Keep An Eye On Smith & Nephew plc & Shire plc Now!

Smith & Nephew (LSE: SN) has lost 7.5% of value in less than a day after US rival Stryker announced a $2bn stock buyback programme. That shouldn’t have come as a surprise — I did warn you earlier this year, after all. 

While Stryker may abandon its ambitious plan to buy the UK medical device maker, weakness in Smith & Nephew stock indicates that it may be a good time to add it to your wish list. But at what price should you actually buy into the stock? Here is my answer, and here’s why you should also pay attention to Shire‘s (LSE: SHP) rally, which looks rather convincing. 

Outlook

“I am not a fan of the concept ‘big is beautiful,'” Smith & Nephew chief executive Olivier Bohuon said at a conference on healthcare in January, when it was on the verge of receiving a takeover offer according to market rumours. To be fair, the company has been a takeover target for about a decade: its equity value has doubled over the period, but most of the gains in its stock value have come in the last 24 months. 

Of course, Smith & Nephew shareholders are concerned now — but Mr Bohuon may be right.

If so, the company will likely continue to deliver value to shareholders for a long time, and a 7.5% drop in its stock price should be perceived as positive news for value hunters. After all, Smith & Nephew is expected to deliver higher revenue growth in 2015 than in 2014, while a further improvement in trading profit margins seems likely. Positive contribution to net earnings is also expected to come from a marginally lower corporate tax rate. 

Furthermore, currency swings may have a minimal impact on 2015 revenues: its balance sheet is solid, and net leverage is manageable. Finally, core profitability may rise faster than expected on the back of ad-hoc cost-cutting measures, so there could be room for an increase in the payout ratio.

S&N is still expensive, however, so I am not saying it is time to buy. But this is one stock to watch, particularly if its valuation drops another 20% or so from here to around 900p. Incidentally, Johnson & Johnson and private equity firms could easily put forward opportunistic bids if S&N traded in the 800p-950p range.

Shire On A Roll

Shire, another company operating in the broader pharmaceutical world, is a different story. Its shares have drawn my attention for a few weeks now.

Shire shareholders were under pressure to sell when the merger with AbbVie was called off in mid-October, but since then weakness in their shares has turn out to be a great buying opportunity: the shares have recorded a 39% pre-tax return, excluding dividends.

Shire is drawing lots of attention from analysts, too — and rightly so. Goldman Sachs suggests a price target of 6,400p, which is way too bullish, but a 10% rise to 5,700p is very possible to the end of the year.  

Shire is a solid company that has proven to be able to allocate capital efficiently over time. It’s a tad more expensive than S&N — which is justified by a higher growth rate, higher profitability, lower net leverage and a decent pipeline of drugs — but there you go: high-quality stocks do not come cheap.