business is not sensitive to the loss (however caused) of any single piece of intellectual property.
In addition to protecting its market position by filing and enforcing patents and trademarks, Smith & Nephew may oppose third party patents and trademark filings where appropriate in those areas that might conflict with the Groups business interests.
In the ordinary course of its business, the Group enters into a number of licensing arrangements with respect to its products. None of these arrangements individually is considered material to the current operations and the financial results of the Group.
The international medical device industry is highly regulated. Regulatory requirements are a major factor in determining whether substances and materials can be developed into marketable products and the amount of time and expense that should be allotted to such development.
National regulatory authorities administer and enforce a complex series of laws and regulations that govern the design, development, approval, manufacture, labelling, marketing and sale of healthcare products. They also review data supporting the safety and efficacy of such products. Of particular importance is the requirement in many countries that products be authorised or registered prior to manufacture, marketing or sale and that such authorisation or registration be subsequently maintained. The major regulatory agencies for Smith & Nephews products include the Food and Drug Administration (FDA) in the US, the Medicines and Healthcare products Regulatory Agency in the UK, the Ministry of Health, Labour and Welfare in Japan and the State Food and Drug Administration in China.
The trend is towards more effective regulation and higher standards of technical appraisal. In the US, many of the Groups products are brought to market following pre-market notification to the FDA under Section 510(k) of the Food, Drug and Cosmetic Act, with a request that FDA clear the product as being substantially equivalent in terms of safety and effectiveness to a previously approved device. The FDA is considering changes in the 510(k) clearance process that might delay or modify the path to clearance in some circumstances. Regulatory requirements may also entail inspections for compliance with appropriate standards, including those relating to Quality Management Systems or Good Manufacturing Practices regulations. All manufacturing and other significant facilities within the Group are subject to regular internal audit for compliance with national and Group medical device regulation and policies.
Payment for medical devices is governed by reimbursement tariff agencies in various countries. Reimbursement rates may be set in response to perceived economic value of the devices, based on clinical and other data relating to cost, patient outcomes and comparative effectiveness. They may also be affected by overall government budgetary considerations. The Group believes that its emphasis on innovative products and services should contribute to success in this environment.
Management believes that the Groups operations currently comply in all material respects with applicable environmental laws and regulations. Although the Group continues to make capital expenditures for environmental compliance, it is not currently aware of any significant expenditure that would be required as a result of such laws and regulations that would have a material adverse impact upon the Groups financial position.
Smith & Nephew recognises that companies have a wide responsibility to the community, the environment and the quality of life enjoyed by society at large. As a leader in its markets, Smith & Nephew believes it should also be a leader in setting and meeting standards of sustainable development. The Group monitors progress and views sustainable development as an integral part of the way the Group does business. We believe this because:
To further advance its commitment to sustainability, Smith & Nephew created a new executive position in 2010, the Senior Vice-President of Corporate Sustainability.
Smith & Nephews approach to sustainability is governed by the policies and principles it has developed to cover four key areas of corporate and social responsibility, namely: corporate governance and business integrity; health, safety and environment; social responsibility and economic contribution. These policies and principles are available at www.smith-nephew.com.
The Group has published a Sustainability Report since 2001. The 2011 Sustainability Report, which provides more comprehensive information on the actions and performance in the four key reporting areas during the last year, will be published on the Groups website in mid 2011 at www.smith-nephew.com.
Corporate Governance and Business Integrity
See the Corporate Governance Statement section on pages 45 to 57 for a discussion of Smith & Nephews governance structures and procedures.
Smith & Nephew aims to be honest and fair in all aspects of its business and expects the same from those with whom it does business. The Groups Code of Conduct and Business Principles governs the way it operates so that it respects stakeholders and seeks to build open, honest and constructive relationships. The Group takes account of ethical, social, environmental, legal and financial considerations as part of its operating methods. The Group has an independently operated whistle-blowing service in all jurisdictions in which the Group operates where such service is allowed.
The Groups health, safety and environmental (HSE) commitment is to:
Smith & Nephew recognises the importance of minimising the environmental impact arising from all aspects of the business and places emphasis on controlling its waste streams, use of energy and overall carbon emissions. Activities at a local and Group level remain key to ensuring our overall HSE performance. Annual targets are set and initiatives put in place to meet these performance goals.
Throughout 2010, operations continued to develop in China and Canada. Results associated with these locations are included for the first time this year.
While we report absolute performance data, we also provide data normalised for changes related to cost of production (using 2010 as the base year) to facilitate better year-on-year comparisons. Performance against the published targets for the key HSE parameters is also shown in the table below.
Energy consumption for the Group increased by over 6% in 2010, but this was largely attributable to 2010 representing the first full year of energy use reporting for the major global distribution centre in Memphis and the newly acquired facility in Alberta, Canada. Energy efficiency initiatives were effected at a number of locations, with particularly notable accomplishments at the Hull Advanced Wound Management site and Endo operations in Massachusetts and Oklahoma.
The Group emission of carbon dioxide was 76,638 tonnes. This figure is calculated from both direct emissions from the combustion of fossil fuels on Smith & Nephews sites and secondary emissions from utility company power generation for Smith & Nephews electricity needs. While carbon dioxide emissions increased by approximately 1% in 2010, this was almost entirely related to the addition of the Memphis distribution facility and Alberta, Canada operations as noted above.
The business generated 3,297 tonnes of non-hazardous waste in 2010. While this represented a substantial decline (33%) from 2009 levels, 2009 represented an anomaly related to increased waste production associated with new construction and closure of a facility.
Over the last year, the amount of hazardous waste has reduced by 10% to 481 tonnes. The largest percentage reductions were achieved at the Advanced Wound Management site in Hull and the Research Centre in York.
Smith & Nephew continues to demonstrate a commitment to recycling; in 2010, our percentage of total waste that was recycled increased to 45% relative to 30% in the previous year. While these recycling initiatives were evident at many sites, the Memphis Orthopaedic facilities were noteworthy for their focus on scrap metals that resulted in diminished landfill costs and improved recycling revenue generation.
Water consumption throughout the Group remained largely unchanged relative to 2009. All sites continue to explore opportunities to minimise water use.
Workplace accidents decreased in 2010. Improvements were notable both in terms of lost time accident frequency rate (-7%) and the number of lost time accidents (46 relative to 58 in 2009). The OSHA recordable rate for the Group also continued to improve (26%). Both indicators of occupational accidents are below published industry average levels. The local HSE training plans continue to drive and promote safe working practices at all sites.
HSE audits were undertaken at six locations in 2010. These audits are a continuation of our protocol of assessing each of our facilities on a bi-annual schedule.
A full analysis of these measurements and key health and safety performance measures will be included in the 2011 Sustainability Report on the Groups website when it is published in mid 2011.
The Group's employment policies are based on equality of opportunity regardless of colour, creed, race, national origin, sex, age, marital status, sexual orientation, or mental or physical disability unrelated to the ability of the person to perform the essential functions of the job.
Smith & Nephew is committed to providing a healthy and safe working environment and operates a set of policies that ensure flexible, family-friendly practices and non-discrimination. It aims to provide an open environment based on constructive relationships and regular and timely dissemination of Group information and encourages feedback and ideas. Smith & Nephew carries out employee opinion surveys across the business. The aim of the surveys is to assess how aligned staff are to the Groups, and local GBUs strategy, to determine what we, as a business, do well and identify what could be improved. We also take the opportunity to test the effectiveness of Performance, Innovation and Trust as the declared company values.
The Human Resources (HR) Policy Framework provides a framework of key HR policies, values, behaviours and management principles that provide the structure within which the business units and global functions plan and deliver successful results. There is also an HR strategy which provides direction on how the Group intends to attract, retain and develop the right talent to meet business needs and create a culture that is aligned to Smith & Nephew values and deliver the Groups long term strategic plans.
Other employee engagement indicators
In 2010, the Group continued to assess indicators of employee engagement. These measurements are a useful monitoring tool and alert mechanism for action as well as giving trend indicators of improved performance. The data below relates to the Groups US and UK population (approximately 60% of the total employees) as these regions have the most established and robust data collection processes in place.
The Group is committed to providing training and information so that all employees can make the best contribution possible. To ensure that the Group continues to improve in this important area, the central global organisational development team continued their programmes to lead talent management, performance management and learning and development across the whole of the Group. Learning and development programmes are used to attract, retain and develop employees. These programmes are linked to formal performance appraisal and development planning. The Group operates training programmes under the banner of Management Excellence. These provide the key management skills required to be successful managers and leaders, covering the requirements of both new and experienced individuals. Additionally the Group has rolled out a global on-line learning resource and in 2011 will be expanding the programmes available to all employees.
The legal frameworks governing employee relations vary from country to country, as does custom and practice. Relations with trade unions are nationally determined and managed locally in line with the applicable legal framework and standards of good practice. The well-developed arrangements for interactions with trade union and worker councils provide the forum for productive discussion and collaborations with regard to collective bargaining agreements and other employment issues. It is the Groups policy to conform to the nationally determined arrangements. The Group does not use any form of forced, compulsory or child labour.
Smith & Nephew values community involvement; it is an active member of its local communities and supports employees who undertake community work. The Groups principles for charitable giving are based on criteria relevant to its business, with priority given to medical education. Individual company sites support their local communities in a range of charitable causes giving donations of money, gifts in kind and employee time.
The Group realises that its technologies and products do not reach everyone. Project Apollo is a charitable and humanitarian service programme of the Orthopaedics business. This links up with physicians and non-profit groups engaged in medical philanthropy that receive donations of Smith & Nephew products through sponsorship and help from the Groups employees. By working in collaboration with these individuals and organisations, Smith & Nephew considers that this is a way of increasing the impact of its charitable giving and work it undertakes.
More examples of community support programmes supported by the Group are given in the Sustainability Report.
In 2010, direct donations to charitable and community activities totalled $5,644,000 comprised of $1,736,000 in cash and $3,908,000 in product donations, primarily for Haiti earthquake relief efforts. This compares with $1,866,000 of cash donations in 2009 and $1,498,000 in 2008. As a matter of policy, Smith & Nephew makes no political contributions.
Smith & Nephew is committed to establishing mutually beneficial relationships with its suppliers, customers and business partners. The Group works only with partners it believes adhere to business principles and health, safety, social and environmental standards consistent with its own. Additional work continues each year to improve the monitoring of supplier standards for service quality and activities relevant to their corporate responsibility including a diversity programme to promote long-term relationships with local or small business enterprises and minority-owned and women-owned business enterprises.
Sustainability by definition includes economic success. The Group is committed to providing innovative, cost-effective healthcare solutions benefiting patients, healthcare professionals, reimbursement agencies and their patients through improved treatment, ease and speed of product use and reduced healthcare costs. The Groups business policies are designed to achieve long-term growth and profits which in turn bring continued economic benefits to shareholders, employees, suppliers and local communities. Highlights for 2010 included:
The Group is fulfilling an important role in the healthcare sector. Increased demands are being placed on healthcare systems by the demographic trends of an ageing population and as the problems with obesity become more widespread. More active lifestyles and the increased incidence of diabetes and other diseases also increase the demand for Smith & Nephews products. In addition, developing and newly industrialised countries are increasing their demands for advanced products driven by similar demographic and health issues as developed nations.
Smith & Nephews vision is to be the best in helping people regain their lives by improving and healing the human body. The Group believes that it can achieve this by setting and meeting ambitious performance targets, by constant innovation in products and services and by earning the trust of its stakeholders. The Group considers sustainability a journey, not an end point and is committed to that journey as an essential part of its long-term strategy.
The average number of full-time equivalent employees in 2010 was 10,172, of whom 1,625 were located in the UK, 4,247 were located in the US and 4,300 were located in other countries. The Group does not employ a significant number of temporary employees.
The average number of employees for the past three years by business segment:
Where the Group has collective bargaining arrangements in place with labour unions, these reflect local market circumstances.
Smith & Nephew operates share option plans that are available to the majority of employees (for further information see Note 25 of the Notes to the Group Accounts). The Group has no share plans in which shares have rights with regard to control of the Company that are not exercisable directly by employees.
Management of Risk
As an integral part of planning and review, Group management and management of each of the GBUs seek to identify the risks involved in the business, the probability of those risks materialising, the impact if they do materialise and the actions being taken, and to be taken, to manage and mitigate those risks. Internal audit reviews and reports on the effectiveness of the operation of the risk management process. The Group Risk Committee meets twice a year to review the major risks identified by the GBUs and Group management and any mitigating actions being taken. As appropriate, the Risk Committee may re-categorise risks or require further information or mitigating action to be undertaken. The Risk Committee reports to the Board on an annual basis detailing all principal risks categorised by potential financial impact on profit and share price. In addition, the risks considered to be most significant to the Group are reported to the Board on a regular basis. These reports include details of new, key or significantly increased risks, the senior management who have primary responsibility for managing each of these risks along with actions they have put in place to mitigate such risks.
There are known and unknown risks and uncertainties relating to Smith & Nephews business. The factors listed below could cause the Groups business, financial position and results of operations to differ materially and adversely from expected and historical levels. In addition, other factors not listed here, that Smith & Nephew cannot presently identify or does not believe to be equally significant, could also materially adversely affect Smith & Nephews business, financial position or results of operations.
Highly Competitive Markets
The Groups business units compete across a diverse range of geographic and product markets. Each market in which the business units operate contains a number of different competitors, including specialised and international corporations. Significant product innovations, technical advances or the intensification of price competition by competitors could adversely affect the Groups operating results. Some of these competitors may have greater financial, marketing and other resources than Smith & Nephew. These competitors may be able to initiate technological advances in the field, deliver products on more attractive terms, more aggressively market their products or invest larger amounts of capital and research and development into their businesses.
There is a possibility of further consolidation of companies, which could adversely affect the Groups ability to compete with larger companies due to insufficient financial resources. If any of the Groups businesses were to lose market share or achieve lower than expected sales growth, there could be a disproportionate adverse impact on the Groups share price and its strategic options.
Competition exists among healthcare providers to gain patients on the basis of quality, service and price. There has been some consolidation in the Groups customer base and this trend is expected to continue. Increased competition and unanticipated actions by competitors or customers could lead to downward pressure on prices and/or a decline in market share in any of the Groups business areas, which could adversely affect Smith & Nephews results of operations and hinder its growth potential.
