The Investment Column: Strong knee sales carry S&N higher

Hold on to Caffè Nero for yet more growth; Stick with Bellway if the housing market slows
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The Independent Online

With obesity on the rise in the West, more and more people are requiring knee surgery to replace all or part of a joint that just can't stand the weight being put on it. And with gym-going on the rise among people trying to avoid obesity and get fit, more of us are requiring surgery to repair knees damaged in training. Sit on the couch eating chips, or get out the house and jog, either way Smith & Nephew wins.

With obesity on the rise in the West, more and more people are requiring knee surgery to replace all or part of a joint that just can't stand the weight being put on it. And with gym-going on the rise among people trying to avoid obesity and get fit, more of us are requiring surgery to repair knees damaged in training. Sit on the couch eating chips, or get out the house and jog, either way Smith & Nephew wins.

The company makes artificial joints, and a stonking 23 per cent rise in knee sales in the US was the highlight of yesterday's full-year figures. S&N is winning market share in this highly competitive orthopaedics market, having invested in innovative new products and a bigger salesforce. And this in a market which is already growing at 13 per cent a year globally.

S&N shares were volatile last year because of investor scepticism that the orthopaedics market can keep up this cracking pace. S&N and its rivals are routinely pumped for clues that a deceleration might be under way. So far, there are none. Yesterday, the company was insistent that the current rate of growth can continue. An ageing population and the improvement of surgical techniques will stay very powerful long-term drivers of this market.

A couple of financial milestones were passed by S&N in 2004: the orthopaedics division had more than $1bn (£500m) and operating margins across the group as a whole topped 20 per cent as the benefits of its increased scale fed through. Unfortunately, the results were marred by the decline in the dollar (in which most of S&N's earnings are made) and by an £80m provision to cover the cost of replacing 1,200 faulty knees.

Prospects for the current year are strong, and S&N made some bullish forecasts for sales growth and further margin expansion. In orthopaedics, a new hip product is being launched. In keyhole surgery, sales of blades are back on the up. In wound management, a clever, silver ion-based dressing is being given a marketing push.

So, all is set fair still. A buy for the long term.

Hold on to Caffè Nero for yet more growth

Shares in Caffè Nero, the coffee shop chain, have got up a head of steam, and yesterday hit a high of 135.5p on news that its cappuccino machines had been running at record levels during the six months to 30 November.

The group is achieving phenomenal growth from new stores, reporting an 118 per cent leap in pre-tax profits. With low central overheads and cheap regional management, it can open new outlets without much additional expense and its takings are high enough to finance expansion from internal cash flow. Price increases have outstripped increased utility bills and minimum wage costs, and while shoppers were cautious on Christmas spending, they were still willing to splash out for their lattes.

Caffè Nero wants to double in size to 400 shops and says the market for branded coffee shop chains shows no sign of slowing (the current rate of sales growth is 12 per cent a year). Starbucks, Costa and Caffè Nero control 60 per cent of the market, so there is scope to continue taking business from independents.

We recommended the shares at 98.5p, but at current levels they trade at a scalding 27 times earnings. It may be too late for new investors, but existing holders should stay in.

Stick with Bellway if the housing market slows

Bellway is the City's favourite house builder. The company, biased towards the budget end of the market and to the north of England, scores at or near the top of the class on financial measures such as return on capital, operating margins and forward sales.

If it wasn't for the psychological scars of the housing market crash of the early Nineties, Bellway's shares would be double their current valuation. It said yesterday that, going into the second half of its financial year, it has already sold 86 per cent of its targeted 7,000 homes. This will be the ninth year of record profits.

Investors value builders so poorly because of the meltdown they fear in the event of a housing market crash. It still seems more likely that the Bank of England has engineered a soft landing, however, and Bellway reports that business is at a "sustainable level" after the exuberance this time last year.

In the event of a bumpy landing, though, Bellway is better placed than its rivals. Its land bank is strong and conservatively valued. The regional structure makes the group flexible and gives it the scope to increase production (it has a target of producing 10,000 homes a year by 2010). It sells to private individuals and housing associations, giving skills that will be useful as the Government pushes for more homes in mixed private and social developments.

We are entering a crucial period for the house-building sector. If it emerges unscathed from a housing market slowdown, it should be on the cusp of a dramatic re-rating. Bellway shares, at 863p, are worth holding for that eventuality.

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