Continual Development and Introduction of New Products
The medical devices industry has a rapid rate of new product introduction. In order to remain competitive, each of the Groups business units must continue to develop innovative products that satisfy customer needs and preferences or provide cost or other advantages. Developing new products is a costly, lengthy and uncertain process. A potential product may not be brought to market for any number of reasons, including failure to work optimally, failure to receive regulatory approval, failure to be cost-competitive, infringement of patents or other intellectual property rights and changes in consumer demand. The Groups products and technologies are also subject to marketing attack by competitors. Furthermore, new products that are developed and marketed by the Groups competitors may affect price levels in the various markets in which the Groups business units operate. If the Groups new products do not remain competitive with those of competitors, the Groups sales revenue could decline.
There is a risk that a major disruptive technology could be introduced into one or more of the Groups markets and adversely affect its ability to achieve business plans and targets.
Dependence on Government and Other Funding
In most markets throughout the world, expenditure on medical devices is ultimately controlled to a large extent by governments. Funds may be made available or withdrawn from healthcare budgets depending on government policy. The Group is therefore largely dependent on future governments providing increased funds commensurate with the increased demand arising from demographic trends.
Pricing of the Groups products is governed in most major markets largely by governmental reimbursement authorities. Initiatives sponsored by government agencies, legislative bodies and the private sector to limit the growth of healthcare costs, including price regulation, excise taxes and competitive pricing, are ongoing in markets where the Group has operations. This control may be exercised by determining prices for an individual product or for an entire procedure. The Group is exposed to changes in reimbursement policy, tax policy and pricing which may have an adverse impact on sales and operating profit. In particular, recent changes to the health care legislation in the US are due to impose significant taxes on medical device manufacturers from 2013. There may be an increased risk of adverse changes to government funding policies arising from the deterioration in macro-economic conditions in some of the Groups markets.
The Group must adhere to the rules laid down by government agencies that fund or regulate health care, including extensive and complex rules in the US. Failure to do so could result in fines or loss of future funding.
World Economic Conditions
Demand for the Groups products is driven by demographic trends, including the ageing population and the incidence of osteoporosis and obesity. Supply of, use of and payment for the Groups products are also influenced by world economic conditions which could place increased pressure on demand and pricing, adversely impacting the Groups ability to deliver revenue and margin growth. The conditions could favour larger, better capitalised groups, with higher market shares and margins. As a consequence, the Groups prosperity is linked to general economic conditions and there is a risk of deterioration of the Groups performance and finances during adverse macro-economic conditions.
During 2010, economic conditions worldwide continued to create several challenges for the Group, including deferrals of joint replacement procedures, heightened pricing pressures and significant declines in capital equipment expenditures at hospitals. These factors tempered the overall growth of the Groups global markets and could have an increased impact on growth in the future.
The Group operates on a worldwide basis and has distribution channels, purchasing agents and buying entities in over 90 countries. Political upheaval in some of those countries or in surrounding regions may impact the Groups results of operations. Political changes in a country could prevent the Group from receiving remittances of profit from a member of the Group located in that country or from selling its products or investments in that country. Furthermore, changes in government policy regarding import quotas, taxation or other matters could adversely affect the Groups turnover and operating profit. War, terrorist activities or other conflict could also adversely impact the Group.
The Group uses the US Dollar as its reporting currency and the US Dollar is the functional currency of Smith & Nephew plc. In 2010, 43% (2009 44%) of Group revenue arose in the US, 26% (2009 27%) in Continental Europe, 24% (2009 21%) in Africa, Asia, Australia, Canada, New Zealand and Latin America, and 7% (2009 8%) in the UK.
The Groups manufacturing cost base is situated principally in the US, the UK, China and Switzerland, from which finished products are exported to the Groups selling operations worldwide. Thus, the Group is exposed to fluctuations in exchange rates between the US Dollar, Sterling and Swiss Franc and the currencies of the Groups selling operations, particularly the Euro, Australian Dollar and Japanese Yen. If the US Dollar, Sterling or Swiss Franc should strengthen against the Euro, Australian Dollar and the Japanese Yen, the Groups trading margin could be adversely affected.
Stock Market Valuations
Changing market conditions, both within the medical devices sector and in stock prices in general, may lead to volatility in the share price, or a stock market valuation of the Group which is materially less than the Groups intrinsic value. This may lead to difficulties in making acquisitions, an increased vulnerability to takeovers at below intrinsic value, and loss of value for our shareholders.
Manufacturing and Supply
The Groups manufacturing production is concentrated at 11 main facilities in Memphis, Tennessee, Mansfield, Massachusetts and Oklahoma City, Oklahoma in the US, Hull, Warwick and Gilberdyke in the UK, Aarau in Switzerland, Tüttlingen in Germany, Alberta in Canada and Suzhou and Beijing in China. If major physical disruption took place at any of these sites, it could adversely affect the results of operations. Physical loss and consequential loss insurance is carried to cover such risks but is subject to limits and deductibles and may not be sufficient to cover catastrophic loss.
Management of orthopaedic inventory is complex, particularly forecasting and production planning. There is a risk that failures in operational execution could lead to excess inventory or individual product shortages.
Each of the business units is reliant on certain key suppliers of raw materials, components, finished products and packaging materials. These suppliers must provide the materials and perform the activities to the Groups standard of quality requirements. If any of these suppliers is unable to meet the Groups needs, compromises on standards of quality or substantially increases its prices, Smith & Nephew would need to seek alternative suppliers. There can be no assurance that alternative suppliers would provide the necessary raw materials on favourable or cost-effective terms at the desired quality. Consequently, the Group may be forced to pay higher prices to obtain raw materials, which it may not be able to pass on to its customers in the form of increased prices for its finished products. In addition, some of the raw materials used may become unavailable, and there can be no assurance that the Group will be able to obtain suitable and cost-effective substitutes. Any interruption of supply caused by these or other factors could negatively impact Smith & Nephews revenue and operating profit.
The Group uses a variety of information systems to conduct its manufacturing, supply and selling operations. An unrecoverable fault in one of these systems could disrupt trading in certain markets and locations.
The Group is in the process of outsourcing to third parties or relocating to lower cost countries certain of its manufacturing processes. As a result of these transfers, there is a risk of disruption to supply.
Attracting and Retaining Key Personnel
The Groups continued development depends on its ability to hire and retain highly skilled personnel with particular expertise. This is critical, particularly in general management, research, new product development and in the sales forces. If Smith & Nephew is unable to retain key personnel in general management, research and new product development or if its largest sales forces suffer disruption or upheaval, its sales and operating profit would be adversely affected. Additionally, if the Group is unable to recruit, hire, develop and retain a talented, competitive workforce, it may not be able to meet its strategic business objectives.
Proprietary Rights and Patents
Due to the technological nature of medical devices and the Groups emphasis on serving its customers with innovative products, the Group has been subject to patent infringement claims and is subject to the potential for additional claims.
Claims asserted by third parties regarding infringement of their intellectual property rights, if successful, could require the Group to expend time and significant resources to pay damages, develop non-infringing products or obtain licences to the products which are the subject of such litigation, thereby affecting the Groups growth and profitability. Smith & Nephew attempts to protect its intellectual property and regularly opposes third party patents and trademarks where appropriate in those areas that might conflict with the Groups business interests. If Smith & Nephew fails to protect and enforce its intellectual property rights successfully, its competitive position could suffer, which could harm its results of operations.
Product Liability Claims and Loss of Reputation
The development, manufacture and sale of medical devices entail risk of product liability claims or recalls. Design and manufacturing defects with respect to products sold by the Group or by companies it has acquired could damage, or impair the repair of, body functions. The Group may become subject to liability, which could be substantial, because of actual or alleged defects in its products. In addition, product defects could lead to the need to recall from the market existing products, which may be costly and harmful to the Groups reputation.
There can be no assurance that customers, particularly in the US, the Groups largest geographical market, will not bring product liability or related claims that would have a material adverse effect on the Groups financial position or results of operations in the future, or that the Group will be able to resolve such claims within insurance limits.
Compliance and Reporting Risk
Regulatory Compliance in the Healthcare Industry
Business practices in the healthcare industry are subject to regulation and review by various government authorities. In general, the trend in many countries in which the Group does business is towards higher expectations and increased enforcement activity by governmental authorities. In the UK, a new Bribery Act was adopted in 2010 that will increase risks for companies that allow improper conduct on their behalf. While the Group is committed to doing business with integrity and welcomes the trend to higher standards in the healthcare industry, the Group and other companies in the industry have been subject to investigations and other enforcement activity that have incurred and may continue to incur significant expense. See Legal Proceedings. Under certain circumstances, if the Group were found to have violated the law, its ability to sell its products to certain customers could be restricted.
Regulatory Approvals and Controls
The medical device industry is highly regulated. Regulatory requirements are a major factor in determining whether substances and materials can be developed into marketable products and the amount of time and expense that should be allotted to such development. The Group is required to comply with a wide range of regulatory controls over the manufacturing, testing, distribution, marketing and sale of its products, particularly in the US, Europe and China. Such controls have become increasingly demanding and costly to comply with and management believes that this trend will continue. At any time, the Group is awaiting a number of regulatory approvals which, if not received, could adversely affect results of operations. Regulatory approval of new products and new materials is required in most countries in which the Group operates, although a single approval may be obtained for all countries within the European Union. Regulatory approval of new products may entail a lengthy process, particularly if materials are employed which have not previously been used in similar products. In the US, the 510(k) process by which many of the Groups products are cleared for sale may be revised in ways that could lead to delays or increased costs. See Regulation.
Failure to comply with these regulatory requirements could have a number of adverse consequences, including withdrawal of approval to sell a product in a country, temporary closure of a manufacturing facility, fines and potential damage to company reputation.
Other Risk Factors
Smith & Nephew is subject to a number of other risks, which are common to most global medical technology groups and are reviewed as part of the Groups risk management process.
EXCHANGE AND INTEREST RATE RISK AND FINANCIAL INSTRUMENTS
The Board of directors of the Company has established a set of policies to manage funding, currency and interest rate risks. Derivative financial instruments are used only to manage the financial risks associated with underlying business activities and their financing. See Note 20 of the Notes to the Group accounts for further details of these risks.
The Groups financial instruments are subject to changes in fair values as a result of changes in market rates of exchange and forward interest rates. Financial instruments entered into to hedge sales and purchase transactions in foreign currency and interest rate exposures are accounted for as hedges. Changes in fair values of effective financial instruments would not affect the Groups income statement immediately. The movements in the fair value of financial instruments that are not accounted for as hedges offset movements in the values of assets and liabilities and are recognised through the income statement. The net impact of these changes in fair value on the Groups income statement is not significant.
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BUSINESS REVIEW, LIQUIDITY AND PROSPECTS
The Business Review, Liquidity and Prospects discusses the operating and financial performance of the Group, including the financial outlook and the financial resources of the Group, under the following headings:
The results for each year are compared primarily with the results for the preceding year.
Smith & Nephews operations are organised into three primary business units that operate globally: Orthopaedics, Endoscopy and Advanced Wound Management. Smith & Nephew believes that its businesses have opportunities for strong growth due to its markets benefiting from an ageing population, an increase in active lifestyles, trends toward less invasive medical procedures and the increasing demand in emerging markets.
Revenue by business segment as a percentage of total revenue was as follows:
Revenue by geographic market as a percentage of total revenue was as follows:
Underlying Growth in Revenue
Underlying growth in revenue is a non-GAAP financial measure which is a key performance indicator used by the Groups management in order to compare the revenue in a given year to that of the previous year on a like-for-like basis. This is achieved by adjusting for the impact both of sales of products acquired in material business combinations and for movements in exchange rates. The Groups management uses this non-GAAP measure in its internal financial reporting, budgeting and planning to assess performance on both a business segment and a consolidated Group basis.
Underlying growth in revenue reconciles to growth in revenue reported in accordance with IFRS by making two adjustments, the constant currency exchange effect and the acquisitions effect, described below. The material limitation of the underlying growth in revenue measure is that it excludes certain factors, described above, which do ultimately have a significant impact on total revenues. The Group measures the performance of local managers using underlying growth in revenue whilst the Groups management additionally considers GAAP revenue each quarter and further assesses the excluded items by monitoring against internal budget amounts.
The constant currency exchange effect is a measure of the increase/decrease in revenue resulting from currency movements on non-US Dollar sales. This is measured as the difference between the increase in revenue translated into US Dollars on a GAAP basis (i.e. current year revenue translated at the current year average rate, prior year revenue translated at the prior year average rate) and the increase measured by translating current and prior year revenue into US Dollars using the prior year closing rate.
The acquisitions effect is the measure of the impact on revenue from newly acquired business combinations. This is calculated by excluding the revenue from sales of products acquired as a result of a business combination consummated in the current year, with non-US Dollar sales translated at the prior year average rate. Additionally, prior year revenue is adjusted to include a full year of revenue from the sales of products acquired in those business combinations consummated in the previous year, calculated by adding back revenue from sales of products in the period prior to the Groups ownership. These sales are separately tracked in the Groups internal reporting systems and are readily identifiable.
Underlying growth in revenue in 2010 by business segment reconciles to reported growth, the most directly comparable financial measure calculated in accordance with IFRS, as follows:
Trading profit reconciles to operating profit in 2009 as follows:
Trading Cash Flow and Trading Profit to Cash Conversion Ratio
Growth in trading cash flow and improvement in the trading profit to cash conversion ratio are measures which present the trend growth in the long-term cash generation of the Group excluding the impact of specific transactions or events that management considers affect the Groups short-term performance.
Trading cash flow is defined as cash generated from operations less net capital expenditure but before acquisition related cash flows, restructuring and rationalisation cash flows and cash flows arising from legal disputes and uninsured losses. Trading profit to cash conversion ratio is trading cash flow expressed as a percentage of trading profit.
The Group presents those measures to assist investors in their understanding of trends. The Groups internal financial reporting (budgets, monthly reporting, forecasts, long-term planning and incentive plans) focuses on cash generation before these items. Trading cash flow and trading profit to cash conversion ratio are non-GAAP financial measures.
Trading cash flow reconciles to cash generated from operations, the most directly comparable financial measure calculated in accordance with IFRS, as follows:
Factors Affecting Smith & Nephews Results of Operations
Smith & Nephews business units participate in the global medical devices market and share a common focus on the repair of human tissue. Smith & Nephews principal geographic markets are in the well-developed healthcare economies of the US, Europe, Japan and Australia.
These markets are characterised by an increase in the average age of the population caused by the immediate post-World War II baby boomer generation approaching retirement, increased longevity, more active lifestyles, obesity and increased affluence. Together these factors have created significant demand for more effective healthcare products which deliver improved outcomes through technology advances. Furthermore, pressure to resist increases in overall healthcare spending has led healthcare providers to demand products which minimise the length of hospital stays and use of surgeon and nursing resources.
Increasing consumer awareness of available healthcare treatments through the Internet and direct-to-customer advertising has led to increased consumer influence over product purchasing decisions.
For a description of the impact on each business unit refer to the Market and Competition sections under Business Description on pages 4 to 9.
The Group must continually develop its existing and new technologies and bring new products to its customers to drive sales growth. Expenditure on research and development in 2010 represented approximately 4% (2009 4%) of Group revenue. The focus of Smith & Nephews innovation is to create new products and surgical techniques with distinct advantages in clinical performance and cost-effectiveness benefits for clinicians, patients and healthcare providers.
Smith & Nephews results of operations are affected by transactional exchange rate movements in that they are subject to exposures arising from revenue in a currency different from the related costs and expenses. The Group manages the impact of exchange rate movements on sales and cost of goods sold by a policy of transacting forward foreign currency commitments when firm purchase orders are placed. In addition, the Groups policy is for forecast transactions to be covered between 50% and 90% for up to one year.
The Groups revenues, profits and earnings are also affected by exchange rate movements on the translation of results of operations in foreign subsidiaries for financial reporting purposes. This exposure is offset partly because the Group incurs interest in currencies other than US Dollars on its indebtedness denominated in currencies other than US Dollars. See Financial Position, Liquidity and Capital Resources on page 39.
Governmental economic, fiscal, monetary and political policies and factors that materially affect the Groups operations or investments of shareholders are discussed in Regulation, External Risk, Compliance and Reporting Risk, Taxation information for shareholders on pages 12, 19, 21 and 145-146, respectively, and elsewhere in this Annual Report.
Critical Accounting Policies
The Groups significant accounting policies are set out in Note 2 of the Notes to the Group Accounts. Of those, the policies which require the most use of managements judgment are as follows:
A feature of the Orthopaedics business (whose finished goods inventory makes up approximately 78% of the Group total finished goods inventory) is the high level of product inventory required, some of which is located at customer premises and is available for customers immediate use. Complete sets of product, including large and small sizes, have to be made available in this way. These sizes are used less frequently than standard sizes and towards the end of the product life cycle are inevitably in excess of requirements. Adjustments to carrying value are therefore required to be made to orthopaedic inventory to anticipate this situation. These adjustments are calculated in accordance with a formula based on levels of inventory compared with historical usage. This formula is applied on an individual product line basis and is first applied when a product group has been on the market for two years. This method of calculation is considered appropriate based on experience, but it does involve management judgements on effectiveness of inventory deployment, length of product lives, phase-out of old products and efficiency of manufacturing planning systems.
In carrying out impairment reviews of goodwill, intangible assets and property, plant and equipment a number of significant assumptions have to be made when preparing cash flow projections. These include the future rate of market growth, the market demand for the products acquired, the future profitability of acquired businesses or products, levels of reimbursement and success in obtaining regulatory approvals. If actual results should differ or changes in expectations arise, impairment charges may be required which would adversely impact operating results.
A number of key judgements have to be made in calculating the fair value of the Groups defined benefit pension plans. These assumptions impact the Balance Sheet liability, operating profit and other finance income/costs. The most critical assumptions are the discount rate and mortality assumptions to be applied to future pension plan liabilities. For example as of 31 December 2010, a 0.5% increase in discount rate would have reduced the combined UK and US pension plan deficit by $84m whilst a 0.5% decrease would have increased the combined deficit by $93m. A 0.5% increase in discount rate would have decreased profit before taxation by $2m whilst a 0.5% decrease would have increased it by $2m. A one year increase in the assumed life expectancy of the average 60 year old male pension plan member in both the UK and US would have increased the combined deficit by $33m. In making these judgements, management takes into account the advice of professional external actuaries and benchmarks its assumptions against external data.
The discount rate is determined by reference to market yields on high quality corporate bonds, with currency and term consistent with those of the liabilities. In particular for the UK and US, the discount rate is derived by reference to a AA yield curve derived by the Groups actuarial advisers.
See Note 33 of the Notes to the Group Accounts for a summary of how the assumptions selected in the last five years have compared with actual results.
Contingencies and Provisions
The recognition of provisions for legal disputes is subject to a significant degree of estimation. Provision is made for loss contingencies when it is considered probable that an adverse outcome will occur and the amount of the loss can be reasonably estimated. In making its estimates, management takes into account the advice of internal and external legal counsel. Provisions are reviewed regularly and amounts updated where necessary to reflect developments in the disputes. The ultimate liability may differ from the amount provided depending on the outcome of court proceedings and settlement negotiations or if investigations bring to light new facts.
The Group operates in numerous tax jurisdictions around the world. Although it is Group policy to submit its tax returns to the relevant tax authorities as promptly as possible, at any given time the Group has unagreed years outstanding and is involved in disputes and tax audits. Significant issues may take several years to resolve. In estimating the probability and amount of any tax charge, management takes into account the views of internal and external advisors and updates the amount of provision whenever necessary. The ultimate tax liability may differ from the amount provided depending on interpretations of tax law, settlement negotiations or changes in legislation.
The following discussion and analysis is based upon, and should be read in conjunction with, the Group Accounts of Smith & Nephew included elsewhere in this Annual Report.
Financial Highlights of 2010
Group revenue was $3,962m for the year ended 31 December 2010, representing a 5% growth compared to 2009. This comprised of underlying revenue growth of 4% and favourable currency translation of 1%.
Profit before taxation was $895m in 2010, compared with $670m in 2009. Attributable profit was $615m compared to $472m in 2009. Adjusted attributable profit (calculated as set out in Selected Financial Data) rose 13% to $654m in 2010, from $580m in 2009.
Basic earnings per Ordinary Share were 69.3¢, compared to 53.4¢ for 2009. EPSA (as set out in Selected Financial Data) was 73.6¢ in 2010 compared to 65.6¢ for 2009, representing a 12% increase.
Fiscal 2010 Compared with Fiscal 2009
The following table sets out certain income statement data for the periods indicated:
Transactional and Translational Exchange
The Groups principal markets outside the US are, in order of significance, Continental Europe, UK, Australia and Japan. Revenues in these markets fluctuate when translated into US Dollars on consolidation. During the year, the average rates of exchange against the US Dollar used to translate revenues and profits arising in these markets changed compared to the previous year as follows: the Euro decreased from $1.39 to $1.32 (5%), Sterling decreased from $1.56 to $1.54 (1%), the Swiss Franc increased from $0.92 to $0.96 (4%), the Australian Dollar increased from $0.78 to $0.92 (18%) and the Japanese Yen increased from ¥94 to ¥88 (6%).
The Groups principal manufacturing locations are in the US (Orthopaedics and Endoscopy), Switzerland (Orthopaedics), UK (Advanced Wound Management and Orthopaedics) and China (Orthopaedics and Advanced Wound Management). The majority of the Groups selling and distribution subsidiaries around the world purchase finished products from these locations. As a result of currency movements compared with the previous year, purchases from the US became relatively more expensive for Europe and the UK and relatively less expensive for Australia, Japan and Switzerland. The Groups policy of purchasing forward a proportion of its currency requirements mitigated the impact of these movements.
Group revenue increased by $190m (5%) from $3,772m in 2009 to $3,962m in 2010. Underlying revenue growth was 4%, and a further 1% growth was attributable to favourable currency translation.
Orthopaedics revenues increased by $60m (3%), of which 2% was attributable to underlying growth, and 1% due to favourable currency translation. Endoscopy revenues increased by $64m (8%), of which 7% was attributable to underlying growth, and 1% due to favourable currency translation. Advanced Wound Management revenues increased by $66m (8%), of which 7% was attributable to underlying growth and 1% due to favourable currency translation.
A more detailed analysis is included within the Revenue sections of the individual business segments that follow on pages 32 and 34.
Cost of goods sold
Cost of goods sold increased by $1m to $1,031m from $1,030m in 2009. This represents 26% of revenue compared to 27% in 2009. During 2010, the Group has continued to deliver on its efficiency commitments, including our new Advanced Wound Management manufacturing facility in China and improved inventory management in Orthopaedics. Other factors contributing to the movement were the decrease of $15m in restructuring and rationalisation expenses and decrease of $12m in other acquisition related costs. Currency had little impact on the year on year movement.
Further margin analysis is included within the Trading profit sections of the individual business segments that follow on pages 32 to 34.
Marketing, selling and distribution expenses
These expenses increased by $63m (5%) to $1,414m from $1,351m in 2009. In line with increased revenue there has been a 4% underlying increase in advertising, marketing and selling costs. Unfavourable currency movements have contributed to the remaining 1% movement.
Administrative expenses decreased by $67m (-13%) to $446m from $513m in 2009. The principal factors contributing to the underlying movement of -14% were a $32m reduction in the amortisation and impairment charge of intangible assets, a $7m reduction in acquisition related costs and a decrease of $5m in restructuring and rationalisation expenses. This was partially offset by a 1% unfavourable movement in currency.
Research and development expenses
Expenditure as a percentage of revenue decreased by 0.3% to 3.8% in 2010 (2009 4.1%). The Group continues to invest in innovative technologies and products to differentiate itself from competitors.
Operating profit increased by $197m to $920m from $723m in 2009 comprising increases of $93m in Orthopaedics, $28m in Endoscopy and $76m in Advanced Wound Management.
Net interest payable
Net interest payable reduced by $25m from $40m in 2009 to $15m in 2010. This is a consequence of the overall reduction of borrowings within the Group and a reduction in the applicable interest rates.
Other finance cost
Other finance costs in 2010 were $10m compared to $15m in 2009. This decrease is attributable to an increase in the expected return on pension plan assets.
The taxation charge increased by $82m to $280m from $198m in 2009. The effective rate of tax was 31.3%, compared with 29.6% in 2009.
The tax charge was reduced by $10m in 2010 (2009 $26m) as a consequence of restructuring and rationalisation expenses, acquisition related costs, amortisation of acquisition intangibles and impairments. The effective tax rate was 30.8% (2009 27.9%) after adjusting for these items and the tax thereon.
Group Balance Sheet
The following table sets out certain balance sheet data as at 31 December of the years indicated:
Non-current assets increased by $99m to $2,579m from $2,480 in 2009. Intangible assets and goodwill increased by $22m of which $65m related to additions of intangibles, $28m related to favourable currency translation and $2m of transfers. These were partially offset by $68m of amortisation and a $4m adjustment to contingent consideration. Property, plant and equipment increased by $34m comprising $250m of additions and $3m of favourable currency translation, partially offset by $203m of depreciation charge, $14m of disposals and $2m of transfers. Deferred tax assets and other non-current assets increased by $43m in the year.
Current assets increased by $83m to $2,154m from $2,071m in 2009. This was due to an increase in trade and other receivables of $78m and an increase in cash at bank of $15m. These increases were partially offset by a reduction in inventories of $10m.
Non-current liabilities decreased by $477m from $1,523m in 2009 to $1,046m in 2010. $448m of this decrease was due to the reduction of long-term borrowings. The net retirement benefit obligation decreased by $60m. This was largely due to the excess of pension contributions totalling $65m over the charge to the income statement in the year of $35m which gave rise to a net $30m reduction in the liability. In addition, there were actuarial gains totalling $26m. Other movements in non-current liabilities related to a reduction in deferred acquisition consideration of $27m due to settlement of the BlueSky Medical Group, Inc (BlueSky) deferred consideration, an increase of $38m in the deferred tax liability and an increase in provisions of $20m due to a change in the expected time frame to settlement which has resulted in a reclassification from current liabilities.
Current liabilities increased by $51m from $863m in 2009 to $914m in 2010. This was due to an increase in bank overdrafts and current borrowings of $12m, an increase in trade and other payables of $21m and an increase in current tax payable of $36m, offset by a decrease in provisions of $18m.
Total equity increased by $594m from $2,179m in 2009 to $2,773m in 2010. The principal movements were an increase of $615m due to attributable profit, currency translation and hedging gains of $53m, an increase of $26m relating to actuarial gains on retirement benefit obligations, offset by a decrease of $7m relating to deferred taxation and a decrease of $132m due to dividends paid during the year.
Business Segment Analysis
Revenue by business segment and geographic market and trading and operating profit by business segment are set out below:
Orthopaedics revenue increased by 3% to $2,195m from $2,135m in 2009. Of this increase, 2% is attributable to underlying growth and 1% is due to favourable currency movements.
In the US, revenue increased by $22m to $1,176m (2%), all of which was due to underlying growth. The main factors were the continued growth of products launched in the year including VERILAST and VISIONAIRE.
Outside the US, revenue increased by $38m to $1,019m (4%). This movement is attributable to underlying growth of 2% and favourable foreign currency translation of 2%.
Global knee revenue increased by $45m to $806m (6%), representing underlying revenue growth of 5% and favourable foreign currency translation of 1%. There has been continued pressure from the challenging environment on higher specification and early intervention hip and knee implant systems. Nevertheless, our knee franchise and in particular our LEGION Knee Systems delivered strong growth. This was driven by the FDA clearance to claim that VERILAST bearing technology for knee replacement provides wear performance sufficient for 30 years of actual use under typical conditions and by our VISIONAIRE Patient Matched Instrumentation sets.
Global hip revenue increased by $7m to $688m (1%), all of which was due to favourable foreign currency translation. In our hip franchise, both our traditional and new products have continued to perform well, led by the R3 Acetabular System. Sales of BIRMINGHAM HIP Resurfacing Systems have been weaker, but we are confident that our programme of reinforcing the superior clinical data with surgeons and patients will be effective.
Global trauma revenue increased by $20m to $434m (5%), representing underlying revenue growth of 3% and 2% favourable foreign currency translation. This improvement is attributable to managements actions to provide additional support and training to the sales force.
In Clinical Therapies, EXOGEN Ultrasound Bone Healing System achieved double digit revenue growth for the year. Our joint fluid therapies franchise continues to perform well despite the increased competitive environment in the US. Early in 2010 we sold our niche pain management business and terminated our small spine distribution business in Germany, which reduced our Orthopaedics revenue growth by approximately 1%.
Trading profit increased by $28m (6%) to $536m from $508m in 2009. Trading profit margin increased from 23.8% to 24.4%. This increase is due to cost management and further investment in improving the efficiency and effectiveness of the main processes, primarily in the cost of sales area.
Operating profit increased by $93m to $503m. This comprises the increase in trading profit of $28m discussed above, a $26m reduction in acquisition related costs, a reduction of $21m in the amortisation of acquisition intangibles and impairments and an $18m reduction in costs associated with the Earnings Improvement Programme (EIP).
Endoscopy revenue increased by $64m, or 8%, to $855m from $791m in 2009, comprising 1% favourable currency translation and 7% underlying growth.
In the US, revenue increased by $4m to $353m (1%), all of which represents underlying growth.
Outside the US, revenue increased by $60m to $502m (14%), of which 11% was underlying growth and 3% was due to favourable foreign currency translation.
Global revenue of knee and shoulder repair products increased by $46m to $391m (13%), of which 11% was underlying growth and 2% favourable foreign currency translation.
Revenue in the global resection products sector increased by $17m to $282m (7%), of which 6% represents underlying revenue growth and 1% of favourable foreign currency translation. The resection franchise benefited from the introduction of a new range of radio-frequency ablation probes early in the year.
Global Visualisation revenue reduced by $9m to $112m (-7%), of which -9% represents negative underlying growth, partially offset by 2% of favourable foreign currency translation. This decrease reflects the Groups strategy to only focus on those capital items which are closely aligned with our core resection and repair businesses.
Trading profit increased by $11m (6%) to $200m from $189m in 2009. Trading profit margin decreased from 23.9% to 23.3%. This reflects the increased investment in product development and in the sales force, particularly in the US.
Operating profit increased by $28m to $197m from $169m in 2009. This comprises the $11m increase in trading profit set out above, a reduction of $14m in amortisation of acquisition intangibles and impairments and a $3m reduction in restructuring costs.
Advanced Wound Management
Revenue increased by $66m, or 8%, to $912m from $846m in 2009, comprising 1% favourable currency translation and 7% underlying growth. A significant portion of the growth came from our Negative Pressure Wound Therapy (NPWT) product range, which we have continued to expand to offer customers a wide range of clinical options. Our Exudate and Infection Management franchises continue to benefit from new products and line extensions.
In the US, revenue increased by $17m to $178m (11%), all of which is attributable to underlying revenue growth.
Outside the US, revenue increased by $49m to $734m (7%). This is represented by an underlying growth of 6% and 1% of favourable foreign currency translation. European revenue increased by $6m to $454m (1%) of which 5% was underlying growth partially offset by 4% of unfavourable currency translation.
Trading profit increased by $73m (46%) to $233m from $160m in 2009 and trading profit margin increased from 18.9% to 25.6%. The settlement in the year with the vendors of BlueSky Medical Group, Inc with regard to legal expenses in defending our NPWT intellectual property position increased trading profit by $25m. During the year, Advanced Wound Management also benefited from a full years production at the new manufacturing facility in China, reducing manufacturing costs.
Operating profit increased by $76m to $220m. This comprises the increase in trading profit of $73m and a reduction of $6m in restructuring and rationalisation costs partially offset by an increase of $3m in the amortisation of acquisition intangibles following the acquisition of Nucryst in December 2009.
The following discussion and analysis is based upon, and should be read in conjunction with, the Group Accounts of Smith & Nephew included elsewhere in this Annual Report.
Financial Highlights of 2009
Group revenue was $3,772m for the year ended 31 December 2009, representing a 1% decline compared to 2008. Unfavourable currency translation of -3% was partly offset by underlying revenue growth of 2%.
Profit before taxation was $670m in 2009, compared with $564m in 2008. Attributable profit was $472m compared with $377m in 2008. Adjusted attributable profit (calculated as set out in Selected Financial Data), rose 18% to $580m in 2009, from $493m in 2008.
Basic earnings per Ordinary Share were 53.4¢, compared to 42.6¢ for 2008. EPSA (as set out in Selected Financial Data) was 65.6¢ in 2009 compared, to 55.6¢ for 2008, representing an 18% increase.
Fiscal 2009 Compared with Fiscal 2008
The following table sets out certain income statement data for the periods indicated:
Transactional and Translational Exchange
The Groups principal markets outside the US are, in order of significance, Continental Europe, UK, Australia and Japan. Revenues in these markets fluctuate when translated into US Dollars on consolidation. During the year, the average rates of exchange against the US Dollar used to translate revenues and profits arising in these markets changed compared to the previous year as follows: the Euro weakened from $1.46 to $1.39 (-5%), Sterling weakened from $1.84 to $1.56 (-15%), the Swiss Franc remained flat at $0.92, the Australian Dollar weakened from $0.84 to $0.78 (-7%) and the Japanese Yen strengthened from ¥103 to ¥94 (+9%).
The Groups principal manufacturing locations are in the US (Orthopaedics and Endoscopy), Switzerland (Orthopaedics) and UK (Advanced Wound Management and Orthopaedics). The majority of the Groups selling and distribution subsidiaries around the world purchase finished products from these locations. As a result of currency movements compared with the previous year, purchases from the US became relatively more expensive. The Groups policy of purchasing forward a proportion of its currency requirements mitigates the impact of these movements.
Group revenue decreased by $29m (-1%) from $3,801m in 2008 to $3,772m in 2009. Underlying revenue growth was 2%, offset by -3% attributable to unfavourable currency translation.
Orthopaedics revenues decreased by $23m (-1%), of which 1% was attributable to underlying growth, offset by -2% due to unfavourable currency translation. Endoscopy revenues decreased by $9m (-1%), of which 1% was attributable to underlying growth, offset by -2% due to unfavourable currency translation. Advanced Wound Management revenues increased by $3m (nil%), of which 6% was attributable to underlying growth, offset by -6% due to unfavourable currency translation.
A more detailed analysis is included within the Revenue sections of the individual business segments that follow on pages 37 and 38.
Cost of goods sold
Cost of goods sold decreased by $47m to $1,030m from $1,077m in 2008. The main drivers of this decrease are continuing focus on cost efficiency, cost effectiveness and the impact of currency. Other factors contributing to the movement were the decrease of $15m in utilisation of the Plus inventory stepped up to fair value on the acquisition, a decrease of $3m in restructuring and rationalisation expenses, offset by an increase of $4m in other acquisition related costs.
Further margin analysis is included within the Trading profit sections of the individual business segments that follow on pages 37 to 38.
Marketing, selling and distribution expenses
These expenses decreased by $65m to $1,351m from $1,416m in 2008. The decrease was largely driven by continuing focus on cost management, efficiencies achieved through the Earnings Improvement Programme and the impact of currency. These were partly offset by an increase in restructuring and rationalisation expenses of $7m.
Administrative expenses decreased by $13m to $513m from $526m in 2008, largely as a result of the focus on cost management and efficiency and the impact of currency. Other factors contributing to the movement were the decrease of $24m in other acquisition related costs, offset by an increase in the amortisation and impairment charge of intangible assets by $15m and an increase of $4m in restructuring and rationalisation expenses.
Research and development expenses
Expenditure as a percentage of revenue increased by 0.1% to 4.1% in 2009 (2008 4.0%). The Group continues to invest in innovative technologies and products to differentiate itself from competitors.
Operating profit increased by $93m to $723m from $630m in 2008 comprising, increase of $28m in Orthopaedics, $23m in Endoscopy and $42m in Advanced Wound Management.
Net interest payable
Net interest payable decreased by $26m from $66m in 2008 to $40m in 2009. This is a consequence of the overall reduction of borrowings within the Group and a reduction in the applicable interest rates.
Other finance cost
Other finance costs in 2009 were $15m compared to $1m in 2008. This increase is attributable to a decrease in the expected return on pension plan assets.
The taxation charge increased by $11m to $198m from $187m in 2008. The effective rate of tax was 29.6%, compared with 33.2% in 2008.
The tax charge was reduced by $26m in 2009 (2008 $30m) as a consequence of restructuring and rationalisation expenses, acquisition related costs, amortisation of acquisition intangibles and impairments. The effective tax rate was 27.9% (2008 30.6%) after adjusting for these items and the tax thereon. This is a lower rate than expected due to favourable progress in, and resolution of, certain historic issues.
Group Balance Sheet
The following table sets out certain balance sheet data for the years ended indicated:
Non-current assets decreased by $43m to $2,480m from $2,523 in 2008. Intangible assets and goodwill decreased by $60m of which $112m related to the Plus settlement, $92m to amortisation and impairments and $4m to disposals. These were offset by $102m of additions, $15m relating to the acquisition of Nucryst and $31m relating to favourable currency translation. Property, plant and equipment increased by $28m comprising $216m of additions, $30m of favourable currency translation and $6m relating to the acquisition of Nucryst. This was offset by $206m of depreciation charge, $10m of disposals and $8m of assets transferred to held for sale. Deferred tax assets decreased by $12m in the year, primarily due to the decrease in post retirement obligations.
Current assets increased by $86m to $2,071m from $1,985m in 2008. This was due to an increase in inventory of $54m and an increase in cash at bank of $47m. These increases were partially offset by a reduction in trade and other receivables of $15m.
Non-current liabilities decreased by $318m from $1,841m in 2008 to $1,523m in 2009. $268m of this decrease was due to the reduction of long-term borrowings. The net retirement benefit obligation decreased by $28m. This was due to experience gains on plan assets and liabilities totalling $88m. These gains were offset by a $47m increase in the defined obligation attributable to changes in actuarial assumptions and $16m of unfavourable currency movements.
Current liabilities decreased by $105m from $968m in 2008 to $863m in 2009. This was due to a decrease in bank overdrafts and current borrowings of $70m, a decrease in trade and other payables of $11m and decrease in current tax payable of $25m.
Total equity increased by $480m from $1,699m in 2008 to $2,179m in 2009. The principal movements were an increase of $472m due to attributable profit, an increase in currency translation and hedging gains of $62m, an increase of $41m relating to actuarial gains on retirement benefit obligations, offset by $10m relating to deferred taxation and $120m due to dividends paid during the year.
Business Segment Analysis
Revenue by business segment and geographic market and trading and operating profit by business segment are set out below:
Orthopaedics revenue decreased by 1% to $2,135m from $2,158m in 2008. Of this decrease, 1% is attributable to underlying growth and -2% is due to unfavourable currency movements. The principal factors in the underlying growth in revenue were the continuing expansion in global orthopaedic markets and the growth of recently launched products.
In the US, revenue increased by $27m to $1,154m (2%), all of which was due to underlying growth. The main factors were the continued growth of products launched in recent years including the LEGION and JOURNEY knees.
Outside the US, revenue decreased by $50m to $981m (-5%), attributable to unfavourable foreign currency translation of -5% and flat underlying revenue growth.
Global knee revenue increased by $3m to $761m (nil%), representing underlying revenue growth of 3% offset by -3% of unfavourable foreign currency translation.
Global hip revenue decreased by $7m to $681m (-1%) of which 1% was due to underlying revenue growth offset by -2% unfavourable foreign currency translation.
Trading profit increased by $27m (6%) to $508m from $481m in 2008. Trading profit margin increased from 22.3% to 23.8%. This increase is due to good cost management and further investment in improving the efficiency and effectiveness of the main processes, primarily in the cost of sales area.
Operating profit increased by $28m to $410m. This largely comprises the increases in trading profit of $27m. A decrease in acquisition related costs of $35m were offset by increases of $17m in costs associated with Earnings Improvement Programme (EIP) and $17m in the amortisation of acquisition intangibles and impairments.
Endoscopy revenue decreased by $9m, or 1%, to $791m from $800m in 2008, comprising -2% unfavourable currency translation and 1% underlying growth.
In the US, revenue decreased by $23m to $349m (-6%), all of which represents negative underlying growth. This is largely attributable to the decrease in demand for capital equipment due to the current economic market conditions.
Outside the US, revenue increased by $14m to $442m (3%), of which 9% was underlying growth offset by -6% of unfavourable foreign currency translation.
Global revenue of knee and shoulder repair products increased by $13m to $325m (4%), of which 12% was underlying growth offset by -8% unfavourable foreign currency translation.
Revenue in the global resection products sector decreased by $29m to $248m (-11%), of which -2% represents negative underlying revenue growth in addition to -9% of unfavourable foreign currency translation.
Global Visualisation revenue decreased by $29m to $121m (-19%), of which -20% represents negative underlying growth offset by 1% of favourable foreign currency translation.
Trading profit increased by $23m (14%) to $189m from $166m in 2008 resulting in a trading profit margin increase from 20.8% to 23.9%. This improvement was mainly due to a greater focus on managing costs and a favourable product mix benefit.
Operating profit increased by $23m to $169m from $146m in 2008. This comprises the $23m increase in trading profit.
Advanced Wound Management
Revenue increased by $3m, or nil%, to $846m from $843m in 2008, comprising -6% unfavourable currency translation and 6% underlying growth. Within the infection management and exudate management markets, growth was driven by the extension of the Groups ALLEVYN brand to new products.
In the US, revenue increased by $3m to $161m (2%), all of which is attributable to underlying revenue growth.
Outside the US, revenue remained constant at $685m. This is represented by an underlying growth of 7% offset by -7% of unfavourable foreign currency translation. European revenue decreased by 2% of which -8% was unfavourable currency translation and 6% was underlying growth.
Trading profit increased by $31m (24%) to $160m from $129m in 2008 and trading profit margin increased from 15.3% to 18.9%. This improvement was mainly due to a greater focus on cost management and overall process improvement.
Operating profit increased by $42m to $144m. This largely comprises the increase in trading profit of $31m and a reduction of $10m in restructuring and rationalisation costs.
Cash Flow and Net Debt
The main elements of Group cash flow and movements in net debt can be summarised as follows:
The Groups net debt decreased from $1,310m at the beginning of 2008 to $492m at the end of 2010, representing an overall decrease of $818m. Translation of foreign currency net debt into US Dollars had the effect of increasing net debt by $14m in the three-year period ended 31 December 2010. Closing net debt includes no currency swap liabilities (2009 nil, 2008 $4m).
Net Cash Inflow from Operating Activities
Cash generated from operations in 2010 of $1,111m (2009 $1,030m, 2008 $815m) is after paying out $5m (2009 $5m, 2008 $10m) of macrotextured claim settlements unreimbursed by insurers, $nil (2009 $22m, 2008 $48m) of acquisition related costs and $16m (2009 $32m, 2008 $28m) of restructuring and rationalisation expenses.
The Groups ongoing capital expenditure and working capital requirements were financed through cash flow generated by business operations and, where necessary, through short-term committed and uncommitted bank facilities. In recent years, capital expenditure on tangible and intangible fixed assets represented approximately 8% of continuing Group revenue.
In 2010, gross capital expenditure amounted to $315m (2009 $318m, 2008 $292m). The principal areas of investment were the placement of orthopaedic instruments with customers, patents and licences, plant and equipment and information technology.
At 31 December 2010, $15m (2009 $7m, 2008 $27m) of capital expenditure had been contracted but not provided for which will be funded from cash inflows.
Acquisitions and Disposals
In the three-year period ended 31 December 2010, $41m was spent on acquisitions, funded from net debt and cash inflows. This comprised $25m for Nucryst, $14m for BlueSky and $2m for Plus. During 2009, the Group reached an agreement with the vendors of Plus Orthopedics Holdings AG to reduce the total original purchase price to CHF927m. This resulted in an additional cash inflow of $137m.
The Groups policy is to ensure that it has sufficient funding and facilities in place to meet foreseeable borrowing requirements. In December 2010 the Group reviewed and replaced its principal banking facilities ahead of their maturity in May 2012. The Group has reduced its $1,000m 5 year term loan to $500m with effect from 20 December 2010. Smith & Nephew has also cancelled its $1,500m multi-currency revolving loan facility and replaced it with a new 5 year $1,000m multi-currency revolving loan facility.
At 31 December 2010, the Group held $207m (2009 $192m, 2008 $145m) in cash and balances at bank. The Group has committed and uncommitted facilities of $1,511m and $332m respectively. Of the undrawn committed facilities totalling $884m, $7m expires in 2011 and $877m after two but within five years. Smith & Nephew intends to repay the amounts due within one year by using available cash and drawing down on the longer-term facilities. In addition, Smith & Nephew has finance lease commitments of $22m (of which $10m extends beyond five years).
The principal variations in the Groups borrowing requirements result from the timing of dividend payments, acquisitions and disposals of businesses, the share buy-back programme (announced as suspended in November 2008), timing of capital expenditure and working capital fluctuations.
Smith & Nephew believes that its capital expenditure needs and its working capital funding for 2011, as well as its other known or expected commitments or liabilities, can be met from its existing resources and facilities.
The Groups planned future contributions are considered adequate to cover the current under funded position in the Groups defined benefit plans.
Further disclosure regarding borrowings, related covenants and the liquidity risk exposures is set out in Note 19 of the Notes to the Group Accounts. The Group believes that its borrowing facilities do not contain restrictions that would have significant impact on its funding or investment policy for the foreseeable future.
The Groups business activities, together with the factors likely to affect its future development, performance and position are set out in the Description of the Group section on pages 3 to 21. The financial position of the Group, its cash flows, liquidity position and borrowing facilities are described in the Business Review, Liquidity and Prospects section set out on pages 23 to 40. In addition, the notes to the financial statements include the Groups objectives, policies and processes for managing its capital; its financial risk management objectives; details of its financial instruments and hedging activities; and its exposure to credit risk and liquidity risk.
The Group has considerable financial resources and its customers and suppliers are diversified across different geographic areas. As a consequence, the directors believe that the Group is well placed to manage its business risk successfully despite the ongoing uncertain economic outlook.
The directors have a reasonable expectation that the Group has adequate resources to continue in operational existence for the foreseeable future. Thus they continue to adopt the going concern basis for accounting in preparing the annual financial statements.
It is the Groups and Companys policy to ensure that suppliers are paid within agreed terms. At the year-end the Company had no trade creditors.
The Company and its subsidiaries are parties to various legal proceedings, some of which include claims for substantial damages. The outcome of these proceedings cannot readily be foreseen, but with the possible exception of those detailed below, management believes none of them will result in a material adverse effect on the financial position of the Group. The Group provides for outcomes that are deemed to be probable and can be reliably estimated. There is no assurance that losses will not exceed the provision or will not have a significant impact on the Groups results of operations or financial condition in the period in which they are realised.
Product Liability Claims
In August 2003, the Group withdrew voluntarily from all markets the macrotextured versions of its OXINIUM femoral knee components. A number of related claims have been filed, most of which have been settled. The aggregate cost to date related to this matter is approximately $212m. The Group has sought recovery from its insurers.
To date the primary insurance carrier has paid $60m in full settlement of its policy liability. An additional $22m was received from a successful legal settlement. At 31 December 2010, at least $133m remains due, and the Group has sought coverage from five excess insurance carriers. However, these excess carriers have denied coverage, citing defences relating to the wording of the insurance policies and other matters. In December 2004, the Group brought suit against them in the US District Court for the Western District of Tennessee, and trial is expected to commence in 2012.
A charge of $154m was recorded in 2004 for anticipated expenses in connection with macrotexture claims. Most of that amount has since been applied to settlements of such claims. Management believes that the $20m provision remaining is adequate to cover remaining claims. Given the uncertainty inherent in such matters, there can be no assurance on this point.
The Group faces other claims from time to time for alleged defects in its products and has on occasion recalled products to minimise risk of harm or claims. The Group maintains product liability insurance subject to limits and deductibles that management believes are reasonable.
Business Practice Investigations
In March 2005 the US Attorneys Office in Newark, New Jersey issued subpoenas to the five largest sellers of hip and knee implants to US orthopaedic surgeons, including the Groups Orthopaedic business, asking for information regarding arrangements with orthopaedic reconstructive surgeons. In September 2007, the Group (and the other four companies involved) settled the charges that could have resulted from this investigation, without admitting any wrongdoing as part of the settlement. At the same time, the Group entered into a Corporate Integrity Agreement with the Office of the Inspector General (OIG) of the US Department of Health and Human Services which requires certain compliance efforts. This agreement is in effect for five years, until September 2012. If the Group meets its terms, the OIG will not attempt to exclude it from receiving Medicare payments for its products. The Group has devoted substantial effort to comply with this agreement and to enhance its compliance programme across all of its business units.
In September 2007, the SEC notified the Group that it was conducting an informal investigation of companies in the medical devices industry, including the Group, regarding possible violations of the Foreign Corrupt Practices Act (FCPA) in connection with the sale of products in certain foreign countries. The US Department of Justice subsequently joined the SECs request. The Group is cooperating fully with the US Department of Justice and the SEC regarding these matters, has conducted a broader review on its own initiative, and has disclosed to them information indicating that at least one independent distributor of its products may have made payments that could have FCPA implications. The Group is engaged in discussions to resolve these matters which might include a settlement by which the Group would pay certain amounts and submit to compliance reporting and oversight obligations. There is no assurance that a settlement will be reached, however.
Intellectual Property Disputes
The Group is engaged, as both plaintiff and defendant, in litigation with various competitors and others over claims of patent infringement and, in some cases, breach of licence agreement. These disputes are being heard in courts in the United States and other jurisdictions and also before agencies that examine patents. Outcomes are rarely certain and costs are often significant.
Since the Groups entry into the negative pressure wound therapy business in 2007, Kinetic Concepts, Inc. (KCI) has pursued claims of patent infringement against the Group in the US, UK, Germany and other jurisdictions. In one case in the US District Court for the Western District of Texas a jury found that KCIs patents were valid but not infringed by the Group. That ruling was upheld on appeal in February 2009. In a subsequent case in the same court, relating to the Groups foam product, a jury concluded in March 2010 that KCIs asserted patents were valid and infringed. But the court determined the relevant patent claims were invalid and entered judgement in favour of the
Group. KCI has appealed the courts judgement. If KCI were to prevail, the Group could be prevented from selling that foam product in the US until patent expiration in 2014. KCI has also pursued patent infringement claims in certain countries relating to pumps, canisters and other negative pressure wound therapy accessories.
The Group has won jury verdicts against Arthrex Inc., (Arthrex) for infringement of the Groups patents relating to suture anchors (in the US District Court for Oregon) and femoral fixation devices for ACL reconstruction (in the US District Court for the Eastern District of Texas). Arthrex appealed both decisions. The Oregon decision was reversed on appeal and remanded to the District Court for a new trial, scheduled to begin in June 2011.
In a case filed in September 2008 in the US District Court for the Western District of Tennessee against the Group's US subsidiary, three individuals are seeking substantial royalty and other damages in connection with sales of certain products within the Groups Orthopaedics business based on various legal theories including alleged breach of contracts entered into in 1988-1999 and patent infringement. The Group disputes these claims. Trial is expected to commence in 2012.
In April 2009, the Group was served with a subpoena by the US Department of Justice in Massachusetts requiring the production of documents from 1995 to 2009 associated with the marketing and sale of the Groups EXOGEN bone growth stimulator. Similar subpoenas have been served on a number of competitors in the bone growth stimulator market. Around the same time a qui tam or whistleblower complaint concerning the industrys sales and marketing of those products, originally filed in 2005 against the primary manufacturers of bone growth stimulation products (including Smith & Nephew), was unsealed in federal court in Boston, Massachusetts. A motion to dismiss that complaint was denied in December 2010.
In June 2010 the Group was served with another subpoena by the US Department of Justice in Massachusetts requiring the production of documents relating to the distribution of samples of the Groups SUPARTZ joint fluid therapy product.
The Group is subject to country of origin requirements under the US Buy American and Trade Agreements Acts with regard to sales to certain US government customers. The Group has voluntarily disclosed to the US Veterans Administration and the US Department of Defense that a small percentage of the products sold to the US government in the past, primarily from the Orthopaedics business, may have originated from countries that are not eligible for such sales except with government consent. Government auditors subsequently conducted an on-site visit at the Groups Orthopaedics business. In December 2008, three months after our initial voluntary disclosure, a whistleblower suit was filed in the US District Court for Massachusetts alleging these violations. Smith & Nephews motion to dismiss the suit was denied in November 2010.
OUTLOOK AND TREND INFORMATION
The discussion below contains certain forward-looking statements that may or may not prove accurate. For example, statements regarding expected revenue growth and trading margins, market trends and our product pipeline are forward looking statements. Phrases such as aim, plan, intend, anticipate, well placed, believe, estimate, target, consider, and similar expressions are generally intended to identify forward looking statements. Forward-looking statements involve known and unknown risks and uncertainties and other important factors that could cause actual results to differ materially from those projected in forward-looking statements. For Smith & Nephew, these factors include: economic and financial conditions in the markets we serve, especially those affecting health care providers, payors and customers; price levels for established and innovative medical devices; developments in medical technology; regulatory approvals; reimbursement decisions or other government actions; products defects or recalls; litigation relating to patent or other claims; legal compliance risks and related investigative, remedial or enforcement actions; strategic actions, including acquisitions and depositions and our success in integrating acquired businesses; and numerous other matters which affect us or our markets, including those of a political, economic business or competitive nature.
For additional information on factors that could cause the Groups actual results to differ from estimates reflected in these forward-looking statements, can be found under Risk Factors within this document.
Information regarding the recent and longer term market growth trends is given for each of the Groups global business units in the relevant Market and Competition sections under Business Description on pages 4 to 9.
The Group has delivered another strong performance, with the majority of businesses outperforming their respective markets. The current market challenges are well understood. The Group is meeting them by supplying innovative products which offer clinical and cost benefit for our customers and continuing to execute efficiency programmes across our businesses. The long-term growth drivers underpinning the Groups industry including demographics, emerging markets and patients desire to return to an active life remain strong.
During 2011, the Group expects Orthopaedic Reconstruction to grow at above the market rate, as the momentum in our knee franchise is expected to continue. In Orthopaedic Trauma the Group made substantial improvements in 2010 and are committed to sustaining this performance. In Endoscopy the Group expects to achieve above market growth in Arthroscopy (sports medicine), driven by the repair product segment. In Advanced Wound Management the Group believes it will continue to grow at above the market rate.
The Group made further trading margin progress during 2010, achieving a trading profit margin of 23.9% (before the benefit of the BlueSky settlement), and continues to see many areas in our businesses which offer further efficiencies. The Group also sees an increasing number of investment opportunities to drive top line growth, both geographically and in new products. The Group is taking advantage of these opportunities and anticipates that in the short to medium term the cost of these investments will broadly offset our further efficiency savings.
The Group believes it has a clear, balanced, plan for the future, based on the same strategic pillars which have maintained growth and investment during the recent global cyclical downturn, while delivering significant margin improvement. We are confident that, by offering our customers the right product, at the right time with the right value proposition, we are positioned to continue to deliver long term growth.
Contractual obligations at 31 December 2010 were as follows:
Other contractual obligations represent $33m of foreign exchange contracts. Provisions that do not relate to contractual obligations are not included in the above table.
The agreed contributions for 2011 in respect of the Groups defined benefits plans are: $38m for the UK (including $29m of supplementary payments), $30m for the US plan and $7m for other funded defined benefit plans. The table above does not include amounts payable in respect of 2012 and beyond as these are subject to future agreement and amounts cannot be reasonably estimated.
There are a number of agreements that take effect, alter or terminate upon a change in control of the Company or the Group following a takeover, such as bank loan agreements and Company share plans. None of these are deemed to be significant in terms of their potential impact on the business of the Group as a whole. In addition, there are service contracts between the Company and its executive directors which provide for the automatic payment of a bonus following loss of office or employment occurring because of a successful takeover bid. Further details on page 66.
The company does not have contracts or other arrangements which individually are essential to the business.
OFF-BALANCE SHEET ARRANGEMENTS
Management believes that the Group does not have any off-balance sheet arrangements, as defined by the SEC in item 5E of Form 20-F, that have or are reasonably likely to have a current or future effect on the Groups financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources that is material to investors.
RELATED PARTY TRANSACTIONS
Except for transactions with associates (see Note 34 of Notes to the Group Accounts), no other related party had material transactions or loans with Smith & Nephew over the last three financial years.
CORPORATE GOVERNANCE STATEMENT
This section discusses Smith & Nephews structures and governance procedures.
THE BOARD AND EXECUTIVE OFFICERS
The Board of directors of Smith & Nephew as at 23 February 2011 comprised:
John Buchanan, Independent non-executive Chairman. John was appointed independent non-executive Deputy Chairman in 2005 and became Chairman in April 2006 and is Chairman of the Nominations Committee. He is Deputy Chairman of Vodafone Group Plc and a non-executive director of BHP Billiton. He was formerly Group Chief Financial Officer of BP plc.
David J. Illingworth, Chief Executive, joined the Group in May 2002 as President of Orthopaedics and was appointed a director and Chief Operating Officer in February 2006. In July 2007 he was appointed Chief Executive. He is a member of the Nominations Committee. Prior to joining the Group he held posts within GE Medical, as Chief Executive Officer of a publicly traded medical devices company, President of a respiratory/critical care company and President of a technology incubator company. He will be retiring from the Board at the end of the Annual General Meeting to be held on 14 April 2011.
Adrian Hennah, Chief Financial Officer, joined the Group and was appointed a director in June 2006. He was previously Chief Financial Officer of Invensys plc and held various senior positions within GlaxoSmithKline. Adrian will be appointed as a member of the Supervisory Board of Reed Elsevier NV and as a non-executive director of Reed Elsevier PLC, subject to shareholder approval at their respective Annual General Meetings, on 19 and 20 April 2011.
Ian E. Barlow, Independent non-executive director. Ian was appointed a director on 5 March 2010 and is Chairman of the Audit Committee. He is a non-executive director and Chairman of the Audit Committees of the PA Consulting Group and the Brunner Investment Trust, Chairman of Think London and the Racecourse Association and a non-executive director of Candy & Candy. Previously he was Senior Partner, London at KPMG.
Prof. Geneviève B. Berger, Independent non-executive director. Geneviève was appointed a director on 5 March 2010. She is Chief Research & Development Officer at Unilever plc and Unilever NV having previously served as a non-executive director. Previously, she has been Chairman of the Health Advisory Board for the European Commission and a Professor at the University of Paris and Le Pitié-Sapêtrière Teaching Hospital and Director General of the French Centre National de La Recherche Scientifique. Subject to her re-appointment by the shareholders, she will join the Ethics and Compliance Committee on 14 April 2011.
Dr. Pamela J. Kirby, Independent non-executive director. Pamela was appointed a director in March 2002 and is a member of the Remuneration and Ethics and Compliance Committees. She is non-executive Chairman of Scynexis Inc and a non-executive director of Informa plc, Novo Nordisk A/S and Victrex plc. Subject to her re-appointment by the shareholders, she will be appointed Chairman of the Ethics and Compliance Committee on 14 April 2011.
Brian Larcombe, Independent non-executive director. Brian was appointed a director in March 2002 and is a member of the Audit and Remuneration Committees. He is a non-executive director of gategroup Holding AG and Incisive Media Holdings Limited. Previously he was Chief Executive Officer of 3i Group plc.
Joseph C. Papa, Independent non-executive director. Joe was appointed a director in August 2008 and is a member of the Ethics and Compliance, Audit and Remuneration Committees. He is Chairman and Chief Executive of Perrigo Company. Previously he was Chairman and Chief Executive Officer of the Pharmaceutical and Technology Services segment of Cardinal Health Inc., and President and Chief Operating Officer of Watson Pharmaceuticals Inc. Subject to his re-appointment by the shareholders, he will be appointed Chairman of the Remuneration Committee on 14 April 2011.
Richard De Schutter, Independent non-executive director. Richard was appointed a director in January 2001 and is Chairman of the Ethics and Compliance Committee and a member of the Audit, Nominations and Remuneration Committees. He is non-executive Chairman of Incyte Corporation and a non-executive director of Navicure Inc. and Slate Pharmaceuticals. Subject to his re-appointment by the shareholders, he will be appointed Senior Independent Director and cease to be Chairman of the Ethics and Compliance Committee on 14 April 2011.
Dr. Rolf W. H. Stomberg, Independent non-executive director and Senior Independent Director. Rolf was appointed a director in 1998 and is Chairman of the Remuneration Committee and a member of the Audit and Nominations Committees. He is Chairman of Lanxess AG and a non-executive director of Hoyer GmbH, Biesterfeld AG and Severstal OAO. He will cease to be Senior Independent Director and Chairman of the Remuneration Committee on 14 April 2011.
The Chief Executive of Smith & Nephew and other senior executives are responsible for the day-to-day management of the Group. In addition to the executive directors, the following are executive officers of Smith & Nephew:
Naseem Amin, Chief Scientific Officer. Naseem joined the Group in 2009 prior to which he held a number of senior business development and research posts, most recently Senior VP of Business Development at Biogen Idec.
Mark Augusti, President of Biologics & Clinical Therapies. Mark joined the Group in 2003 as Vice President of Global Marketing for the Trauma Division, became President of Orthopaedic Trauma and Clinical Therapies in February 2006 and was appointed to his current role in January 2008. He previously worked for GE Medical Systems in the US and Asia. In 2009 Mark was also appointed to the board of Hutchinson Technology Inc. as an independent director.
John W. Campo, Chief Legal Officer. Jack joined the Group in June 2008. Prior to joining the Group he was employed by General Electric Company for 14 years in a variety of roles, including seven years with GE Healthcare (successor to GE Medical Systems) in the US and Asia.
Joseph DeVivo, President of Orthopaedics. Joe joined the Group in June 2007 as President of Orthopaedic Reconstruction and was appointed to his current role in May 2008. Prior to joining the Group, he held senior executive positions with RITA Medical Systems Inc., Computer Motion Inc. and United States Surgical, a division of Tyco Healthcare.
Michael Frazzette, President of Endoscopy. Mike joined the Group as President of Endoscopy in July 2006. Previously he was President and Chief Executive Officer of a US manufacturer of medical devices and spent 15 years at Tyco Healthcare becoming President of the Patient Care, THC Canada and Health Systems divisions.
R. Gordon Howe, Senior Vice President Global Planning and Development. Gordon joined the Group in 1998, and served in planning and business development roles in the Orthopaedics division. He was appointed to his current role in August 2007. Prior to joining the Group, he held management positions with United Technologies Corporation.
Kelvin Johnson, National Executive of China/President of Emerging Markets. Kelvin joined the Group in 1980 and has held a number of key roles within Smith & Nephew. His role as President of Emerging Markets was expanded during 2010 to lead the Groups increased focus in China. Prior to joining Smith & Nephew, Kelvin worked at the Ford Motor Company.
Roger Teasdale, President of Advanced Wound Management. Roger joined the Group in 1989 and has held a number of key roles in businesses within Smith & Nephew, most recently as Senior Vice President of Advanced Wound Management. Roger was appointed to his current role on 1 May 2009.
Susan Henderson, Company Secretary. Susan joined the Group in May 2009, prior to which she held a number of senior company secretarial positions at Amersham plc and Prudential plc.
The Board continues to be committed to the highest standards of Corporate Governance and this report together with the Directors Remuneration Report explains how the provisions and principles of the FSA Listing Rules, Disclosure & Transparency Rules (DTR), the Combined Code on Corporate Governance (the Code) and the UK Corporate Governance Code (the New Code) have been applied throughout the year. The Companys American Depositary Shares are listed on the NYSE and the Company is therefore subject to the rules of the NYSE as well as the US securities laws and the rules of the SEC applicable to foreign private issuers.
The Board considers that it has complied with all relevant provisions of the Code, the New Code, and the requirements of the SEC and NYSE throughout the year, except that the Nominations Committee is not comprised wholly of independent directors, as required by the NYSE, but consists of a majority of independent directors in accordance with the Code.
With effect from the Annual General Meeting in 2011, all directors will submit themselves for re-election at each Annual General Meeting in accordance with the New Code. Whilst the remaining provisions of the New Code do not currently apply to the Company, the Board considers that it does comply with the provisions of the New Code except that, although the Chairman and entire Board have endorsed and approved this corporate government statement, none of our directors use any part of the annual report to make personal statements.
In accordance with the Code, the following paragraphs describe Smith & Nephews Corporate Governance policies and procedures and how it applies the main Principles set out in section one of the Code.
The Board of directors of Smith & Nephew consists of a non-executive Chairman, two executive directors and seven independent non-executive directors. In 2010, the Board met on 10 occasions and individual attendance together with attendance at Board Committee meetings, is shown in the table on page 53. In addition to formal Board meetings, informal telephone updates are held between Board meetings to ensure that directors are kept up to date with matters affecting the Group.
Geneviève Berger and Ian Barlow joined the Board as independent non-executive directors on 5 March 2010.
On 10 February 2011, it was announced that Olivier Bohuon will be joining the Board as an Executive Director on 1 April 2011. He will offer himself for re-election by the shareholders at the Annual General Meeting and, subject to his re-appointment, will assume the position of Chief Executive Officer at the conclusion of the Annual General Meeting on 14 April 2011. David Illingworth will retire from the Board at the conclusion of the Annual General Meeting.
The Scope of the Board
The Board is responsible for the strategic direction, overall management of the Group and the long-term success of the Company. There is a formal schedule of matters reserved for its decisions which include the approval of certain policies, budgets, financing plans, large capital expenditure projects, acquisitions, divestments and treasury arrangements. Otherwise, it delegates the executive management of the Group to the Chief Executive and certain specific responsibilities to Board Committees, as described on pages 50 to 53. It reviews the key activities and performance of the businesses and considers and reviews the work undertaken by the Committees. Succession planning is regularly reviewed and appropriate measures are taken to ensure the Board has the appropriate balance of skills and experience necessary for a major global medical devices company.
Non-executive directors meet regularly prior to each Board meeting without management in attendance. The Senior Independent Director meets with the other non-executive directors annually to evaluate the performance of the Chairman. All directors have access to the advice and services of the Company Secretary, who is also responsible to the Board for ensuring that board and governance procedures are complied with. The appointment and removal of the Company Secretary is a matter for the Board as a whole. Board members individually and Board Committees may obtain independent professional advice, at the Companys expense, where they judge it necessary in order to fulfil their responsibilities as directors. If directors are unable to attend a Board meeting or Board Committee meeting, they are advised of matters to be discussed and have an opportunity to make their views known to the Chairman or the Chairman of the relevant Committee prior to the meeting.
The Role of Individual Directors
Whilst the Chairman and Chief Executive collectively are responsible for the leadership of the Group, there is a clear division of respective responsibilities which has been agreed by the Board. The Chairmans primary responsibility is leading the Board including setting its agenda and ensuring its effectiveness, by encouraging constructive challenge. The Chief Executive is responsible for the performance, management and supervision of the Group in accordance with the strategy, policies, budgets and business plans approved by the Board. The Senior Independent Director is currently Rolf Stomberg, whose role includes consulting with members of the Board on issues relating to the Chairman and chairing meetings of the Nominations and Audit Committee in the absence of the Chairman or Chairman of the Audit Committee. He is available to shareholders if they have concerns that cannot be resolved through the normal channels of contact with the Chairman or Chief Executive. Rolf Stomberg will cease to be the Senior Independent Director on 14 April 2011, when Richard De Schutter will, subject to his re-appointment by shareholders, be appointed in his place. The role of the independent non-executive directors is to provide constructive challenge and to help develop proposals on strategy.
Independence of Non-Executive Directors
The Board has determined that all the non-executive directors are independent in accordance with UK and US requirements. None of the non-executive directors or their immediate families has ever had a material relationship with the Group either directly as an employee or as a partner, shareholder or officer of an organisation that has a relationship with the Group. They do not receive additional remuneration apart from directors fees, do not participate in the Groups share option plans or performance related pay schemes, and are not members of the Groups pension schemes nor do they serve as a director of a company or an affiliate in which any other director of Smith & Nephew is a director.
The Board recognises that a number of the independent non-executive directors have served on the Board for a period of time that might be considered to impact on their independence. The Board has thoroughly considered the independence of each of these long serving directors (Rolf Stomberg, Richard De Schutter, Pamela Kirby and Brian Larcombe) and has concluded that each continues to provide effective challenge both within and outside Board meetings. In 2010, Ian Barlow and Geneviève Berger were appointed non-executive directors on 5 March 2010, and the search for additional directors continued throughout 2010 and into 2011. It is intended that as and when new directors are appointed and have spent some time settling into the Company, some of the longer serving non-executive directors will step down. The Board believes that to provide continuity, it is useful for some non-executive directors to remain on the Board to assist in the period of transition.
Management of Conflicts of Interest
None of the directors or their connected persons has any family relationship with any other director or officer nor has a material interest in any contract to which the Company or any of its subsidiaries are or were a party during the year or up to 23 February 2011.
Each director has a duty under the Companies Act 2006 to avoid a situation in which he or she has or can have a direct or indirect interest that conflicts or possibly may conflict with the interests of the Company. This duty is in addition to the existing duty that a director owes to the Company to disclose to the Board any transaction or arrangement under consideration by the Company. The Companys articles of association permit directors to authorise conflicts and potential conflicts in accordance with the Companies Act 2006 and to approve such situations. Directors inform the Board of any situations which may give rise to a conflict of interest as they arise and this information is recorded in the Companys Register of Conflicts together with the date on which authorisation was given. On an annual basis, directors certify that the information contained in the register is correct. The Board has a procedure when deciding whether to authorise a conflict or potential conflict of interest. Firstly, only directors who have no interest in the matter under consideration are able to take the relevant decision. Secondly, in taking the decision the directors must act in a way they consider, in good faith, will be most likely to promote the Companys success. In addition, the directors may impose limits or conditions when giving authorisation if they think this is appropriate. During the year, one director identified situations which could give rise to conflicts of interest. Each of these situations was authorised by the Board, although no actual conflicts were identified.
Re-appointment of Directors
Under the Companys articles of association, any director who has been appointed by the Board since the previous Annual General Meeting of shareholders, either to fill a casual vacancy or as an additional director, holds office only until the conclusion of the next Annual General Meeting at which they are eligible for re-appointment by the shareholders. In accordance with the New Code, with effect from the Annual General Meeting to be held in 2011, all directors will retire with effect from the conclusion of each Annual General Meeting and offer themselves for re-election at that meeting. However, David Illingworth will not seek re-election at the Annual General Meeting to be held on 14 April 2011. The directors are subject to removal with or without cause by the Board or the shareholders.
Board Development Programme
A number of training and development opportunities were identified for the Board during 2010. As in previous years, training focused mainly on increasing the Boards understanding of the business and markets in which the Company operates. Throughout the year, each global business unit presented to the Board on its business and the current challenges it faced. These themes were explored in greater depth during the two day Strategy Review held in September. In November, the Board visited the headquarters of the Endoscopy business based in Andover, Massachusetts, meeting with the senior management team and major customers and receiving presentations on our products and processes. Two formal Board development sessions were also held which gave the Board technical briefings on, amongst other things, UK corporate governance requirements, the UK Bribery Act and remuneration trends and governance matters. Tailored induction programmes were also held for Geneviève Berger and Ian Barlow who joined the Board in 2010. These programmes included a series of site visits to some of our principal sites and one to one meetings with members of the senior management teams in the global business units and head office functions. All directors are encouraged to visit our principal sites and to meet with key members of staff to gain a more detailed understanding of particular areas of interest. The Chairman continues to keep the training and developmental needs of each director under review.
Review into the Effectiveness of the Board
Towards the end of 2010, the Board undertook a review of its effectiveness and the effectiveness of its key Committees. The review was led by the Chairman and facilitated by the Company Secretary and took the form of a series of one to one discussions between the Company Secretary and individual Directors. These discussions focused on certain areas identified in the previous effectiveness review.
The review concluded that the Board operated well under the effective leadership of the Chairman. There was constructive debate within the Boardroom and directors were kept well advised of and consulted on relevant matters arising between meetings. The Board welcomed the opportunity to meet and engage with members of the management team at site visits and at the Strategy Review. The Effectiveness Review recognised that a number of improvements had been made to processes and communications during the year and has identified further improvements to be made throughout 2011.
Committees of the Board
The Board is assisted by the Audit, Remuneration, Nominations and Ethics and Compliance Committees, each of which has its own terms of reference, which may be found on the Groups website at www.smith-nephew.com. The Company Secretary or her designate is secretary to each of the Committees. For each of the Committees the Chairman of the Committee reports orally to the Board and minutes of the meetings are circulated to all members of the Board.
The principal duties of the Audit Committee are:
The members of the Audit Committee are Ian Barlow (Chairman and designated financial expert), Brian Larcombe, Richard De Schutter, Rolf Stomberg and Joseph Papa. Warren Knowlton served as Chairman of the Audit Committee up to 6 May 2010, when he retired from the Board. All members of the Audit Committee are considered to be independent in accordance with the Code and are qualified as financial experts as defined by the DTR, SEC and NYSE rules. The Chairman, Chief Executive and the Chief Financial Officer attend meetings of the Audit Committee by invitation but are not members of the Audit Committee.
The Audit Committee met five times during the year including discussions with the auditors, without management present.
For 2010, the Audit Committee considered quarterly reporting, the preliminary results and the Annual Report. Due consideration was given to compliance with accounting standards, appropriate accounting policies and practices, accounting and reporting issues, going concern assumptions and Section 404 of the Sarbanes-Oxley Act. The Audit Committee has also reviewed the appropriateness of the Groups principal accounting policies, practices and judgments, including the identification of critical accounting policies which are those requiring the most use of managements judgment which includes the valuation of inventories, impairment review of goodwill, intangible and tangible assets and the valuation of retirement benefits, contingencies and provisions. The Audit Committee also received a presentation from the Group Treasurer. During the year, the Audit Committee additionally took on responsibility for monitoring controls that mitigate quality management system risk.
During the year, no concerns were raised with the Audit Committee about possible improprieties in matters of financial reporting or other matters.
The Audit Committee reviewed the activities of the Internal Audit department, its programme of work and resourcing requirements. Specific activities of the Internal Audit department include; review of the internal controls over financial reporting (compliance with Section 404 of the Sarbanes Oxley Act), assessing the operating effectiveness of the risk management process and review of other internal control processes, including regulatory compliance, quality management systems and the prevention and detection of fraud. The Audit Committee reviewed the Groups approach to internal financial control, its processes, outcomes and disclosures and considered the Groups risk management processes.
The Audit Committee also reviewed the work of the external auditors, Ernst & Young LLP, and received reports on the scope and outcome of the annual audit and managements response. These reports included accounting matters, governance and control and accounting developments. In addition, the Audit Committee reviewed the audit, audit-related, tax and other services provided by the external auditors and ensured that all services provided by the external auditors were pre-approved in accordance with the Auditor Independence policy explained in greater detail on page 55. As part of the review into the services provided by the auditors, the Audit Committee reviewed the independence, objectivity and effectiveness of the external auditors and was satisfied that it was appropriate to recommend to the Board their reappointment.
The members of the Remuneration Committee are Rolf Stomberg (Chairman), Pamela Kirby, Brian Larcombe (appointed to the Remuneration Committee on 7 September 2010), Richard De Schutter and Joseph Papa. Warren Knowlton also served on the Remuneration Committee up to 6 May 2010, when he retired from the Board. With effect from 14 April, Rolf Stomberg will cease to be Chairman of the Remuneration Committee and Joseph Papa will, subject to his re-appointment by the shareholders, be appointed Chairman in his place. All members of the Remuneration Committee are considered to be independent in accordance with the Code, the New Code and SEC and NYSE requirements.
The Remuneration Committee met four times during the year. The principal duties of the Remuneration Committee are reviewing:
The activities of the Remuneration Committee throughout 2010 are described in greater detail in the Directors Remuneration Report on pages 59 to 71.
The members of the Nominations Committee are John Buchanan (Chairman), David Illingworth, Rolf Stomberg and Richard De Schutter. Rolf Stomberg and Richard De Schutter are considered to be independent in accordance with the Code, the New Code and SEC and NYSE requirements. David Illingworth will cease to be a member of the Nominations Committee when he retires from the Board on 14 April 2011 and Olivier Bohuon will, subject to his re-appointment by the shareholders, be appointed in his place.
The Nominations Committee met eight times during the year and those meetings were attended by all members.
The principal duties of the Nominations Committee are:
The principle work of the Nominations Committee in 2010 was to search for a Chief Executive Officer to replace David Illingworth, who had indicated his desire to retire as and when a suitable successor could be found. A thorough search was undertaken using the services of an external firm of headhunters and internal candidates were also considered. A number of meetings were held to define the role and the type of Chief Executive Officer required, to discuss potential candidates and, in 2011, finally to consider making a recommendation to the Board to appoint Olivier Bohuon.
The Nominations Committee also continued the process commenced in 2009 to search for new non-executive directors, recognising that a number of non-executive directors have served on the Board for periods of time which could give rise to questions about their continued independence. Ian Barlow and Geneviève Berger were appointed to the Board as non-executive directors in March 2010. The search however has continued for additional directors to fit the profiles prepared by the full Board in 2009. The services of a headhunting firm were utilised in this process and whilst a number of candidates were considered, no further appointments were made. The search will continue into 2011.
Should the need arise, the Senior Independent Director would oversee the process for the appointment of a new Chairman.
Ethics and Compliance Committee
The members of the Ethics and Compliance Committee are Richard De Schutter (Chairman), Pamela Kirby and Joseph Papa. All members of the Committee are considered to be independent in accordance with the Code, the New Code and SEC and NYSE requirements. David Illingworth, Chief Executive, attends every meeting. With effect from 14 April 2011, subject to their re-appointment by shareholders, Pamela Kirby will replace Richard De Schutter as Chairman of the Ethics and Compliance Committee and Geneviève Berger will join the Committee as an additional member.
The Ethics and Compliance Committee met four times during the year.
The principal duties of the Ethics and Compliance Committee are:
During the year, the Ethics and Compliance Committee has:
Board and Committee Attendance
The table below details attendance of directors at Board and Committee meetings held throughout the year:
From time to time directors also attend Committee Meetings at the invitation of the Committee Chairman even if they are not members of the Committee in order to gain a better understanding of the activities of the Committee.
Liaison with Shareholders
The executive directors meet regularly with investors to discuss the Companys business and financial performance both at the time of the announcement of results and at industry investor events. During 2010, the executive directors held meetings with institutional investors, including investors representing approximately 54% of the share capital as at December 2010. As part of this programme of investor meetings, during 2010, John Buchanan, the Chairman, met with investors representing 11% of the share capital. Over the last three years, he has met investors representing in aggregate 35% of the share capital. The Companys website (www.smith-nephew.com) contains information of interest to both institutional investors and private shareholders, including financial information and webcasts of the results presentations to analysts for each quarter, as well as specific information for private shareholders relating to the management of their shareholding.
Directors Indemnity Arrangements
Appropriate directors and officers liability insurance is in place and Deeds of Indemnity have been entered into between the Company and directors and certain directors of some subsidiary companies. The Deeds of Indemnity allow for indemnification of directors in respect of proceedings brought by third parties and for the Company to provide funds for directors ongoing costs in defending a legal action as they are incurred rather than after judgement has been given. Individual directors would still be liable to pay any damages awarded to the Company in an action against them and to repay their defence costs to the extent funded by the Company if their defence were unsuccessful.
As at 23 February 2011, the Companys total issued share capital with voting rights consisted of 892,091,804 Ordinary Shares of 20 US cents each. 61,720,798 Ordinary Shares are held in treasury and are not included in the above figure.
As at 23 February 2011, notification had been received from the undernoted persons under the DTR in respect of interests in 3% or more of the issued Ordinary Shares of the Company.
Other than disclosed above, the Company is not aware of any person who has a significant direct or indirect holding of securities in the Company and is not aware of any persons holding securities which may control the Company. There are no securities in issue which have special rights as to the control of the Company.
The Board has proposed a final dividend of 9.82 US cents per share which, together with the first interim dividend of 6.00 US cents, makes a total for 2010 of 15.82 US cents. The final dividend is expected to be paid, subject to shareholder approval, on 19 May 2011 to shareholders on the register of Members at the close of business on 3 May 2011.
Annual General Meeting
The Companys Annual General Meeting is to be held on 14 April 2011 at 2pm at The Royal Society, 6-9 Carlton House Terrance, London, SW1Y 5AG. Notice of the meeting has been sent to all registered shareholders with an accompanying letter from the Chairman.
The Directors Report includes the following sections; Description of the Group (pages 3 to 21), Business Review, Liquidity and Prospects (pages 23 to 44), Corporate Governance Statement (pages 45 to 57), Directors Remuneration Report (pages 59 to 71) and Investor Information (pages 135 to 142).
Corporate Headquarters and Registered Office
The corporate headquarters is in the UK and the registered office address is: Smith & Nephew plc, 15 Adam Street, London WC2N 6LA, UK. Registered in England and Wales No. 324357. Tel: +44 (0) 20 7401 7646. Website: www.smith-nephew.com.
Internal Control and Risk Management
The Board has overall responsibility for ensuring that the Group maintains an adequate system of internal control and risk management and for reviewing its effectiveness. The Internal Audit function and the Group Risk Committee consider and test effectiveness and report to the Audit Committee and to the Board respectively on their findings. The Board has reviewed the system of internal control, including financial control for the year ended 31 December 2010 and up to the date of approval of this Annual Report and Accounts. The Groups system of internal control is designed to manage rather than eliminate the risk of failure to achieve business objectives, and can only provide reasonable and not absolute assurance against material misstatement or loss.
The members of the Risk Committee are the executive directors, certain senior executives and the Company Secretary. The Chairman of the Committee is the Chief Executive. As an integral part of planning and review, the management of each of the Global Business Units identifies the risks involved in their business, the probability of those risks occurring, the impact if they do occur and the actions being taken to manage and mitigate those risks. The Risk Committee meets twice a year to review the major risks identified by the Global Business Units and any mitigating actions being taken. As appropriate, the Risk Committee may re-categorise risks or require further information or mitigating action to be undertaken. The Risk Committee reports to the Board on an annual basis detailing all significant risks categorised by potential financial impact on profit and share price and by likelihood of occurrence. Details of new, key or significantly increased risks along with actions put in place to mitigate such risks are reported to the Board as appropriate. The principal risks identified through this process are detailed in Risk Factors to be found on pages 18 to 21.
The activities of the Audit Committee are described in greater detail in pages 50 to 51.
The Audit Committee reviews the Groups approach to internal financial control and the operation of the risk management process. During 2010, the effectiveness of the Global Business Units systems to identify and manage material risks was evaluated and the findings were reported to the Audit Committee. No material weaknesses were identified in these systems.
Auditor Independence Policy
The Audit Committee has adopted an Auditor Independence Policy which forms part of the Committees Terms of Reference. This policy governs the conduct of non-audit work by the external auditors. This prohibits the auditors from performing services which would result in the auditing of their own work, participating in activities normally undertaken by management, acting as advocate for the Group and creating a mutuality of interest between the auditors and the Group, for example being remunerated through a success fee structure. Each year, the Audit Committee pre-approves the budget for fees relating to audit and non-audit work, including taxation services, in accordance with a listing of particular services. In the event that limits for these services are expected to be exceeded or the Group wants the external auditors to perform services that have not been pre-approved, approval by the Chairman of the Audit Committee is required, together with a notification to the Audit Committee of the service and the fees involved. All services provided by the independent auditors during the year were pre-approved by the Audit Committee.
The Auditor Independence Policy also governs the policy regarding the audit partner rotation in accordance with the Auditing Practices Board Ethical Standards in the UK and the SEC rules in the US. Partners and senior audit staff may not be recruited by the Group unless two years have expired since their previous involvement with the Group.
Managements Report on Internal Control over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934.
Because of inherent limitations, internal controls over financial reporting may not prevent or detect all mis-statements. In addition, projections of any evaluation of effectiveness in future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In accordance with the requirement in the US under s404 of the Sarbanes-Oxley Act, management assessed the effectiveness of the Groups internal control over financial reporting as at 31 December 2010. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organisations of the Treadway Commission in Internal Control-Integrated Framework. Based on its assessment, management has concluded and hereby reports that, as at 31 December 2010, the Groups internal control over financial reporting is effective based on those criteria.
Ernst & Young LLP, an independent registered public accounting firm, has issued an audit report on the Groups internal control over financial reporting as of 31 December 2010. This report appears on page 79.
There has been no change in the Groups internal control over financial reporting during the period covered by this Annual Report that has materially affected, or is reasonably likely to materially affect, the Groups internal control over financial reporting.
Disclosures Committee and Evaluation of Disclosure Controls and Procedures
The Disclosures Committee is chaired by the Chief Executive and comprises the Chief Financial Officer and various additional senior executives. The secretary is the Company Secretary or her designate. The Committee meets as required and approves the release of all major communications to investors, to the UK Listing Authority and the London and New York Stock Exchanges.
The Chief Executive and Chief Financial Officer have evaluated the effectiveness of the design and operation of the Groups disclosure controls and procedures as at 31 December 2010. Based upon, and as at the date of that evaluation, the Chief Executive and Chief Financial Officer concluded that the disclosure controls and procedures were effective.
Code of Conduct
The revised Code of Conduct approved by the Ethics and Compliance Committee was issued to all employees during 2010. The Code of Conduct sets out the basic legal and ethical principles for carrying out business and applies both to employees and those who act on the Groups behalf. It sets out in detail how persons covered by the Code of Conduct are expected to interact ethically with healthcare professionals and government officials. It also covers the broader issues of ethics and compliance throughout the business and includes a code of business principles. A copy of the Code of Conduct can be found on the Groups website (www.smith-nephew.com).
The Code of Conduct includes a whistle blowing policy which enables persons in all jurisdictions where the Group operates to contact the Group anonymously through an independent provider. All calls and contacts are investigated and the appropriate action taken, including reports to senior management or the Board where warranted.
Code of Ethics for Senior Financial Officers
The Board of directors has adopted a Code of Ethics for senior financial officers, which is available on the Groups website (www.smith-nephew.com) and on request. It applies to the Chief Executive, Chief Financial Officer, Group Financial Controller and the Groups senior financial officers. There have been no waivers to any of the Codes provisions nor any amendments made to the Code during 2010 or up until 23 February 2011.
Principal Accountant Fees and Services
Fees for professional services provided by Ernst & Young LLP, the Groups independent auditors in each of the last two fiscal years, in each of the following categories were:
Audit fees include fees associated with the annual audit and local statutory audits required internationally. A more detailed breakdown of audit fees may be found in Note 35 of the Notes to the Group Accounts.
Disclosure of Information to the Auditors
In accordance with Section 418 of the Companies Act 2006, the directors serving at the time of approving the Directors Report confirm that, to the best of their knowledge and belief, there is no relevant audit information of which the auditors, Ernst & Young LLP, are unaware and the directors also confirm that they have taken reasonable steps to be aware of any relevant audit information and, accordingly, to establish that the auditors are aware of such information.
Ernst & Young LLP have expressed their willingness to continue as auditors and resolutions proposing their reappointment and to authorise the directors to determine their remuneration will be proposed at the Annual General Meeting as approved by the Audit Committee.
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DIRECTORS REMUNERATION REPORT
The Directors Remuneration Report (the Report) has been prepared in accordance with The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008 (the Regulations) and meets the relevant requirements of the Financial Services Authority (FSA) Listing Rules. As required by the Regulations, a resolution to approve the Report will be proposed at the Annual General Meeting on 14 April 2011.
The Remuneration Committee Membership and Meetings
The members of the Remuneration Committee are Rolf Stomberg (Chairman) Pamela Kirby, Brian Larcombe (appointed to the Remuneration Committee on 7 September 2010), Joseph Papa and Richard de Schutter. Warren Knowlton also served as a member of the Remuneration Committee up to 6 May 2010, when he retired from the Board. With effect from 14 April 2011, Rolf Stomberg will cease to be Chairman of the Remuneration Committee and will be replaced by Joseph Papa. All members of the Committee are non-executive directors and are considered by the Board to be independent in accordance with the Combined Code, the UK Corporate Governance Code and the requirements of the SEC and the NYSE. The Company Secretary acts as secretary to the Remuneration Committee.
The Remuneration Committee met four times during the year and each meeting was attended by all members. In addition, the Remuneration Committee agreed on certain resolutions by e-mail when unable to meet physically.
At the request of the Remuneration Committee, the Chairman, John Buchanan, the Chief Executive, David Illingworth and various members of the Human Resources function were invited to attend meetings of the Remuneration Committee throughout the year. David Illingworth and the Human Resources function advise the Remuneration Committee on all aspects of the Groups reward structures and policies and John Buchanan offers a valuable perspective given his experience on the Boards of other companies. None of these directors or officers is present for any discussion concerning their own remuneration.
During the year, the Remuneration Committee received information from a number of independent consultants appointed by the Company: Deloitte LLP on a broad range of remuneration issues and on long-term incentive plan comparative performance and Towers Watson and Mercer Limited on salary data when considering base salaries of executive directors and executive officers. Deloitte LLP also provided taxation advice to the Group, while Towers Watson and Mercer Limited have provided general salary data and advised on various compensation matters below Board level. None of these advisors advised any director in respect of their own remuneration.
The Role of the Remuneration Committee
The terms of reference of the Remuneration Committee are available on the Groups website at www.smith-nephew.com.
The Remuneration Committee reviews:
The remuneration policy as approved by the Remuneration Committee and the Board is designed to ensure that remuneration is sufficiently competitive to attract, retain and motivate executive directors and executive officers of a calibre that meets the Groups needs to achieve its business objectives. The policy is designed to ensure that remuneration is firmly linked with the success of the Group and achievement against the Groups key performance indicators, so that executive directors and executive officers are suitably incentivised to generate long-term and sustainable value for shareholders.
The Remuneration Committee has responsibility for determining the individual remuneration packages for the executive directors and executive officers of the Company, as detailed on page 51 of this Annual Report. In determining these remuneration packages, the Remuneration Committee has regard to the levels of pay and the structure of remuneration packages across the entire Group. The shape of the remuneration packages for the executive directors and executive officers is broadly similar to the remuneration packages for other
executives in the Group. The salary levels and multiples used in the various incentive plans differ according to level of seniority. This is explained in greater detail within the discussion on each incentive plan.
Across the Group, base pay and benefits are referenced to median competitive levels for acceptable performance whilst incentive plans, both short and long-term, are designed to motivate and reward out-performance. Total remuneration packages are benchmarked by reference to appropriate UK and US companies and where relevant other local markets. Individual remuneration levels are based on measurable performance against fair and open objectives and there are no automatic pay adjustments unless required by law or local protocol.
The policies described in this Report have been applied throughout 2010 and it is intended that they will continue to apply throughout 2011. The Remuneration Committee will however continue to monitor its policies against evolving market practice and relevant guidance which is particularly relevant in the current economic climate.
The Remuneration Committee has a policy to consult with the Companys major shareholders and relevant stakeholders prior to implementing any significant change to the remuneration policy and places great value in developing a transparent relationship on such matters.
Principal Components of Remuneration
The remuneration package for the Companys senior executives, which includes the executive directors and executive officers, comprises the following elements:
As disclosed in last years Report, a full and detailed review of remuneration arrangements was carried out in 2009. A further detailed review was therefore not considered to be appropriate in 2010 as the Remuneration Committee wanted the opportunity to assess the effectiveness of the changes introduced in 2009, some of which were only implemented in 2010. During 2010 therefore, the Remuneration Committee continued to have regard to the latest developments in the economic and corporate governance environment, but proposed no further change to the overall structure of remuneration packages. The Remuneration Committee continues to aim for incentive arrangements which are firmly linked to the long-term success of the business and based on balanced measures of corporate performance. The Remuneration Committee believes that the changes implemented in 2009 and retained in 2010 continue to meet these objectives.
a) Base Salary and Benefits
Across the Group, base salary is determined both by the scope and the responsibility of the position and performance potential of the individual. Salaries are reviewed annually with effect from 1 April each year. Base salary is benchmarked by reference to the median for the relevant geographic market and employees are paid in a currency related to their home market. The Group also provides certain benefits such as private healthcare and a company car or allowance in line with competitive practice for the applicable geographic market. The Remuneration Committee also considers any pension consequences and costs to the Company when determining base salary increases for executive directors and executive officers.
With effect from 1 April 2010, the Remuneration Committee agreed the following base salaries for the executive directors:
Following the annual review conducted in February 2011, the Remuneration Committee determined that with effect from 1 April 2011, David Illingworths base salary would remain unchanged in view of his impending retirement on 10 August 2011.
Adrian Hennah continues to make, what the Board considers, an excellent contribution as Chief Financial Officer. During 2010, he additionally took on responsibility for a number of significant aspects of the day to day handling of operational matters, beyond the remit of a conventional Chief Financial Officer. In particular:
He also continues to deliver outstanding individual performance and contribution to the Group. Following a review of market positioning and in light of his enhanced role, the Remuneration Committee believes that a re-rating of his base salary is appropriate. With effect from 1 April 2011, his base salary will therefore be £580,000, which is an increase of 9.4%.
On 10 February 2011, the appointment of Olivier Bohuon as an Executive Director from 1 April 2011 and Chief Executive Officer with effect from 14 April 2011 was announced. Olivier Bohuons base salary will be 1,050,000. Further details of his remuneration package are disclosed on page 66.
In common with our practice across the Group, the executive directors are each paid in their home currency.
The committee is mindful of salary increase for all employees when considering salaries for executive directors.
Average salary increases across the Group as a whole in 2011 will range between 2.5% and 3%.
b) Annual Incentive with Deferred Element under the Deferred Bonus Plan
An Annual Incentive Plan is operated across the Group. The plan is designed to encourage outstanding performance without promoting excessive risk taking in order to achieve a short term incentive opportunity.
Senior executives also participate in the Deferred Bonus Plan under which a proportion of their annual incentive (dependent upon their seniority in the organisation) is compulsorily deferred into shares which vest in equal annual tranches over three years, subject to the participants continued employment. No further performance conditions apply to these deferred shares. The Deferred Bonus Plan is designed to encourage executives to build up and maintain a significant shareholding in the Company to encourage them to behave and act like shareholders.
Executive directors and officers participate in the same Annual Incentive Plan and Deferred Bonus Plan although the targets and maximum levels are different reflecting their differing roles and levels of responsibility.
During 2010, the maximum annual incentive opportunity for executive directors was 150% of annual base salary with an incentive of 100% for on target performance. For executive officers, the maximum annual incentive opportunity was 140%. A proportion of the annual incentive earned at and above target is compulsorily deferred into shares as explained above. For executive directors, the amount deferred is one third and for executive officers it is one quarter. The maximum cash incentive opportunity is therefore 100% of salary for executive directors. There is no deferral of incentive for below target level performance. The maximum and target incentive awards for executive directors will remain unchanged in 2011.
The performance measures for the Annual Incentive Plan are linked to the four strategic pillars for success set out on page 4 of this Annual Report:
From these four strategic pillars, a scorecard has been developed for each Global Business Unit, which identifies the strategic imperatives for each part of the business. Employees across the Group have performance objectives which link into the business scorecard and ultimately into these four strategic pillars.
The incentive bonus in 2010 for executive directors was subject to performance measures relating to revenue (30% of incentive), trading profit/margin (30%) and trading cash flow (15%). The remaining 25% of the incentive payable was dependent on personal objectives. In respect of 2010, the annual incentives earned by the executive directors were as follows:
Over the period, underlying revenue growth was 4%, underlying trading profit growth was 11%, trading margin improved by 180 bps and trading profit to cash conversion was 85%. Collectively, these performance measures triggered 60.5% of the maximum incentive and personal objectives triggered 25% of the maximum incentive for David Illingworth and 25% of the incentive for Adrian Hennah.
In 2011, the Annual Incentive Plan will remain linked to the four strategic pillars for success and the business scorecard. The performance measures will comprise revenue (30%), trading profit (30%) and trading cash flow (15%). The remaining 25% of the total incentive will be dependent on individual personal objectives.
c) Long-Term Incentives
The Group operates two main long-term incentive plans for executive directors: the 2004 Performance Share Plan and the 2004 Executive Share Option Plan. Annual awards of 150% of salary are made under the 2004 Performance Share Plan and annual grants of options at 100% of salary are made under the 2004 Executive Share Option Plan. In addition, there are some outstanding awards that were made under legacy plans no longer in operation. Performance shares are also awarded and options granted to executive officers and other senior executives under the 2010 Global Share Option Plan which was approved by shareholders in 2010.
(i) 2004 Performance Share Plan (PSP)
Under the 2004 Performance Share Plan, awards over shares are currently made to executive directors in the second half of the year. Awards are made to executive officers and other senior executives at the same time under the Global Share Plan 2010 and further details of this plan are given below.
The initial market value of awards made to executive directors in 2010 was equivalent to 150% of their base. The Remuneration Committee has agreed that for 2011 the level of these awards will remain the same.
Share awards under the 2004 Performance Share Plan will only vest if pre-determined levels of EPSA growth are achieved. In addition, in order to drive enhanced shareholder value and maintain close alignment of executive and shareholder interests, the number of shares delivered to executives may be increased subject to the achievement of superior Total Shareholder Return (TSR) measured against the major companies in the medical devices industry. There is no retesting. The Remuneration Committee believes that the combination of EPSA and TSR measures encourages executives to achieve outstanding performance both in absolute terms looking at the EPSA measurement and also in relative terms compared to our peers looking at the TSR measurement.
A relative EPSA measure was used for awards made in 2009 and 2010. The targets for growth in EPSA are related to growth of relevant markets, taking into account both volume and price changes in each of our major markets, and weighted according to our relative turnover in each of those markets to provide an estimate of global market growth calculated on an annual basis for each year of the plan. The actual EPSA growth over the three years will then be compared to the compounded EPSA growth targets to calculate the level of vesting. Global market growth is derived from a range of publicly available sources including individual competitor company press releases, quarterly results and analyst reports, as well as data purchased from a variety of industry surveys.
The following table sets out the performance measure used for awards made in 2010.
None of the award will vest if the growth in EPSA over three years is less than Threshold and the award will vest pro rata on a straight line basis between the points given in the table above if growth in EPSA is between these levels.
If the Companys TSR is positioned above median when compared with the TSR of medical devices companies, then the number of vested shares delivered to participants following the achievement of the EPSA targets will be increased by a multiplier as follows: