20-F 1 d20f.htm ANNUAL REPORT FILED UNDER A FORM 20-F Annual Report Filed Under a Form 20-F
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 20-F

 


(Mark One)

¨ REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR (g) OF THE SECURITIES EXCHANGE ACT OF 1934

or

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

or

 

¨ SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 0-19003

 


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:

 

Title of each class

 

Name on each exchange on which registered

American Depositary Shares

Ordinary Shares of 20¢ each

 

New York Stock Exchange

New York Stock Exchange*

 

* Not for trading, but only in connection with the registration of American Depositary Shares, pursuant to the requirements of the Securities and Exchange Commission.

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 issuer’s classes of capital or common stock as of the close of the period covered by the annual report: 940,638,300 Ordinary Shares of 122/9p each

Indicate by check mark if the registrant is a well seasoned issuer, as defined in Rule 405 of the Securities Act    Yes  x     No  ¨

If this Report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934    Yes   ¨    No   x

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 is a large accelerated filer, an accelerated filer, or a non-accelerated filer:

Large Accelerated Filer  x     Accelerated Filer  ¨     Non-accelerated filer   ¨

Indicate by check mark which financial statement item the registrant has elected to follow:     Item 17  ¨     Item 18  x

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

 



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LOGO

 

Dear Shareholder

 

As a consequence of the Company’s Ordinary Shares being traded on the New York Stock Exchange (in the form of American Depositary Shares) we are required to prepare and file a Form 20-F with the US Securities and Exchange Commission. In order to provide the same information to both UK and US shareholders the Annual Report and Accounts and the Company’s Form 20-F filing are combined as a single document. US shareholders receive the combined Annual Report and Form 20-F and the Summary Financial Statement.

 

For non-US shareholders, the combined Annual Report and Form 20-F contains a very large amount of information and you may not wish to receive such a large document in the future. If so, please complete the enclosed form of request to elect to receive the Company’s Summary Financial Statement in future, which is sent to the vast majority of shareholders each year in place of the Combined Annual Report and Form 20-F. Alternatively you may elect to receive the Combined Annual Report and Form 20-F electronically by completing the enclosed form. Shareholders electing to receive the Summary Financial Statement, may subsequently choose to receive the full combined Annual Report and Form 20-F. Likewise shareholders electing to receive communications electronically can elect to revert to receiving paper copy versions.

 

Yours sincerely,

 

LOGO

 

Dudley Eustace

Chairman

 

2 March 2006

 

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INTRODUCTION

 

The Smith & Nephew Group is a global medical devices business engaged in orthopaedics, endoscopy and advanced wound management having revenue of over £1.4 billion in 2005. Smith & Nephew plc is the parent company of the Smith & Nephew Group. It is an English public limited company with its shares listed on the official list of the UK Listing Authority which are traded on the London Stock Exchange and on the New York Stock Exchange in the form of ADSs.

 

This report is the Annual Report of Smith & Nephew plc for the year ended 31 December 2005. 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 Securities and Exchange Commission in the US.

 

A summary report on the year, the Summary Financial Statement 2005, intended for the investor not requiring the full detail of the Annual Report, is produced as a separate document. The Summary Financial Statement includes a summary review of operations, a summary remuneration report and summary financial statements.

 

Over 90% of non-US shareholders have chosen to receive only the Summary Financial Statement. The Annual Report is issued to US shareholders and those non-US shareholders who have elected to receive it. Both documents are available on Smith & Nephew’s corporate website at www.smith-nephew.com/investors/annualreport2005.pdf. Shareholders can elect to receive communications electronically which reduces printing and postage costs and reduces the risk of documents getting lost in the post. To elect shareholders should complete the enclosed form or register with the Company’s Registrars at www.shareview.co.uk.

 

The Group’s fiscal year ends on 31 December of each year. 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 12 2/9p each.

 

For the convenience of the reader, a Glossary of technical and financial terms used in this document is included on page 177. The product names referred to in this document are identified by the use of capital letters and are trademarks owned by or licensed to members of the Smith & Nephew Group.

 

Smith & Nephew’s corporate website, www.smith-nephew.com, gives additional information on the Group. Information made available on the website is not intended to be, and should not be regarded as being, part of this Annual Report.

 

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CONTENTS

 

Report of the Directors

   2-67

Financial summary

   2

Description of the Group

   4

Operating and financial review, liquidity and prospects

   27

Corporate governance

   48

Remuneration report

   58
      

Accounts

   68-157

Group auditors’ reports

   70

Group income statement

   72

Group balance sheet

   73

Notes to the Group accounts

   76

Parent company auditors’ report

   134

Parent company balance sheet

   135

Notes to the Parent Company accounts

   136

Restatement of financial information under IFRS

   143
      

Investor information

   158-174

Cross reference to Form 20-F

   175-176

Glossary of terms

   177-179

 

This Annual Report including the Report of the Directors was approved by the Board of Directors on 2 March 2006.

 

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FI NANCIAL SUMMARY

 

Financial Highlights

 

    

2005

£ million


  

2004

£ million


Revenue

   1,407    1,249

Trading profit

   290    250

Operating profit

   237    165

Attributable profit for the year:

         

Before the restructuring and rationalisation expenses, the fair value of hedge of anticipated sale proceeds of joint venture, macrotextured claim, related taxation relief thereon and amortisation of acquisition intangibles

   223    195

After the items above

   187    138

Adjusted basic earnings per Ordinary Share (“EPSA”) (i)

   23.8p    20.8p

Basic earnings per Ordinary Share

   19.9p    14.8p

Dividends per Ordinary Share

   5.6p    5.1p

(i) Throughout this document earnings per share calculated in this way is termed adjusted basic earnings per Ordinary Share (“EPSA”) and profit calculated in this way is termed “adjusted attributable profit”. The calculation of adjusted attributable profit and EPSA is set out in “Selected Financial Data” (page 165).

 

Change in Accounting Policies

From 1 January 2005, as required by the European Union’s IAS Regulation and the Companies Act 1985, the Group has prepared its accounts in accordance with International Financial Reporting Standards (“IFRSs”) as adopted by the European Union (“EU”). IFRSs as adopted by the EU differ in certain respects from IFRSs as issued by the International Accounting Standards Board (“IASB”). However the Group accounts for the years presented would be no different had the Group applied IFRSs as issued by the IASB. Reference to “IFRS” hereafter should be construed as reference to IFRSs as adopted by the EU.

 

Change in Functional and Reporting Currency

On 23 January 2006 the Sterling Ordinary Shares of Smith & Nephew plc were cancelled and new shares denominated in US Dollars were issued, carrying exactly the same rights. The redenomination aligns the capital base of the Group with its effective functional currency. Future dividends will be declared in US Dollars, commencing with the second interim dividend for 2005. The Group changed its reporting currency to US Dollars with effect from the beginning of 2006 so as to align it with the principal business activities. In 2005, only 9% of Group revenue arose in the UK compared with 49% in the US. These changes in functional and reporting currencies will reduce significantly the exposure of the Group’s results to movements in translational exchange rates and thus reduce the volatility of reported revenues, profits and earnings.

 

2005 Dividends

Following the redenomination of share capital into US Dollars the Board has declared a second interim dividend of 6.1¢ per share. Shareholders with a registered UK address will receive 3.5p per share which together with the interim dividend of 2.1p, makes a total for 2005 of 5.6p. The second interim dividend will be paid on 12 May 2006 to shareholders on the register at the close of business on 21 April 2006.

 

Presentation

Smith & Nephew believes that the reporting of profit and earnings before items which may distort comparability, provides additional information on underlying returns and trends to shareholders. Such items arise from events or transactions that fall within the ordinary activities of the Group but which management believes should be separately identified to help explain trends as they are exceptional in nature or derive from specific accounting treatments. The Group’s internal financial reporting focuses primarily on profit and earnings before these items and these are the key performance indicators used in budgets, monthly reporting, forecasts, long-term planning and incentive plans. Such items principally comprise restructuring, rationalisation and acquisition related expenses, the macrotextured claim, net profit on disposal of an associated undertaking and taxation thereon and amortisation of acquisition intangibles.

 

Management’s key indicator of revenue performance is underlying growth in revenue. This is calculated by excluding the effects of foreign currency translation movements (“constant currency”) and acquisitions. Management believes that revenue growth on an underlying basis provides a consistent year-on-year measurement of performance without the distortions created by the translation effect of foreign currency

 

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movements and acquisitions which are separate from the Group’s normal operations. Underlying revenue growth is used by management in its internal financial reporting, budgeting and planning. A reconciliation of reported revenue growth to underlying revenue growth is provided on page 29.

 

The results of the Group, as reported in Sterling, are affected by movements in exchange rates between Sterling and overseas currencies. The Group used the average exchange rates prevailing during the year to translate the results of overseas companies into Sterling. The currencies which most influenced these translations in the years covered by this report were the US Dollar and the Euro. During 2005 average Sterling exchange rates were weaker against the US Dollar by 2% and unchanged against the Euro compared with 2004.

 

The Group Accounts of Smith & Nephew in this Annual Report are presented in Sterling. Solely for the convenience of the reader, certain parts of this Annual Report contain translations of amounts in Sterling into US Dollars at specified rates. These translations should not be construed as representations that the Sterling amounts actually represent such US Dollar amounts or could be converted into US Dollars at the rate indicated. Except as where stated otherwise, the translation of pounds Sterling and pence to US Dollars and cents appearing in this Annual Report has been made at the noon buying rate in The City of New York for cable transfers in Sterling as certified for customs purposes by the Federal Reserve Bank of New York (the “Noon Buying Rate”) on the date indicated. On 24 February 2006, the Noon Buying Rate was US$1.74 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 Group’s 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, constitute “forward-looking statements” within the meaning of the US Private Securities Litigation Reform Act of 1995. In particular, statements regarding planned growth in our business and in our trading margins discussed under “Outlook and Trend Information” are forward-looking statements as are discussions of our product pipeline and discussions of the costs of future revisions of the macrotextured knee product under “Recent Developments”, “Legal Proceedings” and “Operating and Financial Review, Liquidity and Prospects”. When used in this Annual Report, the words “aim”, “anticipate”, “believe”, “consider”, “estimate”, “expect”, “intend”, “plan”, “well-placed”, “target” and similar expressions are generally intended to identify forward-looking statements. Such forward-looking statements involve known and unknown risks, uncertainties and other important factors (including, but not limited to, the outcome of litigation and regulatory approvals) that could cause the actual results, performance or achievements of Smith & Nephew, or industry results, to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Specific risks faced by the Group are described under “Risk Factors” on page 23 of this Annual Report.

 

All forward-looking statements in this Annual Report are based on information available to Smith & Nephew as of 2 March 2006. All written and oral forward-looking statements attributable to Smith & Nephew or any person acting on behalf of Smith & Nephew are expressly qualified in their entirety by the foregoing. Smith & Nephew does not undertake any obligation to update or revise any forward-looking statement contained herein to reflect any change in Smith & Nephew’s expectation with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

 

Market Data

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.

 

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DESCRIPTION OF THE GROUP

 

This section discusses the activities, resources and operating environment of the business under the following headings:

 

The Business

   5

History and development

   5

Business description

   6

Operating Environment

   11

Regulation

   11

Product liability

   11

Risk management

   12

Operating Activities

   13

Marketing and distribution

   13

Manufacture and supply

   13

Seasonality

   14

Research and development

   14

Intellectual property

   14

Property, plant and equipment

   15

Legal proceedings

   16

The Business and the Community

   17

Corporate social responsibility

   17

Employees

   22

Risk Factors

   23

 

Discussion of the Group’s management structure and corporate governance procedures is set out in the “Corporate Governance” section (pages 48 to 57).

 

The “Remuneration Report” gives details of the Group’s policies on senior management’s remuneration in 2005 (pages 58 to 67).

 

Discussion of the Group’s operating and financial performance liquidity and financial resources for 2005 and 2004 is given in the “Operating and Financial Review, Liquidity and Prospects” (pages 27 to 47).

 

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THE BUSINESS

 

HISTORY AND DEVELOPMENT

 

Group Overview

Smith & Nephew is a global business engaged in the development, manufacture and marketing of medical devices in the sectors of orthopaedics, endoscopy and advanced wound management.

 

The Group has a history dating back 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. Smith & Nephew was incorporated and listed on the London Stock Exchange in 1937. Today it is a public limited company incorporated in the UK registered in, and conducted under the laws of, England and Wales. Operations in countries other than the UK are under the laws of those countries. In November 1999, the Group was listed on the New York Stock Exchange. The corporate headquarters is in the UK and the registered address is:

 

Smith & Nephew plc

15 Adam Street

London WC2N 6LA

Tel: +44 (0) 20 7401 7646

Website: www.smith-nephew.com

 

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.

 

Recent Developments

In October 2005, the Group announced its intention to exit the tissue engineering operations of its advanced wound management business due to delays in achieving economic viability. Since no purchaser was found for the going concern, production ceased in December 2005 and the operation will be closed during the first quarter of 2006. A rationalisation charge of £39m was recorded in 2005.

 

In August 2005, Smith & Nephew announced that, together with its partner Beiersdorf AG, it was preparing for the divestment of its joint venture BSN Medical. Subsequently, on 16 December 2005 Smith & Nephew and Beiersdorf AG announced that they had signed an agreement to sell BSN Medical to Montagu Private Equity for an enterprise value of €1,030m. This agreement was conditional upon receipt of competition clearances and completion of the transaction was expected in the first quarter of 2006. The transaction was completed on 23 February 2006. The Group’s share of the results of BSN Medical have been classified as “Discontinued Operations” in accordance with IFRS.

 

In March 2005 the US Attorney’s Office in Newark, New Jersey issued a subpoena to the Group’s orthopaedic business asking for copies of its consulting, professional service and remuneration agreements with orthopaedic reconstructive surgeons. Four of the divisions’ major competitors received similar subpoenas. The Company is co-operating fully with the US Attorney, has provided copies of the requested contracts and is gathering additional documents which have also been requested.

 

In August 2003, Smith & Nephew withdrew from all markets the macrotextured version of its OXINIUM femoral knee component. As at that date, 2,971 components had been implanted of which approximately 2,471 were in the USA, 450 in Australia and 50 in Europe. As at 24 February 2006, 964 revision surgeries had been carried out on affected patients and settlements were agreed with patients in respect of 796 of these revisions. As discussed more fully under “Legal Proceedings”, due to the denial of insurance coverage by certain of the Group’s product liability insurers in respect of existing claims and future claims, a provision of £80m was recorded in 2004, representing unsettled insurance claims and an estimate of claims likely to arise in the future assuming that no further insurance cover is available. After adjusting for costs charged against the provision and for the effect of translational exchange rate movements £44m remains to settle pending and future claims. These estimates constitute forward looking statements that are subject to uncertainties. Depending on the number and average cost of actual revisions, costs to Smith & Nephew may be greater or less than the amount of this provision. See “Legal Proceedings” and “Risk Factors”.

 

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BUSINESS DESCRIPTION

 

Group Structure

Smith & Nephew operates on a worldwide basis. This has been achieved through a series of acquisitions, predominantly in the US but also in Europe, and through continued emphasis on the development and introduction of new products in the Group’s principal markets.

 

During the period covered by the Annual Report Smith & Nephew was organised into three global business units of orthopaedics, endoscopy and advanced wound management and a separate indirect market unit. Each of the global business units manages its sales directly in ten international markets — the US, Canada, the UK, Germany, Japan, Australia, France, Italy, New Zealand and Ireland — and takes full responsibility for strategy, research and development (“R&D”), manufacturing, marketing, sales and financial performance. The remaining 23 markets in which the Group has selling companies are managed by country managers, with business responsibility for the whole of the Group’s product range, and comprise the indirect market unit.

 

With effect from 2006, orthopaedics will be segmented organisationally into orthopaedic reconstruction and orthopaedic trauma, including clinical therapies, to create a fourth global business unit.

 

A head office team in London, England directs the overall business and supports the business units, primarily in the areas of business development, company secretarial, finance, human resources and investor relations, with a legal department based in Memphis, Tennessee. A central research facility in York, England is charged with the development of enabling technologies in both materials science and biology, particularly cell biology.

 

Orthopaedics

 

Overview

Orthopaedic products comprise reconstruction joint implants, trauma products and associated clinical therapies. Reconstruction implants include hip, knee and shoulder joints as well as ancillary products such as bone cement and mixing systems used in cemented reconstruction joint surgery. Trauma products consist of internal and external fixation devices and orthobiological solutions used in the stabilisation of severe fractures and deformity correction procedures. Clinical therapies consist of products applied in an orthopaedic office or clinic setting and currently comprise bone growth stimulators and a joint fluid therapy product.

 

The orthopaedics business is managed worldwide from Memphis, Tennessee, which is also the site of its main manufacturing facility. Orthopaedic implants and trauma products are also manufactured at a small facility in Tuttlingen, Germany. As described in “Property, Plant and Equipment” continuing strong revenue growth has created the need for expansion in both manufacturing and administrative facilities.

 

The Group’s reconstruction knee business is built on two major knee systems: GENESIS II, designed to facilitate the accuracy and efficiency of the operating procedure and provide improved long-term clinical results; and PROFIX, a reconstruction knee system featuring simpler instruments and surgical technique.

 

Within the reconstruction hip line, the SPECTRON cemented hip system and the REFLECTION acetabular cup system have documented positive long-term clinical performance. More recently, the success of SYNERGY, a tapered titanium stem system, ECHELON, a revision stem system and BIRMINGHAM HIP RESURFACING (“BHR”), a hip resurfacing system (approved for sale outside of the US) have established Smith & Nephew as a strong player in this product segment.

 

The BHR product was acquired with the purchase of Midland Medical Technologies (“MMT”) in 2004 for £69m in cash and loan notes. Additional payments of up to £10m in cash are contingent upon certain regulatory milestones being achieved.

 

The Group has developed and manufactures knee and hip implant components made from oxidised zirconium (OXINIUM) which is patent protected and which management believes possesses improved wear characteristics which may be of significant benefit to younger, more active patients.

 

Within the trauma business, internal fixation products, such as the TRIGEN intramedullary nail system and PERI-LOC lower extremity locked plating system and the IMHS CP JET-X and TAYLOR SPATIAL FRAME external fixators, provide orthopaedic surgeons with a comprehensive offering of products to address trauma and osteoporotic procedures. Orthobiologic products, including demineralised bone matrix are also offered for use in conjunction with reconstruction and trauma surgeries.

 

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The EXOGEN ultrasonic bone healing stimulator and SUPARTZ hyaluronic acid joint fluid therapy are the main products in the clinical therapies sector.

 

To compete effectively in the growing global orthopaedic market, management believes that as well as having a leading edge product range it is important to have a skilled sales force that can build strong relationships with surgeons and to provide high levels of customer service. At the end of 2005 the global sales force numbers 1,532 of whom 1,021 serve the US market.

 

Strategy

Smith & Nephew’s orthopaedics strategy is for future growth through innovation in product development in its existing core business and expansion into fast-growing market areas including revision products for hip and knee, extremities fracture management and alternative therapies for pain management and fracture healing. Management believes that the orthopaedic market will continue to grow for the foreseeable future. This is largely attributable to the increasing proportion of the population aged over 55 and the increasing need for joint reconstruction products for this age group, increasing obesity and providing other orthopaedic therapies for younger, more active patients.

 

Smith & Nephew also intends to further penetrate these markets by expanding its sales force and by introducing less invasive and alternative therapies. The Group is also contributing to patient education and empowerment through its websites and other direct-to-consumer activities.

 

Management believes that future growth will be enhanced by segmenting the business into two separate global units, orthopaedic reconstruction and orthopaedic trauma including clinical therapies, effective from the beginning of 2006.

 

In June 2005, certain assets of Leading Kabushiki Kaisah (“Leading Medical”) orthopaedic distributor in Japan were acquired. This combination doubles the size of the Group’s reconstruction sales force in Japan, enabling a greater level of service and coverage in what management believes to be the second largest orthopaedic market in the world.

 

New Products

In 2005, the orthopaedics business continued the promotion and roll-out of OXINIUM technology across the knee and hip product line. OXINIUM is a material exclusive to Smith & Nephew which has the strength of a metal with the wear properties of a ceramic material and expands the market for hip and knee implants. In November 2005 the LEGION Revision Knee System was released for sale. This system utilises OXINIUM technology in the revision implant. The full effect of LEGION, as well as continued extensions of the OXINIUM technology is anticipated in 2006.

 

In February 2005, the PERI-LOC Periarticular Locked Plating System was released for sale. PERI-LOC is a trauma plating device used to treat lower extremity bone fractures and allows the surgeon to save time in the operating room and perform less invasive surgeries. The upper extremity version of the system is expected to be launched in mid 2006.

 

In September 2005, MOBILAB, a comprehensive mobile surgical training facility for orthopaedic surgeons was introduced. By travelling to hospitals and clinics across the US, the MOBILAB enables surgeons to have local access to training in the latest surgical techniques. The unit is scheduled to visit 48 US cities in the first 12 months of operation.

 

Recent Regulatory Approvals

In September 2005, the FDA Orthopaedic Advisory Panel recommended conditional approval of the BHR product to the FDA for use in the US.

 

In 2005 Smith & Nephew received clearance of the Stride (“Onishi”) Porous Hip Stem and GENESIS II minimally invasive (“MIS”) tibial base plates in Japan from the Ministry for Health Labour and Welfare.

 

Competition

Management estimates that the worldwide orthopaedic market (excluding spine) served by the Group grew by 11% in 2005 and is currently worth more than £8 billion per annum. Management believes that Smith & Nephew holds a 9% share of this market by value.

 

Principal global competitors in the orthopaedic market and their estimated global shares, are Zimmer (21%), Stryker (17%), De Puy/Johnson & Johnson (17%), Biomet (11%) and Synthes (11%).

 

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Endoscopy

 

Overview

Smith & Nephew’s endoscopy business, headquartered in Andover, Massachusetts, develops and commercialises a range of endoscopic (minimally invasive surgery) techniques, educational programmes and value-added services for surgeons to treat and repair soft tissue, articulating joints, spinal discs and vascular structures. The business focuses principally on the arthroscopy sector of the endoscopy market. Arthroscopy is the minimally invasive surgery of joints, in particular the knee, shoulder and hip.

 

The endoscopy business offers surgeons endoscopic technologies for surgery, including: fluid management and insufflation equipment for surgical access; digital cameras, digital image capture, central control, multimedia broadcasting, scopes, light sources and monitors to assist with visualisation; radiofrequency wands, electromechanical and mechanical blades, and hand instruments for resecting damaged tissue; and specialised devices, fixation systems and bioabsorbable materials to repair damaged tissue. The business also designs, markets and provides services to its Digital Operating Room suites, which use computer and internet technology to put surgeons and other medical professionals in full control of the operating room environment.

 

Manufacturing facilities are located currently in Andover and Mansfield, Massachusetts and Oklahoma City, Oklahoma. It was announced in August 2005 that the Andover manufacturing facility will close by early 2007. Major service centres are located in the US, the UK, Germany, Japan and Australia.

 

Of the global sales force at the end of 2005 of 684, 374 serve the US market.

 

Strategy

Smith & Nephew’s strategic intent is to establish the business as the leading provider of endoscopic techniques for joint and ligament repair and to use its core capabilities to penetrate other selected endoscopic markets. Management believes that the business capitalises on the growing acceptance of endoscopy as a preferred surgical choice among physicians, patients and payors.

 

To sustain growth and enhance its market position, the endoscopy business supports its strategy with surgeon education programmes, financing solutions, global fellowship support initiatives, partnerships with professional associations and surgeon advisory boards.

 

New Products

In 2005, the 400 Series Camera System, the latest generation of the Group’s surgical camera and camera control unit (“CCU”) was introduced. This system automatically and instantaneously optimises settings in the camera head and CCU to provide the best image.

 

The launch of the DYONICS 25 Fluid Management System, a surgical pump for use during arthroscopy, provides an opportunity to market a pump using updated technology to replace an old product within the access range.

 

Smith & Nephew continues to expand its mechanical and radio frequency products, within arthroscopic resection, with the recent addition of the INCISOR Plus ELITE shaver blades and the GLIDER Articular Cartilage Probe. The INCISOR Plus ELITE’s design represents the sharpest serrated cutting surface offered in the DYONICS POWER range. The GLIDER probe is designed to treat articular cartilage disease in weight-bearing joints, and features a pivoting head that emits radio frequency energy as it follows the contoured surface of the joint, restoring smoothness to a damaged cartilage surface while preserving the maximum amount of healthy tissue. A patent dispute with ArthroCare Inc., was resolved in 2005, enabling the Group to resume selling its DYONICS ELECTROBLADE Resector and SAPHYRE Bipolar Ablation Probe products.

 

Recent additions to the Group’s repair product line include the GTS System for use in soft-tissue ACL reconstruction in the knee and the BIORAPTOR 2.9 Premium Anchor in the shoulder. The ACCU-PASS Suture Shuttle, a fully featured instrument for use in shoulder repair, was also launched.

 

Expanding its line of Spine products, Smith & Nephew introduced the Controlled Disc Stimulation (“CDS”) System, which provides a standard platform for discography, a method of diagnosing the source of disc-related back or neck pain.

 

Recent Regulatory Approvals

During 2005, the endoscopy business obtained regulatory clearances for the following products in most major markets, except Japan where the approval process is more lengthy: CALAXO absorbable osteoconductive

 

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interference screw for fixation of an ACL graft; GLIDER Articular Cartilage radiofrequency probe for controlled smoothing of the articular cartilage surface; DYONICS 25 pump next generation arthroscopy fluid management system; CONDOR Controller, for centralised control of medical and audio-visual equipment in the Digital Operating Room; Controlled Disc Stimulation System for automated diagnosis of discogenic pain (“Discography”); and various other arthroscopy fixation devices.

 

Competition

Management estimates that the global arthroscopy market in which the business principally participates is worth £860 million a year and is growing at 8% annually, 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. Management believes that Smith & Nephew has a 29% share of the global arthroscopy market. Smith & Nephew also participates in the developing minimally invasive spinal and minimally invasive vascular markets and continues to seek ways to leverage its knowledge, experience and core capabilities in other selected endoscopic markets.

 

Smith & Nephew’s main competitors and their estimated shares of the global arthroscopy market are: Mitek/Johnson & Johnson (19%), Arthrex (17%), Linvatec/Conmed (12%), Stryker (12%) and Arthrocare (6%).

 

Advanced Wound Management

 

Overview

Smith & Nephew’s advanced wound management business is headquartered in Hull, England. It supplies a range of products and clinical support services for the treatment of chronic and acute skin wounds. It offers a range of products from initial wound bed preparation through to full wound closure. These products are targeted particularly at chronic wounds connected with the older population, such as pressure sores and venous leg ulcers, burns and complex surgical wounds.

 

Advanced wound management products are manufactured in facilities in Hull and Gilberdyke, England; Largo, Florida and by certain third party manufacturers.

 

The advanced wound management business has continued to build its sales and marketing infrastructure in the world’s major markets. These initiatives have led to increased levels of demand on the Group’s manufacturing and global supply chain, which have been addressed with increased investment in the production capacity in Hull, Gilberdyke and Largo.

 

Strategy

The strategy for the advanced wound management business is to focus on the higher added value segments of wound bed preparation and moist and active healing.

 

The business has built its sales and marketing infrastructure in the world’s major markets, largely through investment in additional sales teams particularly in the key markets of the US, Japan and Europe. At the end of 2005 the global sales force is 924 of whom 185 are in the US.

 

In October 2005, the Group announced its exit from its tissue engineering operations comprising DERMAGRAFT, a human dermal replacement product designed as a treatment for diabetic foot ulcers, and TRANSCYTE, a temporary wound covering for the treatment of burns. Both products were manufactured at La Jolla, California.

 

New Products

Management believes that the market will continue the trend towards advanced products with their ability to accelerate healing rates, reduce hospital stay times and cut the cost of nursing and clinician time and aftercare in the home.

 

The range of ALLEVYN hydrocellular dressings was extended with the re-launch of improved ALLEVYN Plus. Management believes that ALLEVYN is the largest selling dressing in its category in the world.

 

Sales of ACTICOAT have been augmented by the launch of ACTICOAT Moisture Control in the US and Canada, an antimicrobial barrier dressing with foam and waterproof film layers, and the completion of the European launches of ACTICOAT ABSORBENT. The moisture control product provides an effective barrier to bacterial penetration and is designed to help maintain a moist wound environment in the presence of exudate. The absorbent product is

 

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an antimicrobial alginate dressing that provides an effective wound barrier. The ACTICOAT range incorporates the smallest crystallised silver (nanocrystalline silver) used in the treatment of wounds or burns. The silver reduces the risk of bacterial colonisation and acts to kill micro-organisms that can cause infection and prevent or retard healing.

 

2005 was the first full year of VERSAJET, a fluid jet debridement system, acquired in 2004. The product has been launched in thirteen markets worldwide. A new handpiece was launched in the US during 2005 that enables faster debridement with enhanced precision.

 

Recent Regulatory Approvals

During 2005, the advanced wound management business secured over 200 medical device and 120 pharmaceutical registration approvals in various markets throughout the world. Among the most significant approvals were those for ACTICOAT Moisture Control in the US and CADEX (IODOSORB powder and ointment) in Japan. VERSAJET gained CE mark approval in Europe.

 

Competition

Management estimates that the sales value of the advanced wound management market worldwide is £2 billion a year, that this grew 10% in 2005, and that Smith & Nephew has a 18% market share. Growth is driven by an ageing population and by a steady advancement in technology and products that are more clinically efficient and cost effective than their conventional counterparts. Management believes that, with approximately only half of chronic wounds globally still treated with conventional dressings, there is strong growth potential for advanced technology products.

 

Worldwide competitors in advanced wound management and their estimated market shares comprise Kinetic Concepts (25%), the Convatec division of Bristol-Myers Squibb (11%), Johnson & Johnson (8%), and 3M (8%).

 

Joint Ventures and Discontinued Operations

 

Joint Ventures and Associated Undertakings

Joint ventures are those in which the Group holds an interest on a long-term basis and which are controlled by the Group and one other entity under a contractual agreement.

 

Smith & Nephew previously owned 50% of the BSN Medical joint venture, which became operational on 1 April 2001. It was jointly owned with Beiersdorf AG and was independently managed. BSN Medical comprises traditional woundcare, fracture casting and bandaging and compression hosiery businesses. Headquartered in Hamburg, Germany it has manufacturing facilities in US, UK, Germany, France, Republic of Ireland, South Africa, Mexico, Venezuela and Pakistan. During 2004 BSN Medical acquired the fracture casting and splinting business of DePuy, Inc., a Johnson & Johnson company and integrated it with its casting and bandaging business. In certain markets, Smith & Nephew’s sales forces sell BSN Medical’s products on an agency basis in return for an agency commission and in some markets, mainly in Asia, Smith & Nephew distributes BSN Medical products. Results were accounted for using the equity method up to 1 October 2005, whereby 50% of the profit after taxation was incorporated into Smith & Nephew’s income statement as a single line item.

 

Following the Group’s announcement in August 2005 to dispose of BSN Medical, Smith & Nephew and Beiersdorf AG announced in December 2005 that they had signed an agreement to sell BSN Medical to Montagu Private Equity for an enterprise value of €1,030m. The agreement was conditional upon receipt of competition clearances and completion of the transaction was expected in the first quarter of 2006. The transaction was completed on 23 February 2006. Consequently the results are now classified as discontinued operations.

 

Associated undertakings are those in which the Group has a beneficial interest of 50% or less in the equity capital and where the Group is able to exercise significant influence over commercial and financial policy decisions. In September 2003, the Group disposed of its 21.5% interest in AbilityOne Corporation (“AbilityOne”) to Patterson Dental Inc. From 1 April 2002 to 12 September 2003 this interest was included in the Group’s accounts as an associated undertaking and accounted for under the equity method, whereby 21.5% of the profit after taxation was incorporated into Smith & Nephew’s Income Statement as a single line item. This is also classified as a discontinued operation.

 

Discontinued Operations

Discontinued operations represent the share of results of the joint venture, BSN Medical, and in 2003 the associated undertaking, AbilityOne.

 

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OPERATING ENVIRONMENT

 

REGULATION

 

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 testing, approval, manufacturing, labelling, marketing and sale of healthcare and pharmaceutical 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 & Nephew’s products are the FDA in the US, the Medicines and Healthcare products Regulatory Agency in the UK and the Ministry for Health Labour and Welfare in Japan. Payment for many medical device products is governed by reimbursement tariff agencies in each individual country.

 

The trend in recent years has been towards greater regulation and higher standards of technical appraisal, which generally entail lengthy inspections for compliance with appropriate standards, including regulations such as good manufacturing practices. Smith & Nephew believes that these recent changes will not have a material adverse effect on the Group’s financial condition and the results of operations. All significant facilities within the Group are subject to regular internal audit for medical device regulatory compliance with national and Group standards and policies.

 

Smith & Nephew believes that the Group’s operations currently comply in all material respects with applicable environmental laws and regulations. Although the Group continues to make capital expenditure 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 Group’s financial condition.

 

PRODUCT LIABILITY

 

The Group monitors the safety of its products from initial product development through to product use or application. In addition, the businesses of the Group analyse on a worldwide basis reports of adverse reactions and complaints relating to its products. Each business reviews these adverse reactions and complaints and any safety matters arising with independent medical advisors. These conclusions are subsequently reviewed by the Group’s independent medical advisor.

 

Product liability is a commercial risk for the industry of which the Group is a part, particularly in the US. Smith & Nephew has implemented systems it believes are appropriate in respect of loss control techniques. These include reporting mechanisms to ensure early notification of complaints and a legal department which manages product liability claims and lawsuits.

 

The Group carries product liability insurance to cover exposure as far as practicable. With the exception of the macrotextured product liability claim, discussed under “Legal Proceedings”, and “Risk Factors” instances of loss to the Group arising from product liability claims have been covered either directly by the Group or by insurance. Apart from the macrotextured claims, there are no individual product liability claims, and no group of similar claims, that are expected to have a material adverse effect on the Group’s financial position.

 

There can be no assurance that consumers, particularly in the US, will not bring product liability or related claims that would have a material adverse effect on the Group’s financial position or results of operations in the future or that the Group will continue to resolve such claims within insurance limits in view of changing legal doctrines and attitudes regarding such matters. See “Risk Factors — Product Liability Claims and Loss of Reputation”.

 

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RISK MANAGEMENT

 

Smith & Nephew’s products include implantable devices but are not life support medical devices. If these devices malfunction, they could damage or impair the repair of body functions. Management believes that the Group’s quality, regulatory and medical controls and insurance cover is adequate and appropriate for this class of products. The Group’s reputation is crucially dependent on strong performance in this area and on appropriate crisis management if a serious medical incident or product recall should occur.

 

The Board is responsible for the maintenance of the Group’s systems of risk management and internal control and for reviewing their effectiveness. These systems, which accord with the Turnbull Guidance and have been in place for 2005 and to the date of approval of the report and accounts, involve: the identification, evaluation and management of key risks through a Risk Committee, which reports to the Board annually; business reviews by the Board; and the review by the Audit Committee of internal financial controls and the risk management process. These systems are reviewed annually by the Board. Whilst not providing absolute assurance against material misstatements or loss, these systems are designed to identify and manage those risks that could adversely impact the achievement of the Group’s objectives.

 

The Group maintains insurance against product, employers’ and directors’ and officers’ liabilities, and physical and consequential loss, subject to limits and deductibles. The Group maintains liability provisions to cover known uninsured risks. The Group has been advised that three insurers have declined coverage for macrotextured knee claims. See “Legal Proceedings”.

 

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OPERATING ACTIVITIES

 

MARKETING AND DISTRIBUTION

 

Smith & Nephew’s customers are the various providers of medical and surgical services worldwide. In certain parts of the world, including the UK, much of Continental Europe, Australia, Canada and South Africa, these are largely governmental organisations funded by tax revenues. In the US, the Group’s major customers are public and private hospitals, many of which have combined to form large purchasing groups and receive revenue from private health insurance and governmental reimbursement programmes. In the US, Medicare is the major source of reimbursement 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. In many countries, providers are under pressure to reduce the total cost of healthcare delivery. There has been some consolidation in the Group’s customer base, as well as amongst the Group’s competitors, and these trends are expected to continue in the long term. Smith & Nephew competes against both specialised and multinational corporations, including those with greater financial, marketing and other resources.

 

The Group’s 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 HealthTrust in the US. Sales to these customers in 2005 represented approximately 5% and 4% of the Group’s worldwide revenue respectively.

 

In the US the Group’s products are marketed directly to doctors, hospitals and other healthcare facilities. Each business unit operates a separate specialised sales force. Within the orthopaedics business further specialisation of the sales force continues to be introduced progressively for reconstruction, trauma and clinical therapy products. In both orthopaedics reconstruction and endoscopy the US sales forces consist largely of independent commissioned sales agents who are managed by a mix of independent agents and the Group’s own managers. These agents are not permitted contractually to sell products that compete with Smith & Nephew’s. In both businesses, products are shipped and invoiced directly to the ultimate customer. The trauma and clinical therapies and advanced wound management businesses in the US operate sales forces of their own employees who market directly to the ultimate customer. In the US, trauma and clinical therapy products are shipped and invoiced directly to the ultimate customer whereas advanced wound management products are shipped and invoiced to a number of large wholesale distributors.

 

In the other direct markets of the UK, Ireland, France, Germany, Italy, Australia, New Zealand, Canada and Japan the business units manage separate sales forces directly. Except in Australia and New Zealand where independent sales agents are used the sales forces of the direct markets comprise employees and market directly to the ultimate customer.

 

The indirect markets unit comprises direct selling and marketing operations in Austria, Belgium, Denmark, Eastern Europe, Finland, the Netherlands, Norway, Poland, Portugal, Spain, Sweden, Switzerland, China, Hong Kong, Korea, Malaysia, Singapore, Taiwan, Thailand, the United Arab Emirates, South Africa, Mexico and Puerto Rico. In these markets orthopaedics and endoscopy frequently share sales resources. The advanced wound management sales force is separate since it calls on different customers. In all other countries Smith & Nephew sells to third party distributors which market the Group’s products locally.

 

In Continental Europe, the Group operates three centralised distribution facilities. Orthopaedics operates a facility in Paris which acts as a central holding and consolidation point for Continental European stock and stock returns. Product is shipped to Group companies who hold small amounts of stock locally for immediate or urgent customer requirements. Advanced wound management operates distribution centres at Nijmegen, Netherlands and Gothenburg, Sweden from where stock is shipped directly to the ultimate customer in most European markets.

 

MANUFACTURE AND SUPPLY

 

Where management considers that the Group possesses a core competence its policy is to manufacture products internally whenever possible to ensure quality, regulatory and cost goals are met. The Group invests in the expansion of its manufacturing facilities and equipment to meet these aims. The Group may outsource some manufacturing for several reasons including requirements for specialised expertise, where appropriate to achieve lower costs of production and due to capacity constraints.

 

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Where products and services are outsourced, suppliers are determined based on a number of factors which include the complexity of the product, manufacturing technology, manufacturing capabilities, cost competitiveness and intellectual property. Suppliers are selected based on their capability to provide products and services, their ability to establish and maintain a quality system and their financial stability. Suppliers are monitored by on-site assessments and on-going monitoring of delivered products. Ongoing product assurance is maintained by effective quality plans.

 

Each business unit purchases raw materials, components, finished products and packaging materials from certain key suppliers. These comprise principally 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 for all businesses. Management believes that whilst prices of principal raw materials can be volatile the effect is not material to the Group. Finished goods purchased for resale are primarily SUPARTZ joint lubricant and the BHR hip resurfacing product in the orthopaedic business, screen displays and electrical devices in the endoscopy business and enzyme debrider agents and ACTICOAT in the advanced wound management business.

 

SEASONALITY

 

Smith & Nephew’s revenues are generally at their highest in quarter four of any year. This is caused by the relatively high number of accidents and sports injuries which occur in the North American and European autumn and winter seasons which increase revenues of orthopaedic and endoscopy products and by the higher rates of elective surgery in the quarter.

 

RESEARCH AND DEVELOPMENT

 

The business units each manage a portfolio of short and long-term product development projects designed to meet the future needs of their customers and to continue to provide growth opportunities for their businesses. The Group’s research and development is directed towards all three business segments. Expenditure on research and development amounted to £67m in 2005 (2004 — £66m, 2003 — £67m), representing approximately 5% of group turnover (2004 — 5%, 2003 — 6%).

 

The Group’s principal research facility is located in York, England. The Group’s research programme seeks to underpin the longer-term technology requirements for its businesses and to provide a flow of innovative products. The Group continues to invest in future technology opportunities, particularly bio-resorbable materials, tissue engineering and non-invasive healing devices across the Group. In-house research is supplemented by work performed by academic institutions and other external research organisations principally in the UK and the US.

 

Product development is carried out at the Group’s principal locations, notably in Memphis, Tennessee (orthopaedics), Andover and Mansfield, Massachusetts (endoscopy) and Hull, England (advanced wound management).

 

INTELLECTUAL PROPERTY

 

Management believes that the Group’s policy concerning intellectual property rights promotes innovation in its businesses. Smith & Nephew has a policy of protecting, with patents, the results of the research and development carried out by the Group. Patents have been obtained for a wide range of products, including those in the fields of orthopaedic, endoscopic and advanced wound management technologies. Patent protection for Group products is sought routinely in the Group’s principal markets. Currently, the Group’s patent portfolio stands at over 2,300 existing patents and patent applications.

 

Smith & Nephew also has a policy of protecting the Group’s products in the markets in which they are sold by registering trademarks as soon as possible under local laws. The Group vigorously protects its trademarks against infringement and currently is not aware of any significant infringement of its trademark registrations. The present trademark portfolio of the Group consists of over 3,300 trademarks and design rights.

 

Smith & Nephew’s principal products are protected by intellectual property comprising patents, licences and know-how, and it strives to provide a collection of intellectual property for each major product that reduces the risk associated with failure of any individual piece of intellectual property. In addition, most 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.

 

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In addition to maintaining a policy of protecting its market position by the filing and enforcement of patents and trademarks, Smith & Nephew has a policy of opposing third party patents and trademarks in those areas that might conflict with the Group’s 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 operations and the financial results of the Group.

 

PROPERTY, PLANT AND EQUIPMENT

 

The Group’s principal locations are as follows:

 

     Approximate
area


     (Square feet
000’s)


Group Head Office in London, England

   15

Group research facility in York, England

   83

Orthopaedics headquarters and manufacturing facilities in Memphis, Tennessee

   784

Orthopaedics distribution facility in Memphis, Tennessee

   102

Orthopaedics administration facility in Memphis, Tennessee

   84

Endoscopy headquarters in Andover, Massachusetts

   112

Endoscopy manufacturing facility in Mansfield, Massachusetts

   98

Endoscopy manufacturing facility in Oklahoma City, Oklahoma

   100

Advanced Wound Management headquarters and manufacturing facility in Hull, England

   546

Advanced Wound Management manufacturing facility in Gilberdyke, England

   269

Advanced Wound Management manufacturing facility in Largo, Florida

   188

 

The orthopaedic headquarters and manufacturing facilities in Memphis and the advanced wound management facilities in Hull, Gilberdyke and Largo are freehold while all 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 significant individually to the Group. Where required, the appropriate governmental authorities have approved the facilities.

 

During 2005 the Group announced the closure of two of its manufacturing locations. The endoscopy facility in Andover, Massachusetts will be closed gradually during 2006 and its production relocated partly to other endoscopy facilities and partly out-sourced to third party suppliers. Production at the advanced wound management facility in La Jolla, California has ceased following the decision to exit its tissue engineering operations and the facility will be closed in the first quarter of 2006.

 

As a result of its rapid rate of sales growth in recent years and anticipated continuing strong demand for its products, the orthopaedics business increased its manufacturing capacity and administrative facilities in 2005 in line with its capacity expansion plans. Additional freehold manufacturing space of 104,000 square feet and leasehold administrative space of 84,000 square feet were acquired in Memphis.

 

During 2005, in the UK, new leasehold facilities for the development, manufacture and distribution of BHR products were acquired in the Warwick area and consolidated with the UK Orthopaedics operations. Leasehold locations in Bromsgrove and Cambridge were vacated.

 

The expansion in the Group’s facilities did not and is not expected to have a material impact on liquidity and resources.

 

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LEGAL PROCEEDINGS

 

The Company and its subsidiaries are parties to product liability and various legal proceedings, some of which include claims for substantial damages, which are considered to constitute ordinary and routine litigation incidental to the businesses conducted by the Group. The outcome of such proceedings cannot readily be foreseen, but other than as detailed below management believes that they will not result in any material adverse effect on the financial position or results of operations of the Group.

 

In August 2003 the Group withdrew voluntarily from all markets the macrotextured versions of its OXINIUM femoral knee components. As at that date 2,971 components had been implanted of which approximately 2,471 were in the USA, 450 in Australia and 50 in Europe, the first component having been implanted in December 2001.

 

The product was withdrawn when management became aware of a higher than usual percentage of reports of early revisions (“revisions” are implants which need to be replaced). It appears that some patients do not achieve adequate initial fixation and that in other patients, while there appears to be good initial fixation, this does not persevere. Smith & Nephew has extensively tested and investigated the cause of these early revisions. A group of medical and scientific experts retained and managed by the Group’s defence lawyers is expected to finish its work in this regard in mid-2006.

 

As at 31 December 2005 955 implants had been revised and settlements agreed with patients in respect of 771 of these revisions. The total amount paid out in settlements, legal costs and associated expenses was £78m of which £32m was recovered from the insurer that provides the primary layer and 65% of the first excess layer in the Group’s global product liability programme. The balance of £46m is due from insurers in respect of the remainder of the first excess layer and the second excess layer.

 

In December 2004 the Group was notified that two insurance carriers who comprise 35% of the first and 80% of the second excess layers of the Group’s global product liability programme had declined coverage for macrotextured claims due to differences in the interpretation of the policy wording. In December 2005 the other insurance carrier with a 20% participation in the second excess layer declined coverage. Management intends to take all steps available to it in order to enforce this coverage. A charge of £80m representing the amount outstanding from these insurers and an estimate of the cost associated with claims likely to arise in the future assuming that insurance cover continues to be unavailable from these and subsequent excess layer insurers was recorded in 2004. Apart from the impact of translational exchange rate movements there has been no change to the estimated liability during 2005.

 

The charge was calculated based on: (1) the amount outstanding at 31 December 2004 from the insurers who declined coverage; (2) an estimate of the average cost in respect of revisions where claims were unresolved at that date; and (3) an estimate of the number of settlements of future revisions based on the current trend and decaying to zero after five years and an estimation of the average future cost per settlement. The amount of provision remaining at 31 December 2005 to cover pending claims and claims in respect of future revisions, assuming no insurance cover is available, was £44m, which management believes is adequate.

 

As at 24 February 2006, 964 implants had been revised and settlements agreed with patients in respect of 796 of these revisions. The costs remain in line with expectations.

 

The Group’s assessment of the impact of these revisions and related matters constitute forward looking statements that are subject to uncertainties, including uncertainties relating to the outcome of settlements as compared to the assumptions made in estimating claim amounts. Smith & Nephew cannot provide assurance that these estimates will prove correct. Depending on the number and average cost of future settlements, costs may be greater or less than the amount provided (see “Risk Factors”).

 

In March 2005 the US Attorney’s Office in Newark, New Jersey issued a subpoena to the Group’s orthopaedic business asking for copies of its consulting, professional service and remuneration agreements with orthopaedic reconstructive surgeons. Four of the divisions’ major competitors received similar subpoenas. The Company is co-operating fully with the US Attorney, has provided copies of the requested contracts and is gathering additional documents which have also been requested.

 

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THE BUSINESS AND THE COMMUNITY

 

CORPORATE SOCIAL RESPONSIBILITY

 

Smith & Nephew’s aim is to help people live longer, healthier and more active lives by repairing and healing the human body with advanced technology products. The Group contributes to the treatment and the recovery of patients throughout the cycle of medical care. This is achieved by the design of products and instruments, the training of medical professionals and the procedures used to provide treatment and recovery. Cost effective solutions for healthcare systems are achieved through the use of advanced technology.

 

In developing a sustainable business, Smith & Nephew considers that it has a low impact on the environment and is committed to improving the management of its environment, social and economic impact.

 

Smith & Nephew is dedicated to helping improve people’s lives. The Group prides itself on the strength of its relationship with its clinicians and other healthcare professional customers with whom it has a reputation for product innovation and high standards of customer service. Healthcare economic considerations are integrated into the product development process to ensure that the benefits from the Group’s new products and line extensions not only improve patient outcomes but provide better treatment and procedures for both clinician and patient and contribute to more cost effective solutions for healthcare services.

 

The Group has published a Sustainability Report since 2001. The Group aims to improve the report each year by providing more information and relevant measurements. The Group monitors progress and views sustainable development as an integral part of the way it does business. The sixth Sustainability Report will be published on the Group’s website in May 2006 at www.smith-nephew.com.

 

Smith & Nephew’s progress is measured by two leading organisations that assess sustainable development. In 2005, the Group was included in the Dow Jones Sustainability Index (“DJSI”) with improved scores for the second year running and was named as a leader in its sector. In the UK, Smith & Nephew is a member of FTSE4Good.

 

Business Integrity

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 code of standards for suppliers, and the compliance processes for these standards, was further developed in 2005. Smith & Nephew does not give or receive improper financial inducements, either directly or indirectly, for business or financial gain. The Group complies with the industry standards set by Eucomed in Europe and Advamed in the US in its relationships with customers. Accounting records and supporting documents are designed to accurately describe and reflect the business’ transactions and conform to IFRS and US GAAP.

 

The Group’s Code of Business Principles (available at www.smith-nephew.com/who/principles-business.html) governs the way it operates so that it respects the rights of all its 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. During the year a formal whistleblower policy was introduced.

 

Innovation

Smith & Nephew uses innovation to create cost-effective products and techniques which deliver benefits for clinicians and patients. The Group’s scientific and technical leadership combined with an understanding of the needs of clinicians, enables Smith & Nephew to produce unique new products with distinct advantages in clinical performance and cost-effectiveness.

 

The Group’s research and development strategy is based on assessment of market needs and a longer range view of future requirements and opportunities. Fundamental scientific work and the development of new technologies are used to create new products and surgical techniques for delivery in the future.

 

It is the Group’s practice to develop platform technologies on which to build product ranges. This provides an efficient and cost effective means for product development.

 

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Health, Safety and Environmental Management

The Group has a health, safety and environmental (“HSE”) policy which was reviewed in 2005. Smith & Nephew has committed to:

 

  Give due regard to the effects of its operations on the environment and community to create a sustainable business.

 

  Provide and maintain a safe and healthy work environment for employees, contractors and visitors.

 

  Operate each Smith & Nephew business at the level required by the HSE policy standards.

 

  Aim to improve HSE performance through continuous evaluation and development of measures to control risk, conserve resources and minimise waste.

 

  Recognise, promote and reinforce the responsibility of employees, contractors and visitors to work safely and follow procedures.

 

In 2005 the advanced wound management factory at Hull, England joined the orthopaedics sites at Memphis, Tennessee and Tuttlingen, Germany in having its environmental management system accredited under ISO14001. All Group manufacturing and research sites have designed environmental management systems to deliver cost savings and benefits to the environment. Manufacturing processes are relatively low in environmental impact. Particular emphasis is placed on the close control of energy, water consumption and waste in manufacturing and research and development. Improvement targets are set and performance is measured against these targets. Smith & Nephew’s key environmental measurements over the last five years are as follows:

 

     2005

   2004

   2003

   2002

   2001

Emissions to air VOCs (tonnes)

   1    1    10    20    18

Emissions to air carbon dioxide (tonnes)

   50,212    48,954    50,160    47,888    n/a

Waste (tonnes)

   4,685    3,596    4,054    3,774    3,024

Hazardous waste (tonnes)

   303    234    275    270    184

Waste recycled (tonnes)

   1,009    767    646    750    813

Total energy (GwH)

   139    132    145    137    132

Water usage (1,000 cu. Metres)

   480    427    457    433    389

Discharges/effluent (1,000 cu. Metres)

   400    384    399    386    342

Lost time accidents (ii)

   0.6    1.0    0.9    1.4    N/A

Lost time ill health (iii)

   1.8    5.6    1.9    10.1    N/A

(i) Totals are for the Group as a whole for the year and therefore include divested businesses.
(ii) Number of accidents (resulting in a person being unable to work the following day) per 200,000 hours worked.
(iii) Number of cases of occupational ill health (resulting in a day or more away from work) per 1,000 people employed.

 

The 2004 hazardous waste figure excludes a spillage of chrome plating materials which occurred at the orthopaedics manufacturing site in Memphis. Working closely with the state authorities, prompt action was taken resulting in a total of 920 tonnes of affected soil being removed from the site to eliminate any possible contamination.

 

Carbon dioxide emissions are calculated from the energy consumption and are dependent on the mix of energy used. Emissions rose in 2005. However the figure quoted includes carbon dioxide emissions arising from the energy used at La Jolla, Florida, which was not included in 2004. Like for like, carbon dioxide emissions fell slightly.

 

Non hazardous waste rose sharply. This is a result of improved accounting of the waste disposed at Memphis, Tennessee, disposal of out of date material at Gilberdyke, England and waste from new process validation at both Largo, Florida and Gilberdyke, England.

 

Hazardous waste increased in 2005 despite significant reductions at most sites. This was largely the result of FLAMAZINE waste at Hull, England being reclassified as hazardous and an increase at Memphis, Tennessee, arising from more frequent maintenance routines.

 

Having focused on opportunities for recycling, all sites were able to show a significant increase in recycled waste. Despite the fact that many sites were able to show significant energy savings, total energy consumption rose in 2005. This is a result of the energy consumed by La Jolla, Florida, being included for the first time and an increase in consumption at Memphis, Tennessee and Gilberdyke, England due to increased production.

 

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Lost time accident frequency rate is measured as the number of accidents (those which results in a person being unable to report for work on the following day) per 200,000 hours worked. Various initiatives across the Group lead to a significant reduction in 2005.

 

Lost time ill health performance is measured as the number of cases of occupational ill health that result in a day or more away from work per 1,000 people employed.

 

A full analysis of these measurements and key health and safety performance measures will be included in the 2006 Sustainability Report on the Group’s website when it is published in May 2006.

 

Social responsibility

The Smith & Nephew Code of Business Principles governs the Group’s interactions with its stakeholders. This sets out the behaviours and conduct stakeholders can expect from the Group. The Code of Business Principles describes the Group’s values and provides a framework for employees.

 

Employees

Smith & Nephew has a policy of non-discrimination and aims to provide an open environment based on constructive relationships. Smith & Nephew welcomes people with disabilities and makes every effort to retain any employee who has a disability. The Group is committed to engaging with employees through the regular and timely dissemination of Group information and soliciting their feedback and ideas. An employee global opinion survey is used every two years as a catalyst for improvements.

 

The 2004 Global Opinion Survey indicated continued high levels of employee engagement with the values and direction of the Group. The next survey will be conducted in 2006 using improved methodology including the introduction of regular sample surveys to measure progress and obtain employee feedback on issues that arise between the main surveys. Details of these planned changes will be covered in the next Sustainability Report in May 2006.

 

Recruitment and retention of skilled employees emerged as a key issue to ensure continued high performance. A recruitment excellence programme launched in 2005 resulted in the implementation of clear and consistent standards and practices for key recruitment processes. Managers are trained in the application of these as part of a series of management development modules being delivered across the Group. New employees will now experience a consistent and high quality recruitment selection process that carries through to the first year of induction.

 

In 2005 a number of measures of employee engagement were monitored. These measurements are a useful monitoring tool and alert mechanism for action as well as giving trend indicators of improved performance. Two years data is now available and is given below.

 

Internal Appointments

In 2005 an average of 23.1% (2004 — 21.3%) of vacancies across all parts of the business were filled by internal applicants with an average of 35% (2004 — 30%) of vacancies filled in the Group’s orthopaedics, endoscopy and advanced wound management business units. The Group has a policy of open advertising and providing opportunities for existing employees wherever possible, while recognising the need to bring in new ideas and approaches that external recruitment brings.

 

Labour Turnover

For the last two years the Group measured both general voluntary labour turnover and turnover relating specifically to employees who have been with the business less than two years. The latter measure is an indication of how well the Group recruits and then retains its employees so that they can make a contribution to the business.

 

The average voluntary labour turnover for 2005 was 3.0% (2004 — 2.5%) ranging from 2.2% to 3.8% across the Group. The average turnover of employees leaving the Group within two years of joining was 4.3% (2004 — 5.8%) ranging from 2.4% to 9.2% for the year.

 

The average labour turnover figures are well within the expected level for businesses in the Group’s sector and there is a reduction in the number of employees leaving within two years of joining which the Group believe reflects the improvements in its recruitment, induction and training introduced in the last two years. The highest incidence of leavers within two years is seen in the indirect markets. This has been reduced to 9.2% in 2005 (2004 — 14.8%)

 

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Training and Development Investment

The Group is committed to providing training and information so that all employees can make the best contribution possible. Learning and development programmes are used to attract, retain and develop employees. These programmes are linked to formal performance appraisal and development planning. 2005 has seen the development and implementation of a range of 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. These are available throughout the Group and additional modules are planned for 2006.

 

Leadership

The Group aims to develop its current and future leaders to improve the performance of the business. The senior management has developed a set of group-wide leadership competencies and management development is a regular item on their meeting agenda. Performance evaluation, coaching and attendance at leadership programmes are utilised.

 

In late 2004, the Group introduced a “leadership excellence programme”. This is a three-day purpose designed residential course facilitated by a business school coach. The programme focuses on leadership style and interaction and to date, 36 senior managers attended the programme which continues to be rolled out in 2006.

 

Workplace

Smith & Nephew aims to provide healthy and safe working conditions for all its employees. Health and safety is managed as an integral part of the business and employee involvement is recognised as a key part of the process.

 

The Group does not use any form of forced, compulsory or child labour. The Group supports the Universal Declaration of Human Rights of the United Nations and respects human rights, the dignity and privacy of the individual, the right of employees to freedom of association, freedom of expression and the right to be heard.

 

Society and Community

The Group works with national and local governments and other organisations to meet its legal and civic obligations, manage its impact on the environment, and contribute to the development of laws and regulations that affect its business. Smith & Nephew values community involvement and is an active member of its local communities and supports employees who undertake community work.

 

The Group’s principles for charitable giving are based on the criteria relevant to its business areas, 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 who receive donations of Smith & Nephew products, sponsorship and help from the Group’s employees. Teamed with these individuals and organisations, Smith & Nephew believes it has found a way of increasing the impact of charitable giving and the work it undertakes.

 

The Smith & Nephew Foundation is an independent charitable trust funded by Smith & Nephew advanced wound management. It makes awards to individuals in the nursing professions for postgraduate research to improve clinical practice in nursing and midwifery. The Foundation is the largest single charitable awarding body to the nursing professions in the UK.

 

More examples of the programmes supported by Smith & Nephew are given in the Sustainability Report.

 

In 2005, direct donations to charitable and community activities totalled £1,379,000 of which £300,000 went to the Smith & Nephew Foundation. Smith & Nephew made no political contributions in 2005.

 

Customers

The Group is committed to providing innovative, cost-effective healthcare solutions benefiting healthcare professionals and their patients through improved treatment, ease and speed of product use and reduced healthcare costs. It will continue to provide education and training support for healthcare professionals and maintain investment in research and development.

 

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In 2005 Smith & Nephew orthopaedics introduced MOBILAB, a state of the art mobile training centre in the US. MOBILAB takes the Group’s advanced training facilities direct to hospitals enabling surgeons to train with their operating team on their own hospital site.

 

The Group’s products are designed to be safe and reliable for their intended use and comply with or exceed all legal and regulatory requirements, including those concerning packaging, labeling and user instructions. The aim is to anticipate future standards and requirements promoting health and safety of its customers and patients.

 

Business Partners

Smith & Nephew is committed to establishing mutually beneficial relationships with its suppliers, customers and business partners. The Group works only with partners who it believes adhere to business principles and health, safety, social and environmental standards consistent with its own. Additional work has been done in 2005 to improve the monitoring of the supplier standards for service quality and activities relevant to their corporate responsibility.

 

Economic Contribution

The Group 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. Smith & Nephew’s sustainable development depends ultimately on its ability to provide a satisfactory economic return. In 2005, the Group generated an operating return on capital employed (ratio of trading profit to average equity plus net debt less investment in joint venture, as set out in “Selected Financial Data”) of 36%.

 

The Group prides itself on the strength of its relationship with its clinicians and other healthcare professionals with whom it has a reputation for product innovation and high standards of customer service. Healthcare economic considerations are integrated into the product development process to ensure that the benefits from the Group’s products improve patient outcomes, treatments and procedures for both clinician and patient and create cost effective solutions for healthcare services.

 

The Group has built expertise in the area of measuring healthcare economics within its advanced wound management business and has made good progress in introducing a similar system across its other businesses. A description of the principles of healthcare economics and its integration into the business is given in the Sustainability Report.

 

Looking Ahead

The Group is fulfilling an important role in its areas of expertise. Increased demands are being made on healthcare systems as the baby boomer generation ages and obesity, more active lifestyles and the increased incidence of diseases increase the demand for Smith & Nephew’s products.

 

Smith & Nephew’s strategy is to build upon its leading technologies, expand its markets and provide advanced technology to the medical profession. 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. In all its business activities, the drive towards sustainability is an ongoing process and Smith & Nephew is committed to maintaining a consistent effort to improve. The Group’s aim is to innovate to improve treatments and reduce healthcare costs thus contributing to sustainable and improving healthcare systems.

 

In reporting sustainability, Smith & Nephew is committed to improved monitoring of its performance in its development as a sustainable business. It is intended to introduce reporting of Key Performance Indicator targets for environmental, health and safety and social responsibility and to expand economic impact reporting.

 

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EMPLOYEES

 

The average number of full-time equivalent employees in 2005 was 8,618, of whom 1,750 were located in the UK, 3,977 were located in the US and 2,891 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:

 

     2005

   2004

   2003

Orthopaedics

   3,581    3,016    2,727

Endoscopy

   1,788    1,644    1,635

Advanced Wound Management

   3,249    3,206    3,089
    
  
  
     8,618    7,866    7,451
    
  
  

 

Where the Group has collective bargaining arrangements in place with labour unions, these reflect local market circumstances and operate effectively.

 

Smith & Nephew operates share option schemes that are available to the majority of employees (for further information see Note 27 of the Notes to the Group Accounts).

 

Further information about Smith & Nephew employees, management principles and “Vision and Values” is set out in the Sustainability Report on the Smith & Nephew corporate website.

 

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RISK FACTORS

 

There are risks and uncertainties related to Smith & Nephew’s business. The factors listed below are those that Smith & Nephew believes could cause the Group’s actual financial condition or results of operations to differ materially from expected and historical results. Factors other than those listed here, that Smith & Nephew cannot presently identify, could also adversely affect Smith & Nephew’s business. The factors listed below should be considered in connection with any forward-looking statements in this report and the cautionary statements contained in “Financial Summary — Special Note Regarding Forward-Looking Statements”.

 

Product Liability Claims and Loss of Reputation

The development, manufacture and sale of medical devices and products entail risk of product liability claims or recalls. Design defects and manufacturing defects with respect to products sold by the Group or by companies it has acquired could result in damage to or impairing the repair of body functions. Smith & Nephew may become subject to liability, which could be substantial, because of actual or alleged malfunction of its products. In addition, product malfunction could also lead to the need to recall from the market existing products, which may be costly and harmful to the Group’s reputation which is crucially dependent on product safety and efficacy.

 

Product liability is a risk in the medical devices industry, particularly in the US, the Group’s largest geographic market where claims for pain and suffering and loss of earnings may involve substantial amounts. There is a risk that patients bring product liability or related claims that could have a material adverse effect on the Group’s financial position. The potential exists for claimants to join together in a class action which could have the effect of increasing the total potential liability.

 

The Group maintains product liability insurance, but this insurance is subject to limits and deductibles. There is a risk that this insurance could become unavailable at a reasonable cost or at all, or will be inadequate to cover specific product liability claims. Insurance premiums are relatively high, particularly for coverage in the US, and there is a risk at the medical devices industry level that insurance coverage could become increasingly costly. If Smith & Nephew or any companies it acquires do not have adequate insurance, product liability claims and costs associated with product recalls could significantly limit Smith & Nephew’s available cash flow and negatively impact product sales from any associated loss of business.

 

In August 2003 the Group withdrew voluntarily from all markets the macrotextured versions of its OXINIUM femoral knee components. As at that date 2,971 components had been implanted of which approximately 2,471 were in the USA, 450 in Australia and 50 in Europe, the first component having been implanted in December 2001.

 

The product was withdrawn when management became aware of a higher than usual percentage of reports of early revisions (“revisions” are implants which need to be replaced). It appears that some patients do not achieve adequate initial fixation and that in other patients, while there appears to be good initial fixation, this does not persevere. Smith & Nephew has extensively tested and investigated the cause of these early revisions. A group of medical and scientific experts retained and managed by the Group’s defence lawyers is expected to finish its work in this regard in mid-2006.

 

In December 2004 the Group was notified that two insurance carriers who comprise 35% of the first and 80% of the second excess layers of the Group’s global product liability programme had declined coverage for macrotextured claims due to differences in the interpretation of the policy wording. In December 2005 the other insurance carrier with a 20% participation in the second excess layer declined coverage. Management intends to take all steps available to it in order to enforce this coverage. A charge of £80m representing the amount outstanding from these insurers and an estimate of the cost associated with claims likely to arise in the future assuming that insurance cover continues to be unavailable from these and subsequent excess layer insurers was recorded in 2004. Apart from the impact of translational exchange rate movements there has been no change to the estimated liability during 2005.

 

Medical Device Company Valuations

In 2005 the valuation of medical device companies declined relative to broader indices but as a growth industry medical device companies still have higher stock market valuations than other industrial companies. If market conditions change, or other companies in its sector fail to perform, or the Group is perceived to be performing less well than the sector, then the share price rating of the Group may be adversely affected.

 

Highly Competitive Markets

The Group’s principal business units compete across a diverse range of geographic and product markets. The markets in which each of the business units operates each contain a number of different competitors, including

 

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specialised and international corporations. Significant product innovations, technical advances or the intensification of price competition by competitors could adversely affect the Group’s operating results. Some of these competitors may have greater financial, marketing and other resources than Smith & Nephew. These competitors may be able to deliver products on more attractive terms, more aggressively market their products or invest larger amounts of capital and research and development into their businesses. The competitive risk in the endoscopy market from the reprocessing and re-use of single use disposable devices such as arthroscopic resection blades has declined in the US during 2005 but is still a factor in certain countries outside the US.

 

There is a risk of further consolidation particularly in the orthopaedic industry, which could adversely affect the Group’s ability to compete with much larger companies due to insufficient financial resources. If any of the Group’s businesses were to lose market share or achieve lower than expected revenue growth there could be a disproportionate adverse impact on the Group’s share price and its strategic options.

 

Failure to Make Successful Acquisitions

A key element of the Group’s strategy for continued growth is to make acquisitions or alliances to complement its existing businesses. Failure to identify appropriate acquisition targets or failure to integrate them successfully would have an adverse impact on the Group’s competitive position and profitability.

 

Attracting and Retaining Key Personnel

The Group’s continued development depends on its ability to hire and retain highly skilled personnel with particular expertise. This is critical, particularly in research and new product development and in the orthopaedics and endoscopy sales forces of which the largest are in the US. If Smith & Nephew is unable to retain key personnel in research and new product development or if its largest sales forces suffer disruption or upheaval, its sales and operating profit would be adversely affected.

 

Trends in the Healthcare Industry

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 Group’s products is governed in most major markets largely by governmental reimbursement authorities. 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 and pricing which may have an adverse impact on sales and operating profit. The Group must adhere to the rules laid down by funding agencies including the US Medicare and Medicaid fraud and abuse rules. Failure to do so could result in fines or loss of future funding.

 

Business practice in the healthcare industry is subject to review by government authorities and regulators. In March 2005 the Group’s orthopaedic business was issued with a subpoena by the US Attorney’s office requesting copies of its consulting, professional service and remuneration agreements with orthopaedic reconstruction surgeons. There have been no significant developments since then but any unfavourable ruling against the Group or the orthopaedics industry as a whole could have a material adverse impact on the Group’s results or cause a loss of reputation. See “Legal Proceedings”.

 

In addition, competition exists among healthcare providers to gain patients on the basis of quality, service and price. There has been some consolidation in the Group’s customer base, as well as among the Group’s competitors, and these trends are expected to continue long term. 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 Group’s business areas which would adversely affect Smith & Nephew’s results of operations and hinder its growth potential.

 

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. 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 each country in which the Group operates although a single approval

 

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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. Regulatory approvals in the US, Europe and Japan and are the most critical to the Group’s success in launching new products.

 

The Group is required to comply with a wide range of regulatory controls over the manufacturing, testing, distribution and marketing of its products, particularly in the US, UK and Continental Europe. Such controls have become increasingly demanding and management believes that this trend will continue. Failure to comply with such controls could have a number of adverse consequences, including withdrawal of approval to sell a product in a country or temporary closure of a manufacturing facility.

 

Patent Infringement Claims

Due to the technological nature of medical devices, the Group is subject to the potential for patent infringement claims. Smith & Nephew attempts to protect its intellectual property and regularly opposes third party patents and trademarks in those areas that might conflict with the Group’s business interests. If Smith & Nephew fails to successfully enforce its intellectual property rights, its competitive position could suffer, which could harm its operating results.

 

Claims asserted by third parties regarding infringement of their intellectual property rights, if successful, could require the Group to expend significant resources to pay damages, develop non-infringing products or to obtain licences to the products which are the subject of such litigation.

 

Continual Development and Introduction of New Products

The Group operates in the medical devices industry, which has a rapid introduction rate of new products. In order to remain competitive, each of the Group’s 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 Group’s products and technologies are subject to marketing attack by competitors. Furthermore, new products that are developed and marketed by the Group’s competitors may affect price levels in the various markets in which the Group’s business units operate. If new products do not remain competitive with competitors’ products, the Group’s sales revenue could decline.

 

There is a risk that a major disruptive technology could be introduced into one of the Group’s markets and adversely affect its ability to achieve business plans and targets.

 

Manufacturing and Supply

The Group’s manufacturing production is concentrated at six main facilities in Memphis, Tennessee; Mansfield, Massachusetts; Oklahoma City, Oklahoma; and Largo, Florida in the United States and Hull and Gilberdyke in the United Kingdom. If major physical disruption took place at any of these sites, it would 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 orthopaedics 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 three business units is reliant on certain key suppliers of raw materials, components, finished products and packaging materials. If any of these suppliers is unable to meet the Group’s needs 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. 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. There is currently a risk that supplies of SUPARTZ, which is extracted from rooster combs, may be impacted by the outbreak of avian flu in Asia. Any interruption of supply caused by these or other factors could negatively impact Smith & Nephew’s revenue and operating profit.

 

Currency Fluctuations

The Group has reported its 2005 results in Sterling. However only 9% of Group revenue arose in the UK compared with 49% in the US, 22% in Continental Europe and 20% in Africa, Asia, Australia, Canada and Latin

 

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America. Fluctuations in the exchange rates used to translate the financial statements of operations outside the UK into Sterling had the effect of increasing Group revenue by 2%. In 2004 the effect was to reduce Group revenue by 7%. In 2006 the Group will change its reporting currency and Smith & Nephew plc will change its functional currency to US Dollars. This will reduce the Group’s exposure to exchange rate fluctuations in the translation of its revenue and profits.

 

The Group’s manufacturing cost base is situated in the US and the UK from where finished products are exported to the Group’s selling operations worldwide. Thus the Group is exposed to fluctuations in exchange rates between the US Dollar and Sterling and the currencies of the Group’s selling operations, particularly the Euro and the Japanese Yen. If the US Dollar and/or Sterling should strengthen against the Euro and the Japanese Yen then Group trading margin would be adversely affected.

 

Political and Economic Uncertainties

Because the Group has operations in 33 countries, political and economic upheaval in those countries or in the regions surrounding those countries may impact the Group’s 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 investments in that country. Furthermore, legislative measures in a country could result in changes in tariffs, import quotas or taxation that could adversely affect the Group’s turnover and operating profit. Terrorist activities and ongoing global political uncertainties, including conflict in the Middle East, could adversely impact the Group.

 

Other Risk Factors

The Board considers that Smith & Nephew is subject to a number of other risks which are common to most global medical technology groups and which are reviewed as part of its risk management process.

 

In the financial area these include interest rate volatility, share price volatility, challenges by taxation authorities, failures in reporting and internal financial controls and uninsured losses.

 

Adverse events in the areas of corporate social responsibility could also adversely impact Group operating results.

 

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OPERATING AND FINANCIAL REVIEW,

LIQUIDITY AND PROSPECTS

 

The Operating and Financial 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:

 

Business overview

   28

2005 Year

   32

2004 Year

   37

Outlook and trend information

   42

Financial position, liquidity and capital resources

   43

Exchange and interest rate risk and financial instruments

   45

Contractual obligations

   46

Off-balance sheet arrangements

   46

Related party transactions

   46

US GAAP

   47

 

The results for each year are compared primarily with the results for the preceding year.

 

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BUSINESS OVERVIEW

 

Smith & Nephew’s operations are organised into three business units that operate globally: orthopaedics, endoscopy and advanced wound management. Smith & Nephew believes that its businesses have the opportunities for strong growth due to its markets benefiting from an ageing population, an increase in active lifestyles and trends toward less invasive medical procedures.

 

Revenue by business segment as a percentage of total revenue was as follows:

 

     2005

   2004

   2003

     (%)

Orthopaedics

   50    47    45

Endoscopy

   24    24    25

Advanced Wound Management

   26    29    30
    
  
  

Total revenue

   100    100    100
    
  
  

 

Revenue by geographic market as a percentage of total revenue was as follows:

 

     2005

   2004

   2003

     (%)

Europe (Continental Europe and United Kingdom)

   31    33    31

United States

   49    49    51

Africa, Asia and Australia and other America

   20    18    18
    
  
  

Total revenue

   100    100    100
    
  
  

 

Trading profit by business segment as a percentage of total trading profit was as follows:

 

     2005

   2004

   2003

     (%)

Orthopaedics

   58    55    54

Endoscopy

   24    24    27

Advanced Wound Management

   18    21    19
    
  
  

Total trading profit

   100    100    100
    
  
  

 

Operating profit by business segment as a percentage of total operating profit was as follows.

 

     2005

   2004

   2003

     (%)

Orthopaedics

   68    33    51

Endoscopy

   26    36    28

Advanced Wound Management

   6    31    21
    
  
  

Total operating profit

   100    100    100
    
  
  

 

Underlying Growth in Sales

Management’s key indicator of revenue performance is underlying growth in revenue. This is calculated by excluding the effects of foreign currency translation movements and acquisitions (see Note 3(c) of the Notes to the Group Accounts). Management believes that revenue growth on an underlying basis provides a consistent year-on-year measurement of performance without the distortions created by the translational effect of foreign currency movements and acquisitions which are separate from the Group’s normal operations. Underlying revenue growth is used by management in its internal financial reporting, budgeting and planning.

 

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Reported growth in revenue by business segment reconciles to underlying growth in 2005 as follows:

 

     Reported
growth


   Foreign
currency
translation
effect


    Acquisitions
effect


    Underlying
growth


     (%)    (%)     (%)     (%)

Orthopaedics

   19    (2 )   (1 )   16

Endoscopy

   10    (2 )       8

Advanced Wound Management

   5    (1 )       4
    
  

 

 

Total revenue

   13    (2 )       11
    
  

 

 

 

Reported growth in revenue by business segment reconciles to underlying growth in 2004 as follows:

 

     Reported
growth


   Foreign
currency
translation
effect


   Acquisitions
effect


    Underlying
growth


     (%)    (%)    (%)     (%)

Orthopaedics

   12    9    (4 )   17

Endoscopy

   2    7        9

Advanced Wound Management

      5        5
    
  
  

 

Total revenue

   6    7    (1 1/2 )   11 1/2
    
  
  

 

 

Reported growth in revenue by geographic market reconciles to underlying growth in 2005 as follows:

 

     Reported
growth


   Foreign
currency
translation
effect


    Acquisitions
effect


    Underlying
growth


     (%)    (%)     (%)     (%)

Europe (Continental Europe and United Kingdom)

   8    (1 )   (1 )   6

United States

   14    (2 )       12

Africa, Asia and Australia and other America

   18    (3 )       15
    
  

 

 

Total revenue

   13    (2 )       11
    
  

 

 

 

Reported growth in revenue by geographic market reconciles to underlying growth in 2004 as follows:

 

     Reported
growth


   Foreign
currency
translation
effect


   Acquisitions
effect


    Underlying
growth


     (%)    (%)    (%)     (%)

Europe (Continental Europe and United Kingdom)

   11    1    (4 )   8

United States

   2    12        14

Africa, Asia and Australia and other America

   8    4    (2 )   10
    
  
  

 

Total revenue

   6    7    (1 1/2 )   11 1/2
    
  
  

 

 

Factors Affecting Smith & Nephew’s Results of Operations

 

Sales Trends

Smith & Nephew’s business units participate in the global medical devices market and share a common focus on the repair of human tissue. Smith & Nephew’s 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

 

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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 the use of surgeon and nursing resources.

 

A recent trend has been increasing consumer awareness of available healthcare treatments through the Internet and direct-to-customer advertising. This has led to increased consumer influence over product purchasing decisions.

 

In orthopaedics, improvements in technology have lengthened the effective life of reconstruction implants and have facilitated the implantation of knees and hips in relatively young patients thereby improving the quality of life for a new generation. The decision to create separate sales forces for reconstruction, trauma and clinical therapy products was a strategic move intended to generate greater customer focus. Management believes that the creation of separate global business units in 2006 for orthopaedic reconstruction and orthopaedic trauma, including clinical therapies, will increase focus and result in increased revenue growth for both businesses.

 

The endoscopy business is benefiting from the continued trend worldwide towards less invasive surgery but with particular focus on arthrosopic 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 spinal disc repair and arthroscopic hip repair.

 

The advanced wound management business 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. The market for advanced wound treatments is relatively unpenetrated and it is estimated that the potential market is significantly larger than the current market. This increased penetration is expected to be driven by improved outcomes from new technology, health economic benefits, increasing nursing shortages, quality of life expectations and education of healthcare providers to convert from traditional to advanced treatments.

 

In order to take advantage of the expanding markets the Group must continually develop its existing and new technologies and bring new products to its customers. Expenditure on research and development in 2005 represented 5% of Group turnover and products launched within the last three years represented 17% of Group turnover.

 

Sales Force

The Group’s sales force, which includes independent commissioned sales agents, increased by 10% to 3,140 during 2005. The biggest increase was 21% in orthopaedics where the most significant increase was in the US. The size of the endoscopy sales force increased by 4% whereas the advanced wound management sales force was broadly unchanged.

 

Currency Movements

Smith & Nephew’s 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 attempts to manage the impact of exchange rate movements on cost of goods sold by a policy of purchasing forward all its foreign currency commitments when firm purchase orders are placed. In addition, businesses are required to purchase forward a minimum of 50% of their forecast foreign currency requirements on a twelve-month rolling basis. The Group’s 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 Sterling on its indebtedness denominated in currencies other than Sterling. See “Financial Position, Liquidity and Capital Resources”. The change of reporting currency to US Dollars with effect from the beginning of 2006 will reduce significantly the Group’s exposure to exchange rate movements on the translation of results. See “Financial Summary”.

 

Other

Other than national governments seeking to control or reduce healthcare expenditure management is not aware of any governmental, economic, fiscal, monetary or political policies or factors that have materially affected, directly or indirectly, the Group’s operations or investments by shareholders.

 

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Critical Accounting Policies

The Group’s 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 management’s judgment are as follows:

 

Inventories

A feature of the orthopaedic business (whose finished goods inventory makes up 67% of the Group total finished goods stock) is the high level of product inventory required, inventory 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 outer 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 stock to anticipate this situation. These adjustments are calculated in accordance with a formula based on levels of stock 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.

 

Impairment

In carrying out impairment reviews of goodwill and intangible and tangible assets 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.

 

Retirement Benefits

The Group accounts for its defined benefit pension plans and retirement healthcare plans under IAS19. In order to preserve consistency with previous disclosures the option under IAS19 was chosen which is most similar to the UK accounting standard, FRS17. Under this treatment the balance sheet reflects the full value of the total plan deficits without the use of the corridor approach by which valuation movements may be recognised over time. Actuarial gains and losses are recognised directly in equity through the statement of recognised income and expense.

 

A number of key assumptions have to be made in calculating the fair value of the Group’s defined benefit pension plans which impact the balance sheet liability and finance costs. The most sensitive assumptions are:

 

  A 1% increase in the discount rate applied to projected plan liabilities would reduce the combined deficit by £80m whilst a decrease of 1% would increase the deficit by £105m.

 

  The effect of increasing the life expectancy assumption in 2005 of a male member of the UK plan aged 60 from 23.3 years to 24.6 years was to increase the deficit by £10 million.

 

  The effect of raising the life expectancy assumption in 2006 of a male member of the US plan aged 60 from 20.7 years to 21.8 years will be to increase the deficit by £3 million.

 

  A movement of 1% in the assumed return on equities would have changed other finance costs by £3m while a movement of 1% in the notional interest cost assumption would have changed other finance costs by £4m.

 

See Note 34 of the Notes to the Group Accounts for a summary of how the assumptions selected in the last three years have compared with actual results.

 

The discount rate is determined by reference to market yields on high quality corporate bonds at the balance sheet date. The Group selects its discount rate by benchmarking against published indices and by consultation with its actuaries. The principal index used for benchmarking is the iBOXX Corporate AA index for bonds with terms consistent with the estimated defined benefit payments.

 

Contingencies and Provisions

The recognition of provisions for loss contingencies is subject to a significant degree of estimation. Provision is made for loss contingencies when it is deemed 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

 

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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.

 

A provision of £80m ($154m) was recorded in 2004 to cover the estimated cost of settling claims by patients in respect of macrotextured knee revision surgeries assuming that insurance cover continues to be declined. After adjusting for costs charged against the provision and for the affect of translation exchange rate movements a provision of £44m remains to cover pending and future claims. The key variables in assessing the adequacy of the provision are the number of revisions likely to arise in the next four years and the average cost of settling patient claims for those revisions. Whilst management’s estimate of the most probable total cost is $154m, which is the amount provided, it is possible that the eventual outcome may be different. Based on independent statistical projections of revisions through to the end of 2009 the range of possible costs is $133m to $194m.

 

The Group operates in numerous tax jurisdictions around the world, and it is Group policy to submit its tax returns to the relevant tax authority on or before the time limits specified by local tax legislation. However, the relevant tax authorities are entitled to make enquiries into or audit the information set out in those returns until that year has been formally closed by agreement or is subject to a statutory limitation.

 

At any given time, tax audits are being carried out in a number of territories covering multiple years and tax returns are subject to possible enquiry in most locations in which the Group operates. The Group’s policy is to provide in current liabilities for additional taxes that may become payable in future years as a result of the settlement of tax audits or other tax enquiry procedures. This provision represents the Group’s best estimate of the tax liability that may arise on resolution of these disputes but the ultimate tax liability may differ from the amount provided dependent upon negotiations with the tax authority, changes in tax legislation, interpretation of tax law, and decisions in the relevant judicial system.

 

2005 YEAR

 

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. The Group’s Accounts are prepared in accordance with IFRS, as adopted by the EU, which differ in certain respects from US GAAP. All data has been adjusted to comply with IFRS. Reconciliations reflecting the effect of the significant differences between IFRS and US GAAP are set forth in Note 39 of Notes to the Group Accounts.

 

Accounting Policies Adopted in 2005

See Note 51 of Notes to the Group Accounts for information regarding accounting policies adopted in 2005.

 

Financial Highlights of 2005

Group revenue was £1,407m for the year ended 31 December 2005, representing 13% growth compared to 2004. Underlying growth in revenue was 11%.

 

Profit before taxation was £240m, compared with £167m in 2004. Adjusted attributable profit (calculated as set out in “Selected Financial Data”), improved 14% to £223m.

 

Basic earnings per Ordinary Share were 19.9p, a 34% increase compared to 14.8p for 2004. Adjusted basic earnings per Ordinary Share including discontinued operations (as set out in “Selected Financial Data”) were 23.8p compared to 20.8p for 2004, representing a 14% increase.

 

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Fiscal 2005 Compared with Fiscal 2004

The following table sets out certain profit and loss account data for the periods indicated:

 

     2005

    2004

 
     (£ million)  

Revenue (i)

   1,407     1,249  

Cost of goods sold

   (361 )   (335 )
    

 

Gross profit

   1,046     914  

Marketing, selling and distribution expenses

   (543 )   (477 )

Administrative expenses

   (161 )   (136 )

Research and development expenses

   (67 )   (66 )

BSN agency and management fees

   15     15  
    

 

Trading profit (i)

   290     250  

Restructuring and rationalisation expenses

   (47 )    

Macrotextured claim

       (80 )

Amortisation of acquisition intangibles

   (6 )   (5 )
    

 

Operating profit (i)

   237     165  

Net interest receivable

   5     4  

Other finance costs

   (3 )   (2 )

Fair value of hedge of anticipated sale proceeds of joint venture

   1      
    

 

Profit before taxation

   240     167  

Taxation

   (70 )   (45 )
    

 

Profit from continuing operations

   170     122  

Discontinued operations — share of results of the joint venture

   17     16  
    

 

Attributable profit for the year

   187     138  
    

 


(i) Group revenue, trading profit and operating profit are derived wholly from Continuing Operations.

 

Revenue

For the year ended 31 December 2005 Group revenue increased by £158m (13%) to £1,407m from £1,249m. Underlying revenue growth was 11% and favourable currency translation, particularly the stronger US Dollar relative to Sterling added 2%.

 

Orthopaedics revenues increased by £109m or 19% of which 16% was underlying growth, 2% was due to favourable currency translation and 1% arose from the full year effect of the revenues of MMT, compared with nine months in the previous year. Endoscopy revenues increased by £29m or 10%, of which 8% was underlying growth and 2% was due to favourable currency translation. Advanced wound management revenues increased by £20m or 5%, of which 4% was underlying growth and 1% was due to favourable currency translation.

 

A more detailed analysis is included within the Revenue sections of the individual business segments that follow on pages 35 to 37.

 

Cost of goods sold

Cost of goods sold at £361m, represented 25.7% of revenue compared to £335m (26.8%) in 2004. The main factor in this improvement was the 0.7% effect of business mix caused by the higher rate of revenue growth of orthopaedics which has the lowest cost of goods sold, compared with the lower growth rates of endoscopy and advanced wound management. Orthopaedics increased its share of Group revenue from 47% to 50%. A secondary factor was a 0.2% benefit from transactional currency. This was achieved despite the US Dollar appreciating against the Euro and Sterling through the group’s policy of covering forward its foreign exchange purchases on a rolling twelve month basis.

 

Further margin analysis is included within the Trading Profit sections of the individual business segments that follow on pages 35 to 37.

 

Marketing, selling and distribution expenses

These costs increased by £66m from £477m to £543m and represented 38.6% of revenue, compared to 38.2% in 2004. This is due mainly to the costs of increasing the number of sales representatives in orthopaedics in the US.

 

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Administrative expenses

Administrative expenses were £25m higher than in 2004 and represented 11.4% of revenue compared with 10.9% in 2004. Administrative expense grew in line with revenue growth except that increases in insurance premiums accounted for an additional £5m and the costs of combining and relocating the UK orthopaedic business with MMT was £2m.

 

Research and Development expenses

There was no material change in expenditure on research and development but expenditure as a percentage of revenue fell from 5.3% to 4.8%. This was caused by a rationalisation of development projects at orthopaedics and endoscopy. The Group continues to invest in innovative technologies and products to differentiate itself from competitors. In 2005, 17% of the Group’s revenue was from products introduced in the last three years.

 

BSN Medical agency and management fees

Agency and management fees of £15m were received in respect of services provided to BSN Medical for sales force resource, physical distribution and logistics and administration in certain countries. The calculation of the fees is designed to result in a neutral, cost-recovery position for Smith & Nephew and is intended to be for a transitional period only. Recoveries were broadly unchanged in 2005 as there was no material change in the number or nature of shared service agreements.

 

Trading profit

Trading profit was £290m, an increase of £40m compared to £250m in 2004, resulting from an increase in gross profits of £132m partly offset by an increase of £92m in expenses. Trading profit margins rose from 20.0% to 20.6%.

 

Restructuring and rationalisation expenses

This comprises two items. £39m related to the Group’s decision to close the tissue engineering operations within its advanced wound management business. Production ceased in December 2005 and final closure is expected to be during the first quarter of 2006. The components of the closure costs are £14m for the impairment of intangible assets related to patents and other intellectual property, £2m to write down plant and equipment, £3m inventory write down, £5m for redundancy payments, £10m for onerous lease obligations and £5m for other items.

 

In addition £8m relates to the closure of the Andover, Massachusetts endoscopy manufacturing facility. The components are £3m related to impairment of freehold land and buildings, £4m for redundancy payments and £1m for other items.

 

Amortisation of acquisition intangibles

The increase from £5m to £6m reflects the full year amortisation of MMT intangible assets compared with nine months in 2004.

 

Operating profit

Operating profit increased by £72m compared with 2004. The trading profit increase of £40m was augmented by the absence of the macrotextured charge of £80m from 2004 less the £47m charge for restructuring and rationalisation and the £1m increase in amortisation of acquisition intangibles.

 

Net interest receivable

Interest income decreased by £2m from £17m in 2004 to £15m in 2005. Interest expense decreased by £3m from £13m in 2004 to £10m in 2005. Interest payable on currency swaps amounting to £19m was set off against interest receivable on swaps. Overall net interest receivable moved favourably by £1m from £4m to £5m.

 

Other finance costs

Comprises notional interest on the defined benefit pension plan deficit less the expected return on investing pension plan assets.

 

Fair value of hedge of anticipated sale proceeds of joint venture

A financial instrument was purchased in December 2005 to hedge the anticipated proceeds of the BSN Medical disposal from Euros into US Dollars. This was fair valued at the end of the year resulting in a gain of £1m.

 

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Taxation

The taxation charge rose by £25m to £70m in 2005. The effective rate of taxation on trading profit less interest and finance costs was 29.5% compared with 29.0% in 2004 due to changes in the mix of profits. The taxation charge was reduced in 2005 by £16m as a consequence of the restructuring and rationalisation expenses and in 2004 by £28m as a consequence of the macrotextured claim.

 

Discontinued operations — Share of Results of the Joint Venture

The Group’s share of results of the joint venture rose by £1m from £16m in 2004 to £17m in 2005. Revenues decreased by £39m from £166m to £127m as a result of the Group ceasing to equity account with effect from 1 October 2005 following the reclassification of the investment to “Held for sale”. Operating profits decreased by £4m from £24m to £20m due to the short period. Interest payable was unchanged from prior year at £1m and the tax charge was £1m lower at £6m, compared with £7m. In the fourth quarter the group recognised as profit a dividend received of £4m.

 

Business Segment Analysis

Revenue by business unit and geographic market and trading and operating profit by business unit are set out below:

 

     2005

   2004

     (£ million)
Revenue by business segment          

Orthopaedics

   698    589

Endoscopy

   334    305

Advanced Wound Management

   375    355
    
  

Total revenue

   1,407    1,249
    
  
Revenue by geographic market          

Europe (Continental Europe and United Kingdom)

   441    410

United States

   694    609

Africa, Asia and Australia and other America

   272    230
    
  

Total revenue

   1,407    1,249
    
  
Trading profit by business segment          

Orthopaedics

   167    138

Endoscopy

   70    61

Advanced Wound Management

   53    51
    
  

Total trading profit

   290    250
    
  
Operating profit by business segment          

Orthopaedics

   162    54

Endoscopy

   61    60

Advanced Wound Management

   14    51
    
  

Total operating profit

   237    165
    
  

 

Orthopaedics

 

Revenue

Revenue increased by £109m, or 19%, to £698m of which 16% was underlying growth, 2% due to favourable currency translation movements and 1% arose from the full year effect of the revenues from MMT compared with nine months in the previous year. The principal factors in the growth in revenue were the growth in the global orthopaedics market (excluding the spine sector) which was estimated to be 11% in the year and the 21% increase in the size of the global sales force from 1,260 to 1,532. The sales force was expanded in order to improve market coverage, particularly in the US, through the continuing strategy of creating specialist sales forces for each of the reconstruction, trauma and clinical therapies sectors.

 

In the US, revenue increased by £73m to £433m (21%), of which 19% was underlying growth and 2% due to favourable foreign currency translation. The main contributory factor in the underlying growth rate was the increase in the year of 25% in the size of the US sales force from 815 to 1,021.

 

Outside the US, revenue increased by £36m to £265m (16%), of which 2% was due to favourable currency translation movement, 2% was due to the full year effect of the MMT acquisition and 12% was underlying growth.

 

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Revenue growth was driven by Japan at 19%, which comprised 20% underlying growth less 1% adverse foreign currency translation mainly, due to an increase of 25% in the sales force following the purchase of the business and assets of Leading Medical. The increase in sales force size was consistent with the strategy of enhancing market coverage in Japan. UK revenue grew 23% as it benefited from combining its business with MMT, resulting in increased numbers of sales representatives and greater access to surgeons and new customers. Australia revenue grew by 22% of which 5% was due to favourable foreign currency translation and 17% was underlying growth largely due to the purchase, in late 2004, of the rights to distribution of the BHR product.

 

In reconstruction, global knee revenue increased by £36m to £250m (17%), of which 2% was underlying growth due to favourable foreign currency translation and 15% was underlying growth. 4% of the underlying growth was due to growth in revenue of OXINIUM and the balance was due to sales force additions. This is a slower rate of growth than the 21% achieved in 2004 which is believed to reflect a reduction in the number of procedures in the US market and the fact that the Group launched fewer knee products during the year pending a number of new releases in 2006.

 

Global hip revenue increased by £28m to £189m (17%), of which 1% was due to favourable foreign currency translation movements. The MMT acquisition accounted for 3% of growth and underlying growth was 13% which was due to the increased size of the sales force. The FDA Advisory Panel recommended conditional approval of the BHR product to the FDA for use in the US and it is expected that this product will be released during 2006.

 

Global trauma revenue increased by £24m to £169m (17%), of which 3% was due to favourable foreign currency translation and 14% was underlying growth, 6% of this growth was due to the launch of the PERI-LOC locking compression plate system and the balance due to sales force additions.

 

Clinical therapies revenue increased by £20m to £72m (39%), of which 1% was due to favourable foreign currency translation and 38% was underlying growth driven by a 26% increase in the size of the sales force.

 

Trading Profit

Trading profit rose by £29m (21%) from £138m in 2004 to £167m in 2005. The trading profit margin increased from 23.4% to 23.9% as a result of a small improvement to 0.4% points in gross margin due to favourable transactional currency and lower research and development expenditure of 0.5% points, partly offset by a 0.4% points increase in other expenses caused by ongoing sales force investment, higher costs of insurance (£4m) and the cost of relocating and combining the UK business with MMT (£2m).

 

Operating Profit

Operating profit increased by £108m of which £29m was trading profit, £80m was due to the macrotextured claim in 2004 less £1m due to the increase in amortisation of acquisition intangibles.

 

Endoscopy

 

Revenue

Endoscopy revenue increased by £29m or 10% to £334m, comprising 2% favourable currency translation and 8% underlying growth. In the US, revenue increased by £13m to £182m (8%), of which 2% was due to favourable foreign currency translation and 6% was underlying growth.

 

Outside the US, revenue increased by £16m to £152m (12%), of which 2% was due to favourable foreign currency translation and 10% was underlying growth. Revenue growth was driven by Japan at 23%, of which 24% was underlying growth driven by higher revenue from knee repair products due to the increased adoption of ACL reconstruction surgery in that market, less 1% adverse foreign currency translation. Canada revenue grew by 23%, of which 15% was underlying growth, due to an increase in government healthcare funding in the year and 8% was due to favourable foreign currency translation.

 

Global revenue of repair products grew by £19m to £100m (23%), of which 2% was due to favourable foreign currency translation and 21% was underlying growth driven by the release of a number of new products in the knee and shoulder segments.

 

Revenue in the global resection products sector grew £3m to £130m (2%), within which blades grew by 4%, benefiting from lower levels of re-use in the US of these disposable devices. Radio-frequency arthroscopy products declined by 1% because 2005 included only 4 months of revenue of the products affected by the injunction in the patent dispute with ArthroCare Inc. compared with 6 months in 2004 prior to the injunction. The foreign currency translation effect on resection products was zero.

 

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Global visualisation and Digital Operating Room revenue grew £6m to £66m by (10%), of which 3% was due to favourable foreign currency translation and 7% was underlying growth. This was due to a number of new contracts being gained in Digital Operating Rooms due to the enhanced expertise gained with the acquisition of Reed Medical in 2004.

 

In total, products brought to market within the last 3 years comprised 24% of total revenue mainly in knee and shoulder repair, a new camera in visualisation, a new pump in the access sector and a new hip arthroscopy product.

 

Trading Profit

Trading profit rose by £9m (14%) from £61m in 2004 to £70m in 2005. The trading profit margin increased from 20.0% to 20.9% as a result of a 0.3% improvement in gross margin due to gains on favourable transactional currency and expense control of 0.6% points.

 

Operating Profit

Operating profit increased by £1m comprising an increase of £9m in trading profit less £8m of costs related to the closure of the Andover manufacturing facility.

 

Advanced Wound Management

 

Revenue

Revenue increased by £20m to £375m or 5% of which 4% was underlying growth and 1% was due to favourable foreign currency translation.

 

In the US, revenue was unchanged at £80m, comprising favourable foreign currency translation of 2% and 2% negative underlying growth. The main factors were inventory reduction by major distributors as they sought to become more efficient in their supply chains, which reduced revenues by an estimated 5% and lower sales of intermediate products to industrial customers which reduced revenues by 6%. Outside the US, revenue growth was £20m to £295m (8%), of which 2% was due to favourable foreign currency translation and 6% was underlying growth. Growth in Japan was 31% of which 32% was underlying growth driven by the acquisition of distribution rights to the CADEX product which increased revenue by 11% and by the increased market acceptance of ALLEVYN hydrocellular dressings which added 13% to underlying growth. UK revenue growth was zero due to the NHS, the largest customer, operating under severe budget constraints.

 

The global sales force continued to develop during the year with an increased focus on clear market segments. Focus on the key brands of ALLEVYN and ACTICOAT combined with the launch of the ACTICOAT Moisture Control product resulted in underlying global revenue growth for these product lines of 13% and 25% respectively.

 

Trading Profit

Trading profit rose by £2m (4%) from £51m in 2004 to £53m in 2005 broadly in line with revenue growth. The trading profit margin barely changed at just over 14%.

 

Operating Profit

Operating profit decreased by £37m comprising an increase of £2m in trading profit less £39m of restructuring charges related to the exit from tissue engineering operations.

 

2004 YEAR

 

Financial Highlights of 2004

Group revenue was £1,249m for the year ended 31 December 2004, representing 6% growth compared to 2003. Underlying growth in revenue of continuing operations was 11 1/2%.

 

Profit before taxation was £167m, compared with £189m in 2003. Adjusted attributable profit, (calculated as set out in “Selected Financial Data”), improved 15% to £195m.

 

Basic earnings per Ordinary Share including discontinued operations were 14.8p, a 20% decrease compared to 18.5p for 2003. Adjusted basic earnings per share Ordinary Share (as set out in “Selected Financial Data”) were 20.8p compared to 18.2p for 2003, representing a 14% increase.

 

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Fiscal 2004 Compared with Fiscal 2003

The following table sets out certain profit and loss account data for the periods indicated:

 

     2004

    2003

 
     (£ million)  

Revenue (i)

   1,249     1,179  

Cost of goods sold

   (335 )   (345 )
    

 

Gross profit

   914     834  

Marketing, selling and distribution expenses

   (477 )   (440 )

Administrative expenses

   (136 )   (126 )

Research and development expenses

   (66 )   (67 )

BSN agency and management fees

   15     19  
    

 

Trading profit (i)

   250     220  

Acquisition related expenses

       (22 )

Macrotextured claim

   (80 )    

Amortisation of acquisition intangibles

   (5 )    
    

 

Operating profit (i)

   165     198  

Net interest receivable/(payable)

   4     (5 )

Other finance costs

   (2 )   (4 )
    

 

Profit before taxation

   167     189  

Taxation

   (45 )   (56 )
    

 

Profit from continuing operations

   122     133  

Discontinued operations — share of results of the joint venture

   16     13  

Discontinued operations — net profit on disposal and share of results of associated undertaking

       26  
    

 

Attributable profit for the year

   138     172  
    

 


(i) Revenue, trading profit and operating profit are derived wholly from Continuing Operations.

 

Revenue

For the year ended 31 December 2004, reported Group revenue increased by £70m (6%) to £1,249m from £1,179m. Reported revenue benefited by 1 1/2% from the acquisition of MMT but adverse currency translation, particularly the weakness of the US Dollar relative to Sterling reduced revenue by 7%. Underlying revenue growth was 11 1/2%.

 

A more detailed analysis is included within the Revenue sections of the individual business segments that follow on pages 40 and 41.

 

Cost of Goods sold

Cost of goods sold represents 26.8% of revenue compared to 29.3% in 2003. This improvement of 2.5% points mainly arose from manufacturing cost and efficiency savings of 1.4% points and transactional currency benefits of 0.7% points from the relative decline in the value of the US Dollar which reduced the cost of purchasing finished goods in many countries, particularly in Europe and Australia. There was also a mix benefit of 0.4% points as the fastest growing business, orthopaedics, also has the lowest cost of sales.

 

Further margin analysis is included within the Trading Profit section of the individual business segments that follow on pages 40 and 41.

 

Marketing, selling and distribution expenses

These costs represented 38.2% of revenue, compared to 37.3% in 2003. This increase is due mainly to additions to sales forces, particularly in orthopaedics in the US.

 

Administrative Expenses

Administrative expenses were 8% higher than in 2003 and represented 10.9% of revenue compared with 10.7% of revenue in 2003. Administrative expenses items broadly grew in line with revenue.

 

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Research and Development expenses

There was no material change in expenditure on research and development. Smith & Nephew continues to invest in innovative technologies and products to differentiate the Group from its competitors. In 2004, 20% of Smith & Nephew’s sales were from products introduced in the last three years.

 

BSN Medical Agency and Management Fees

Agency and management fees were received in respect of services provided to BSN Medical for sales force resource, physical distribution and logistics and administration in certain countries. The calculation of the fees is designed to result in a neutral, cost-recovery position for Smith & Nephew and is for a transitional period only. In 2004 recoveries fell by £4m (21%) as a number of shared service agreements expired and BSN established its own independent operations.

 

Trading Profit

Trading profit was £250m, an increase of £30m compared to £220m in 2003, resulting from an increase in gross profits of £80m less higher expenses of £50m. Trading profit margins improved from 18.7% to 20.0%.

 

Macrotextured Claim

The macrotextured claim of £80m represents provision of £13m for the amount due from excess layer insurers who have declined insurance coverage for claims relating to macrotextured knee revisions together with an estimate of £67m for the cost of settlements with patients likely to arise in the future and assuming that insurance cover remains unavailable.

 

Amortisation of Acquisition Intangibles

The amortisation charge on acquisition intangibles arose principally from the acquisition of MMT in March 2004, which was the first material acquisition to be accounted for under IFRS.

 

Operating Profit

Operating profit decreased by £33m compared with 2003. The increase in trading profit of £30m was more than offset by the £80m charge for the macrotextured claim and £5m for the amortisation of acquisition intangibles less £22m for the absence of acquisition related expenses for the previous year.

 

Net Interest Receivable/(Payable)

Interest income increased by £6m from £11m in 2003 to £17m in 2004. Interest expense decreased by £3m from £16m in 2003 to £13m in 2004. Interest payable on currency swaps amounting to £15m was set off against interest receivable on swaps. Overall interest moved favourably by £9m from a net interest payable position of £5m to a net interest receivable position of £4m, due to favourable movements in interest and foreign exchange rates.

 

Other Finance Costs

Other finance costs comprise notional interest costs on the defined benefit pension plan deficits less the expected return on investing plan assets. The net charge was £2m lower than 2003 due to lower notional interest rates.

 

Taxation

The taxation charge decreased by £11m to £45m in 2004. The taxation charge on adjusted profits was £73m an increase of £13m on the 2003 charge due to higher adjusted profits. The effective rate of taxation was 29.0% as compared with 28.4% in 2003. The taxation charge was reduced in 2004 by £28m as a result of the macrotextured item and increased in 2003 by £4m as a result of acquisition related expenditure.

 

Discontinued Operations — Share of Results of the Joint Venture

The Group’s share of operating profit increased by £4m from £20m in 2003 to £24m in 2004. 2003 included £3m of restructuring and acquisition related expenses. Operating profit margins before this £3m improved from 13.8% in 2003 to 14.3% in 2004 as a result of cost and efficiency savings and from the benefits of integrating the fracture casting and splinting business acquired from DePuy Inc. in March 2004. Net profit after taxation increased by £3m from £13m in 2003 to £16m in 2004.

 

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Business Segment Analysis

Group revenue by business unit and geographic market and trading and operating profit by business unit are set out below:

 

     2004

   2003

     (£ million)

Revenue by business segment

         

Orthopaedics

   589    525

Endoscopy

   305    300

Advanced Wound Management

   355    354
    
  

Total revenue

   1,249    1,179
    
  

Revenue by geographic market

         

Europe (Continental Europe and United Kingdom)

   410    370

United States

   609    595

Africa, Asia and Australia and other America

   230    214
    
  

Total revenue

   1,249    1,179
    
  

Trading profit by business segment

         

Orthopaedics

   138    119

Endoscopy

   61    60

Advanced Wound Management

   51    41
    
  

Total trading profit

   250    220
    
  

Operating profit by business segment

         

Orthopaedics

   54    102

Endoscopy

   60    55

Advanced Wound Management

   51    41
    
  

Total operating profit

   165    198
    
  

 

Orthopaedics

 

Revenue

Orthopaedics sales were £589m in 2004, an increase of £64m or 12% compared to £525m for 2003. Underlying revenue growth was 17%. Growth in sales in the US was 10% (22% underlying less 12% adverse currency translation). Outside the US, growth was 17% (10% underlying less 4% adverse currency translation and including 11% from the acquisition of MMT). Sales pricing in reconstruction and trauma increased by approximately 3% in the US.

 

In reconstruction, knee sales increased by 12% (21% underlying less 9% adverse currency translation). This comprised 12% in the US (24% underlying less 12% adverse currency translation), and 14% outside the US (16% underlying less 2% adverse currency translation). Hip sales increased globally by 21% (15% underlying less 10% adverse currency and including 16% from the acquisition of MMT), which included 2% growth in the US (14% underlying after 12% adverse currency translation), and 60% outside the US (17% underlying less 2% adverse currency translation plus 45% from the acquisition of MMT). This reflects continuing strong market conditions particularly in the US, the expansion of sales forces and the introduction of minimal incision surgery (“MIS”) procedures.

 

Trauma benefited from the substantial investment in creating a dedicated US sales force, achieving a sales increase of 5% in the US, ahead of the market (17% underlying less adverse currency translation of 12%). Sales growth outside the US was 1% (4% underlying growth less 3% adverse currency translation). These result in 3% global growth (11% underlying less 8% adverse currency translation). Clinical Therapy sales, which consist of the SUPARTZ joint fluid therapy and EXOGEN ultrasound bone healing products, also benefited from sales force investment, growing 32% (44% underlying less 12% adverse currency translation) compared with last year.

 

A number of new orthopaedic products are in the pipeline. Marketing approval in the US for the ceramic on ceramic hip was received in December 2004. Surgical evaluations for a new locking plate trauma product were started during the year and it is expected to launch this product in the first half of 2006. US pre-market approval application for the BHR product has been accepted for consideration by the FDA.

 

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Trading Profit

Trading profit from the orthopaedics business increased by £19m (16%) from £119m in 2003 to £138m in 2004. The trading profit margin increased from 22.7% to 23.4% as a result of improvements to gross margin from volume related cost and efficiency savings and transactional currency benefits from the weaker US Dollar partly offset by additional investment in selling and marketing expense which cost 1.4% points of margin.

 

Operating Profit

Operating profit decreased by £48m with the increase of £19m in trading profit offset by the £80m charge related to the macrotextured claim, £4m of amortisation of acquisition intangible assets and £17m of aborted acquisition costs in 2003.

 

Endoscopy

 

Revenue

Endoscopy sales in 2004 were £305m, an increase of £5m or 2% compared to £300m for 2003. The underlying growth of 9%, represents a recovery from a problematic 2003. Sales in the US declined 3% (9% underlying growth less 12% adverse currency translation), but grew 7% outside the US (10% underlying less 3% adverse currency translation).

 

The new progressive scan camera system and the Group’s comprehensive integration capability for digital operating rooms increased visualisation sales by 12% (22% underlying less 10% adverse currency translation). Repair product sales grew by 9% (underlying 16% less 7% adverse currency translation), led by the comprehensive range of shoulder products. Radio frequency sales were affected by an injunction imposed on US sales in connection with an ongoing patent dispute with a competitor, and declined by 12% (negative 2% underlying growth and 10% adverse currency translation). Blade sales declined 3% (3% underlying growth less 6% adverse currency translation) following a stabilisation of the re-use of blades by US hospitals.

 

Trading Profit

Trading profit from the endoscopy business increased by £1m (2%) from £60m in 2003 to £61m in 2004. The trading profit margin remained constant between 2004 and 2003.

 

Operating Profit

Operating profit increased by £5m comprising the increase in trading profit of £1m less amortisation of acquisition intangible assets of £1m less acquisition integration costs of £5m in 2003 related to Oratec.

 

Advanced Wound Management

 

Revenue

Advanced wound management sales were £355m for 2004 largely unchanged from £354m in 2003. This is equivalent to 5% underlying growth less 5% adverse currency translation. Outside the US, sales grew 5% (8% underlying less 3% adverse currency translation). However, sales in the US declined 14% (negative 4% underlying growth and 10% adverse currency translation), where they were seriously affected by the need to switch to another enzyme debrider product. Loss of sales of the previous enzyme debrider negatively affected underlying global sales growth by 4%.

 

Globally, sales forces have refocused on the market opportunities for ALLEVYN hydrocellular dressings and ACTICOAT antimicrobial silver dressings. In the US, a targeted approach to DERMAGRAFT tissue engineered dermal replacement has been implemented. The benefits of this approach are evident in the sales of ALLEVYN, which grew 11% (15% underlying less 4% adverse currency translation), ACTICOAT, which grew by 38% (47% underlying less 9% adverse currency translation) and DERMAGRAFT, which grew by 16% (underlying 28% less 12% adverse currency translation).

 

Trading and Operating Profit

Both trading and operating profit from the advanced wound management business increased by £10m (24%) from £41m in 2003 to £51m in 2004. The trading profit margin increased from 11.6% to 14.4% principally as a result of higher gross margins due to manufacturing efficiencies at the La Jolla facility and the elimination of adverse variances at the Largo facility together with expense control through the business.

 

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OUTLOOK AND TREND INFORMATION

 

The discussion below contains statements that express management’s expectations about future events or results rather than historical facts. These forward-looking statements involve known and unknown risks and uncertainties that could cause the Group’s actual results, performance or achievements to differ materially from those projected in forward-looking statements. Smith & Nephew cannot give assurance that such statements will prove correct. These risks and uncertainties include factors related to: the medical devices industry in general, product liability claims and related insurance coverage, the geographical markets in which the Group operates, the nature and efficiency of the Group’s products, the Group’s ability to research, develop, manufacture and distribute its products, the translation of currencies and the values of international securities markets. For additional information on factors that could cause the Group’s actual results to differ from estimates reflected in these forward-looking statements, you should read “Risk Factors” of this document.

 

The markets on which the Group concentrates continue to demonstrate robust growth and are expected to benefit for many years to come from an ageing population, obesity, more active lifestyles and technological developments including less invasive techniques in orthopaedic and endoscopic surgery. In advanced wound management continuing innovation and the potential for further penetration of moist wound healing and wound bed preparation techniques should continue to stimulate expansion of this market. Management expects that innovative new product development programmes and sales force investment will enable the Group to grow as well as expand its market share.

 

As described in “Financial Summary — Change in Functional and Reporting Currency” the Group will report its results in US Dollars instead of pounds Sterling with effect from 2006. The effect of this change on future trends will be to reduce the Group’s exposure to translational exchange rate fluctuations and thereby reduce the volatility of its revenues and profits.

 

For 2006, management expects orthopaedic trauma to grow revenues in the mid-teens range whilst orthopaedic reconstruction is expected to be slightly below this, reflecting tighter market conditions. Revenue growth in endoscopy is expected to improve to just into double digits as it benefits from its new product programme. Advanced wound management expects revenue growth from continuing products in mid-single digits, reducing to low-single digits after taking into account the exit from tissue engineering. Group revenue growth, combined with margin enhancement of around 1 1/2% from ongoing cost and efficiency savings and from exiting tissue engineering is expected to deliver high teens growth in trading profit for 2006.

 

Earnings for 2006 will be affected by a number of specific factors. The divestment of BSN Medical will dilute earnings by around 4% since interest on the proceeds will not match earnings from the joint venture. Additionally, a loss of favourable interest rate differentials between the US and the UK, coupled with the move of functional currency to US Dollars, is expected to dilute earnings by between 3% and 4%. After taking into account these factors, interest and other finance income is expected to be around $9m for 2006. The effective tax rate is expected to increase by around 1% per annum for the next three years, and this will further dilute 2006 earnings by 1 1/2%. After the effect of these specific factors, EPSA growth of around 7% to 8% is expected for 2006, before movements in translational currency.

 

The net proceeds of the divestment of BSN Medical in February 2006 were $560m and the gain on disposal was $315m which will be recognised in 2006.

 

Management does not anticipate that the dispute with certain insurers over their declination of coverage of macrotextured product liability claims will be resolved during 2006. Consequently, it is expected that settlements with patients will not be reimbursed by insurers and that this will continue to have an adverse impact on cash flow of approximately $43m (£25m) during 2006. See “Legal Proceedings” and “Risk Factors”. Cash expenditure of $26m (£15m) is estimated on the exit from tissue engineering and the closure of the endoscopy manufacturing facility at Andover, Massachusetts. There will be no impact on operating profit since these payments will be charged to provisions.

 

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FINANCIAL POSITION, LIQUIDITY AND CAPITAL RESOURCES

 

Cash Flow and Net Debt

The main elements of Group cash flow and movements in net debt can be summarised as follows:

 

     2005

    2004

    2003

 
           (£ million)        

Cash generated from operations

   204     228     216  

Interest received net of interest paid

   5     4     (5 )

Income taxes paid

   (62 )   (38 )   (52 )
    

 

 

Net cash inflow from operating activities

   147     194     159  

Capital expenditure (including trade investments and net of disposal of property, plant and equipment)

   (110 )   (101 )   (72 )

Acquisitions and disposals (net of loan notes issued on acquisition of £50m in 2004)

   (14 )   (35 )   48  

Dividends received from joint venture

   14     14     7  

Equity dividends paid

   (50 )   (47 )   (45 )

Issue of ordinary share capital and own shares purchased

   11     4     8  
    

 

 

Change in net debt from net cash flow (see Note 29 of the Notes to the Group Accounts)

   (2 )   29     105  

Loan notes issued on acquisition

       (50 )    

Exchange adjustments

   (55 )   37     46  

Opening net debt

   (121 )   (137 )   (288 )
    

 

 

Closing net debt

   (178 )   (121 )   (137 )
    

 

 

 

The Group’s net debt decreased by £110m from £288m at the beginning of 2003 to £178m at the end of 2005. Translation of foreign currency net debt into Sterling had the effect of decreasing net debt by £28m in the three-year period ended 31 December 2005. Closing net borrowings includes £11m of net currency swap liabilities (2004 and 2003 net currency swap assets of £31m and £43m respectively).

 

Acquisitions and Disposals

In the three-year period ended 31 December 2005, £51m (including the issuance of £50m of Loan Notes in 2004) was spent on acquisitions, net of disposal proceeds, funded from net debt. Acquisitions totalled £103m and comprised MMT £69m, Acticoat £11m, Collagenase £6m, and other £17m.

 

In the same three-year period, £52m was received from the disposal of AbilityOne.

 

Capital Expenditure

The Group’s ongoing capital expenditure and working capital requirements have been 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 has represented approximately 7% to 8% of continuing group revenue. Capital expenditure in 2006 is expected to be approximately the same percentage of Group revenue as 2005.

 

In 2005 capital expenditure of £111m (£110m net of disposals of property, plant and equipment) was incurred. The principal areas of investment were the placement of orthopaedics instruments with customers, manufacturing facilities, plant and equipment and information technology.

 

At 31 December 2005, £4m of capital expenditure had been contracted but not provided for which will be funded from borrowing facilities.

 

Operating Cash Flow

Management assesses available cash flow in terms of “trading cash flow” which is defined as cash flows after capital expenditure and before material items which derive from events or transactions that fall within the ordinary activities of the Group but which management believes should be separately identified to help explain trends in cash flows. Ongoing capital expenditure on fixed assets is regarded as essential to develop and grow the Group’s businesses and to drive operating efficiencies. Management believes that trading cash flow provides useful information to investors because it provides a consistent year on year comparison of operating cash flows.

 

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This figure (£173m for 2005) is after several adjustments to cash generated from operations, the most comparable IFRS figure. This measure is used in the Group’s management reporting, budgeting and planning because it provides information on those elements of cash flows which local managers are most directly able to influence. Management also uses as a key indicator the “cash conversion ratio” i.e. the percentage of trading cash flow compared to trading profit. This was 60% for 2005 (2004 — 58%, 2003 — 77%) similar to the previous year. Management uses this cash conversion ratio to target cash generation, to monitor and control its use of capital employed and to provide meaningful year-on-year trend information. Management has set long-term targets for the Group of 70% — 75% cash conversion ratio.

 

The following table presents a reconciliation of cash generated from operations to trading cash flow.

 

     2005

    2004

    2003

 
     (£ million)  

Cash generated from operations

   204     228     216  

Less: capital expenditure (including trade investments and net of disposal of property, plant and equipment)

   (110 )   (101 )   (72 )
    

 

 

Operating cash flow

   94     127     144  

Add:

                  

Special pension fund contributions

   49          

Restructuring, rationalisation, acquisition integration and divestment costs

   4     2     10  

Macrotextured knee revisions unreimbursed by insurers

   26     17      

Centerpulse transaction costs

           17  
    

 

 

Trading cash flow

   173     146     171  
    

 

 

 

Liquidity

The Group’s policy is to ensure that it has sufficient funding and facilities in place to meet foreseeable borrowing requirements.

 

At 31 December 2005, the Group held £88m in cash and balances at bank and had committed and uncommitted bank facilities of £355m and £257m respectively. Undrawn bank facilities amounted to £417m, of which £240m were committed. Of the undrawn committed facilities, £4m expires within one year, and £236m after two but within five years. Of the drawn facilities, £81m expires within one year and £114m expires within 3-5 years. In addition Smith & Nephew has £50m of loan notes payable within one year and finance lease commitments of £10m (of which £8m extends beyond 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.

 

The principal variations in the Group’s borrowing requirements normally result from the timing of dividend payments, acquisitions and disposals of businesses, timing of capital expenditure and working capital fluctuations. In 2005 the settlement of macrotextured patient claims was a factor which will continue in 2006. £49m of special contributions, over and above the previously agreed and planned contributions, were made in 2005 to improve the funding of the UK and US defined benefit pension schemes. In February 2006 the Group received $560m from the sale of the BSN Medical joint venture which will be held in cash or used to repay borrowing facilities.

 

Smith & Nephew believes that its capital expenditure needs and its working capital funding for 2006, as well as its other known or expected commitments or liabilities, can be met from its existing resources and facilities.

 

Further information regarding borrowings at 31 December 2005 is set out in Note 20 of the Notes to the Group Accounts. The Group believes that the borrowing facilities do not contain restrictions that are expected to impact on funding or investment policy for the foreseeable future.

 

Pension Funding

The movements in the stock market values, falling long term interest rates and increased longevity experience over the last five years have adversely affected the funding levels of Smith & Nephew’s major defined benefit plans in the UK and US. Existing provisions and planned future contributions are considered adequate to cover the current under funded position.

 

Payment Policies

It is Company policy to ensure that suppliers are paid within agreed terms. At the year-end, the Company’s trade creditors represented the equivalent of 37 days’ credit.

 

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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.

 

Foreign Exchange Exposure

The Group trades in over 90 countries and as a consequence has transactional and translational foreign exchange exposure. The Group’s policy is to protect shareholders’ funds by matching foreign currency assets, including acquisition goodwill, with foreign currency liabilities wherever practicable. These liabilities take the form of either borrowings or currency swaps. It is the Group’s policy for operating units not to hold unhedged monetary assets or liabilities other than in their functional operating currencies.

 

Foreign exchange variations affect trading results in two ways. Firstly on translation of overseas sales and profits into Sterling and secondly, the currency cost of purchases by Group companies of finished products and raw materials. The principal flows of currency are purchases of US Dollars and Sterling from Euros, Japanese yen, Australian and Canadian Dollars, as well as cross purchases between the US and the UK.

 

The Group partly mitigates the translational impact on profits through the interest arising on foreign currency borrowings or swaps. The impact of currency movements on the cost of purchases is partly mitigated by the use of forward foreign exchange contracts.

 

The Group managed £330m of foreign currency purchase transactions by using forward foreign exchange contracts, of which the major transaction flow is Euros into US Dollars. The Group’s policy is for firm commitments to be fully covered and forecast transactions to be covered between 50% and 90% for up to one year. If the Euro were to weaken against the US Dollar by 10% on average over the year, the fair value of forward foreign exchange contracts would increase by £4m (2004 — increase by £5m).

 

Had the Group not transacted forward foreign exchange purchase contracts and if Sterling were to have weakened on average over the year by 10% against all other currencies, Smith & Nephew’s profit before taxation in 2005 would have increased by £37m on account of transactional and translational movements; if the Euro were to have weakened on average over the year by 10% against all other currencies, profit before taxation in 2005 would have reduced by £13m; if the US Dollar were to have weakened on average over the year by 10% against all other currencies, profit before taxation in 2005 would not have changed materially.

 

The Group’s net debt is exposed to movements in exchange rates on foreign currency liabilities. Based upon the net debt position at 31 December 2005 if Sterling were to weaken against the US Dollar by 10%, the increase in the Group’s net debt would be £51m. If Sterling were to weaken against all currencies excluding the US Dollar by 10%, the Group’s net debt would be increased by £10m. That is, if Sterling were to weaken against all currencies by 10%, the Group’s net debt would increase by £61m.

 

Interest Rate Risk

The Group contracts fixed rate currency swaps and uses simple floating to fixed rate interest rate swaps to meet its objective of protecting borrowing costs and differentials between borrowing and deposit rates within parameters set by the Board.

 

As at 31 December 2005, the Group had not fixed interest rates forward for 2006 due to uncertainties over the timing of the receipt of the proceeds from the anticipated sale of the BSN Medical joint venture.

 

Based upon the net debt position at 31 December 2005, an increase in short-term interest rates across all currencies by one percentage point would increase the Group’s annual net interest payable by £2m (2004 — increase by £1m). The Group’s financial assets and liabilities were principally at floating interest rates and thus their fair values are not directly affected by movements in market rates of interest.

 

Financial Instruments

The Group’s 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 foreign currency purchase transactions and foreign currency assets are accounted for as hedges. As a result, changes in fair values of these financial instruments do not affect the Group’s profit before taxation.

 

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At 31 December 2005 the Group had transacted a contingent foreign exchange contract to hedge the anticipated proceeds on the sale of its investment in the BSN Medical joint venture. This contract does not qualify for hedge accounting. The maturing of the contract is contingent on the receipt of the proceeds of sale. If the US Dollar were to have weakened against the Euro by 10% profit before taxation would have reduced by £29m. In the event that the sale did not complete no amounts would have been payable or receivable in respect of the contract. The transaction was completed on 23 February 2006.

 

The Group limits exposure to credit risk on counterparties used for financial instruments through a system of internal credit limits which, with certain minor exceptions due to local market conditions, require counterparties to have a minimum “A” rating from the major ratings agencies. The financial exposure of a counterparty is determined as the total of cash and deposits, plus the risk on derivative instruments, assessed as the fair value of the instrument plus a risk element based on the nominal value and the historic volatility of the market value of the instrument. Smith & Nephew does not anticipate non-performance of counterparties and believes it is not subject to material concentration of credit risk.

 

CONTRACTUAL OBLIGATIONS

 

Contractual obligations at 31 December 2005 were as follows:

 

          Payments due by period

     Total

  

Less than 1

year


   1-3 years

   3-5 years

  

More

than 5

years


     (£ million)

Short-term debt obligations

   81    81         

Long-term debt obligations

   114          114   

Loan Notes

   50    50         

Finance lease obligations

   10    1    1       8

Operating lease obligations

   79    20    26    13    20

Purchase obligations

   6    6         

Capital expenditure

   4    4         

Other

   43    34    7    2   
    
  
  
  
  
     387    196    34    129    28
    
  
  
  
  

 

Other contractual obligations consist of credit balances on currency swaps and foreign exchange contracts and acquisition consideration.

 

The agreed contribution rates to the UK defined benefit pension plan are 12.5% of pensionable earnings plus supplementary payments of £18m over the next three years. Payments to the US defined benefit pension plan in 2006 are estimated to be £15m. £2m is estimated to be paid to the other funded defined benefit plans.

 

In 2005 the Group made a special contribution of £49m to the UK and US plans, over and above the previously agreed and planned contributions, in order to improve the funding of these plans.

 

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 Group’s 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 BSN Medical and AbilityOne (see Note 36 of Notes to the Group Accounts), no other related party has had material transactions or loans with Smith & Nephew over the last three financial years.

 

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US GAAP

 

Smith & Nephew prepares its accounts in accordance with IFRS as adopted by the EU which differs in certain respects from US GAAP. Reconciliations of profit for the financial year and equity are set out in Note 39 of the Notes to the Group Accounts.

 

Results

 

     2005

   2004

   2003

Profit for the financial year

   £ 173m    £ 143m    £ 180m

Basic earnings per Ordinary Share

     18.4p      15.2p      19.3p

Diluted earnings per Ordinary Share

     18.4p      15.1p      19.2p

 

US GAAP profit for the financial year in 2005 is £14m lower than IFRS with the main differences being:

 

    higher amortisation of intangible assets of £9m since IFRS amortisation applies only to acquisitions after transition in 2003;

 

    higher pension expense of £10m mainly due to the amortisation of gains and losses through the income statement rather than through equity; and

 

    impairment of intangible assets by £25m; partly offset by:

 

    lower rationalisation and restructuring costs of £17m since certain costs are recognised later in US GAAP; and

 

    differences of £13m in deferred tax methodology.

 

Equity

 

     2005

   2004

   2003

At 31 December

   £ 947m    £ 782m    £ 691m

 

US GAAP equity in 2005 is £84m higher than IFRS with the main differences being:

 

    higher book value of £64m for goodwill and intangibles mainly due to the set-off directly to reserves of pre-1998 goodwill (the treatment of which is grandfathered for IFRS);

 

    lower pension liability of £53m due to deferred recognition of losses under US GAAP; and

 

    lower provisions of £17m related to rationalisation and restructuring; partly offset by:

 

    lower cost of investment in BSN Medical of £39m due to different accounting bases on formation; and

 

    higher deferred tax liabilities of £31m.

 

Prospects

Smith & Nephew has published expectations of future results in “Outlook and Trend Information”.

 

New accounting standards in the US which may affect US GAAP results are detailed in Note 38 of the Notes to the Group Accounts.

 

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CORPORATE GOVERNANCE

 

This section discusses Smith & Nephew’s structures and governance procedures.

 

The Board

   49

Executive officers

   50

Governance and policy

   51

Accountability, audit and internal control framework

   54

Shareholders

   57

 

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THE BOARD

 

The Board of Directors of Smith & Nephew as at 24 February 2006 comprised:

 

Director


  

Position


  

Initially elected

or appointed


  

Term of

appointment

expires at

AGM in


Dudley G. Eustace

   Independent Non-Executive Chairman    10 November 1999    2006

John Buchanan

   Independent Non-Executive Deputy Chairman    3 February 2005    2008

Sir Christopher O’Donnell

   Executive Director, Chief Executive    1 September 1992    2007

Peter Hooley

   Executive Director (responsible for Finance and Information Technology)    2 April 1991    2006

David J. Illingworth

   Executive Director, Chief Operating Officer    8 February 2006    2006

Dr. Pamela J. Kirby

   Independent Non-Executive Director    1 March 2002    2008

Warren D. Knowlton

   Independent Non-Executive Director    1 November 2000    2007

Brian Larcombe

   Independent Non-Executive Director    1 March 2002    2008

Richard De Schutter

   Independent Non-Executive Director    1 January 2001    2007

Dr. Rolf W. H. Stomberg

   Independent Non-Executive Director    1 January 1998    2007

 

Directors’ Biographies

Dudley G. Eustace (69) Chairman, was appointed independent Deputy Chairman in 1999 and independent non-executive Chairman in January 2000 and is Chairman of the Nominations Committee. He is non-executive Chairman of Aegon NV and non-executive director of Hagemeyer NV and Royal KPN NV. He will retire at the close of business of the AGM on 27 April 2006.

 

John Buchanan (62) was appointed independent non-executive Deputy Chairman in 2005 and is a member of the Nominations Committee. He is a non-executive director of AstraZeneca PLC, BHP Billiton Plc and Vodafone Group Plc and was formerly Group Chief Financial Officer of BP p.l.c. Previously he was a member of the United Kingdom Accounting Standards Board and a non-executive director of Boots Group PLC.

 

Sir Christopher O’Donnell (59) Chief Executive, joined the Group in 1988 as managing director of the medical division and was appointed a director of Smith & Nephew in 1992. He was appointed Chief Executive in 1997 and is a member of the Nominations Committee. He is a non-executive director of BOC Group plc. Previously he held senior positions with UK and US companies in the medical engineering and devices industry.

 

Peter Hooley (59) Finance Director, joined the Group and was appointed Finance Director in 1991. He is a non-executive director of Cobham plc. Previously he held senior financial positions with Matthew Hall plc and BICC plc. He is to retire in the summer of 2006.

 

David J. Illingworth (52) Chief Operating Officer. He joined the Group in May 2002 as President of Orthopaedics and was appointed to the Board in February 2006 as Chief Operating Officer. Prior to joining the Group he held posts within GE Medical, was Chief Executive Officer of a publicly traded medical devices company, President of a respiratory/critical care company and President of a technology incubator company.

 

Dr. Pamela J. Kirby (52) was appointed a director in March 2002 and is a member of the Remuneration Committee. She is non-executive Chairman of Scynexis Inc and a non-executive director of Informa plc, Oscient Pharmaceuticals Corporation and Curalogic A/S.

 

Warren D. Knowlton (59) was appointed a director in November 2000. He is Chairman of the Audit Committee and a member of the Remuneration Committee. He is Group Chief Executive of Morgan Crucible plc.

 

Brian Larcombe (52) was appointed a director in March 2002 and is a member of the Audit Committee. He is Senior Independent Director of Partygaming plc and a non-executive director of F&C Asset Management plc. Previously he was Chief Executive Officer of 3i Group plc.

 

Richard De Schutter (65) was appointed a director in January 2001 and is a member of the Audit Committee and the Remuneration Committee. He is non-executive Chairman of Incyte Corporation and a non-executive director of Varian Inc., MedPointe Pharmaceuticals, Ecolab Inc and Navicure Inc.

 

Dr. Rolf W. H. Stomberg (65) was appointed a director in 1998. He is the Senior Independent Director, Chairman of the Remuneration Committee and a member of the Audit and Nominations Committees. He is Chairman of Management Consulting Group plc and Lanxess AG and a non-executive director of Reed Elsevier plc, Hoyer GmbH, TNT N.V., Deutsche BP AG and Biesterfeld AG.

 

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EXECUTIVE OFFICERS

 

The Chief Executive of Smith & Nephew and other senior executives are responsible for the day-to-day management of the Group. The Group Executive Committee (‘GEC’), which comprises the executive directors and certain other senior executives of Smith & Nephew (the ‘Executive Officers’), assists the Chief Executive in the management of the business. The following are Executive Officers of Smith & Nephew and all, apart from the Company Secretary, are members of the GEC:

 

Dr. Peter Arnold (44) Group Director of Technology. He joined the Group in 1997 and worked in business development and research and development roles. He was appointed to the GEC in January 2004. Prior to joining the Group he was responsible for research and development for Johnson & Johnson’s wound care business.

 

Mark Augusti (40) President Orthopaedic Trauma and Clinical Therapies. He joined the Group in April 2003 as Vice President of Global Marketing for the Trauma Division and was promoted to Senior Vice President and General Manager Trauma Division in 2005. He was appointed to the GEC in February 2006. Previously he worked in the US and Asia for GE Medical Systems.

 

Sarah Byrne-Quinn (42) Group Director of Strategy and Business Development. She joined the Group in 2004 and was appointed to the GEC in April 2005. Prior to joining the Group, she held management positions with Cable & Wireless plc, Ameritech Corp and a number of investment banks.

 

Scott Flora (50) President Orthopaedic Reconstruction. He joined the Group in 1986 and worked in various sales and marketing roles. He was promoted to Senior Vice President of Trauma and Clinical Therapies Division in 2003. In 2005 he became Senior Vice President and General Manager of the Reconstruction Division. He was appointed to the GEC in February 2006. Previously he worked for Johnson & Johnson.

 

Peter W. Huntley (45) Group Director — Indirect Markets. He joined the Group and was appointed to the GEC in April 1998, responsible for the Group’s strategy and business planning. He was appointed to his current role in December 2003. Prior to joining the Group, he was a consultant with Deloitte Haskins and Sells, and the Business Development Director for Matthew Clark plc.

 

James A. Ralston (59) Chief Legal Officer. He joined the Group in 1999 as Senior Vice President and General Counsel for Smith & Nephew Inc., and was appointed to the GEC in February 2002. Prior to joining the Group he was in private practice and VP General Counsel and Secretary for Eagle-Pitcher Industries, Inc.

 

Paul M. Williams (59) Group Director — Human Resources. He joined the Group and was appointed to the GEC in December 1998. Prior to joining the Group he held senior human resources director roles with NCR, Heinz, Glaxo and Rolls-Royce.

 

Joe Woody (40) President Advanced Wound Management. Joined the Group in 2003 as Vice President and General Manager of the Clinical Therapies Division. Previously he worked for Alliance Imaging, Acuson and GE Medical Systems.

 

James M. Taylor President, Endoscopy has resigned as of 24 February 2006. After 30 years with Smith & Nephew, the last seven years as President of Advanced Wound Management, James L. Dick will retire in the summer of 2006.

 

Company Secretary

Paul R. Chambers (61) Company Secretary. He joined the Group in 1994 as Assistant Company Secretary and was appointed Company Secretary in April 2002.

 

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GOVERNANCE AND POLICY

 

The Combined Code on Corporate Governance (the “Code”), issued by the Financial Reporting Council, requires UK listed companies to make a disclosure statement on the application of the Principles and Supporting Principles and compliance with the Provisions of the Code.

 

The Board is committed to the highest standards of Corporate Governance and considers that it has complied in full with the Code throughout the year, except that no member of the Audit Committee has ‘recent’ financial experience. However, all members have relevant financial experience as senior executives of large corporations. The Board further considers that the members of the Audit Committee have the skills and experience of corporate financial matters to discharge properly the Committee’s responsibilities. All members of the Audit Committee are independent, as defined by the New York Stock Exchange (“NYSE”), and meet the definition of ‘financial expert’ in the Sarbanes-Oxley Act in the US.

 

In accordance with the Code, the following paragraphs describe Smith & Nephew’s Corporate Governance policies and procedures and how it applies the Principles and Supporting Principles in the Combined Code.

 

The Company’s 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 US Securities and Exchange Commission (“SEC”) applicable to foreign private issuers. The Board believes that it has complied throughout the year with both SEC and NYSE requirements related to corporate governance except that, to accord with the Combined Code, the Nominations Committee consists of a majority of independent directors and does not consist wholly of independent directors, as required by the NYSE.

 

The Board

The Board of Directors of Smith & Nephew consists of an independent non-executive Chairman, three executive directors and six independent non-executive directors. In 2005, the Board met on seven occasions and individual attendance was: Dudley Eustace (7), Sir Christopher O’Donnell (7), Peter Hooley (7), Dr Pam Kirby (7), Warren Knowlton (7), Brian Larcombe (6), Richard De Schutter (7) and Dr Rolf Stomberg (7). John Buchanan joined the Board in February 2005 (4) and David Illingworth was appointed in February 2006. John Buchanan’s non attendance at some meetings was anticipated at the time of his appointment due to prior commitments and Brian Larcombe’s absence was anticipated for one meeting. When directors are unable to attend a meeting, they are advised of matters to be discussed and have an opportunity to make their views known to the Chairman prior to the meeting.

 

The Board is responsible for the strategic direction and overall management of the Group and has 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 52 to 53. It reviews the key activities of the businesses and considers and reviews the work undertaken by the Committees.

 

Non-executive directors meet regularly prior to each Board meeting without management in attendance and the Senior Independent Director meets with the other non-executive directors annually to evaluate the performance of the Chairman. Board meetings are held at the major business units enabling directors to have a greater understanding of the business and to meet the management of these units. All directors have full and timely access to all relevant information and, if necessary, to independent professional advice. Appropriate directors and officers liability insurance is in place. Induction programmes are provided for new directors and training is offered to all directors. 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.

 

Whilst the Chairman and Chief Executive collectively are responsible for the leadership of the Group, there is a clear division of respective responsibilities which have been agreed by the Board. The Chairman’s primary responsibility is for leading the Board including setting its agenda and ensuring its effectiveness. The Chief Executive is responsible for managing and supervising the day-to-day business of the Group in accordance with the strategy, policies, budgets and business plans approved by the Board. The Chief Operating Officer reporting to the Chief Executive will take responsibility for leading the forward growth of the four business units enabling the Chief Executive to focus more on strategy and business development. The GEC advises and assists the Chief Executive and the Chief Operating Officer in the management of the Group.

 

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The Senior Independent Director is Dr 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.

 

In 2004, a formal evaluation of the performance of the Board and its Committees was undertaken by an external consultant with the emphasis on continuous improvement and effectiveness of the Board and its Committees. This was followed up in 2005 with an internal evaluation of the Board and its Committees led by the Senior Independent Director again with the emphasis on continuous improvement and effectiveness. This was effected through a confidential questionnaire and individual discussions with the Senior Independent Director. The evaluation concluded that the Board continues to function effectively and to manage the direction of the Group appropriately, and the Board Committees continue to function effectively and discharge their duties in the manner prescribed by their terms of reference. The evaluation provided inputs which are expected to lead to further improvement of Board process. Individual evaluation is carried out by the Nominations Committee with particular emphasis on the evaluation of those directors standing for re-appointment at the AGM. The non-executive directors, led by the Senior Independent Director, evaluate the performance of the Chairman.

 

The Board has determined that 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 and therefore are considered independent. With the exception of the Chairman, who is provided with healthcare cover, they do not receive additional remuneration apart from directors’ fees, do not participate in the Group’s share option schemes or performance related bonus schemes, and are not members of the Group’s pension schemes. No director of Smith & Nephew is a director of a company or an affiliate in which any other director of Smith & Nephew is a director.

 

None of the directors or executive officers (or any relative or spouse of such person, or any relative of such spouse, who has the same address as the director or officer, or who is a director or officer of any subsidiary of Smith & Nephew) has a material interest in any contract to which the Company or any of its subsidiaries are or were a party from the beginning of fiscal year 2004 to 24 February 2006.

 

Details of the Group’s policies on remuneration, service contracts and compensation payments are included in the “Remuneration Report”.

 

Board Committees

The Board is assisted by the Audit, Remuneration and Nominations committees, each of which has its own terms of reference, which may be found on the Group’s website at www.smith-nephew.com. The Company Secretary is secretary to each of the committees.

 

Audit Committee

The Audit Committee met on six occasions in 2005 (individual attendance is shown in parenthesis). The Committee, consisting entirely of independent non-executive directors, is chaired by Warren D. Knowlton (6). He was appointed to the Committee in February 2001 and became Chairman of the Committee in July 2001. The other members of the Committee are Brian Larcombe (5) who was appointed to the Committee in January 2003, Richard De Schutter (6) who was appointed in February 2001 and Dr Rolf Stomberg (5) who was appointed in February 1998. The Chairman of the Committee reports orally to the Board and minutes of the meetings are circulated to all members of the Board.

 

Remuneration Committee

The Remuneration Committee, consisting entirely of independent non-executive directors, met four times in 2005 (individual attendance is shown in parenthesis) and is chaired by Dr Rolf Stomberg (4). The other members of the Committee are Dr Pam Kirby (4), Warren Knowlton (3) and Richard De Schutter (4). The Remuneration Committee sets the pay and benefits of the executive directors and members of the GEC, approves their main terms of employment and determines share options and long-term incentive arrangements for the Group. It also reviews management succession planning. The Remuneration Report is on pages 58 to 67.

 

Nominations Committee

The Nominations Committee, consisting of three independent non-executive directors and the Chief Executive, met three times in 2005 and its Chairman, Dudley Eustace, and members, Dr. Rolf Stomberg and Sir Christopher

 

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O’Donnell, attended all meetings. John Buchanan was appointed to the Committee in May 2005 and attended two meetings. The Committee oversees plans for Board of Directors’ succession, recommends appointments to the Board of Directors and determines the fees of the non-executive directors. 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. It provides a formal and transparent procedure for the appointment of new directors to the Board. Candidate profiles are agreed by the Committee before external consultants are engaged to advise on prospective Board appointees. Shortlisted candidates are interviewed by members of the Committee who then recommend candidates to be interviewed by all members of the Board. The final decision is made by the Board. The Senior Independent Director oversees the process for the appointment of a new Chairman.

 

Directors’ Re-appointment

Under Smith & Nephew’s articles of association, any director who has been appointed by the Board of Directors since the previous annual general meeting of shareholders, either to fill a casual vacancy or as an additional director, holds office only until the next annual general meeting and then is eligible for reappointment by the shareholders. Subsequently, directors retire and offer themselves for re-election at the third annual general meeting after the meeting at which they were last reappointed. The directors are subject to removal with or without cause by the Board of Directors or the shareholders. Executive Officers serve at the discretion of the Board of Directors.

 

David Illingworth was appointed a director by the Board on 8 February 2006 and, in accordance with the articles of association, will retire at the annual general meeting to be held in April 2006 and, being eligible, will offer himself for re-election. Peter Hooley will retire by rotation and, being eligible, will offer himself for re-election at the AGM. In February 2006 Smith & Nephew announced that Peter Hooley will retire in the summer of 2006. It was also announced that John Buchanan would succeed Dudley Eustace as independent non-executive Chairman following Dudley Eustace’s retirement at the conclusion of the 2006 AGM.

 

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ACCOUNTABILITY, AUDIT AND INTERNAL CONTROL FRAMEWORK

 

Risk Management and Internal Control

The Board is responsible for the maintenance of the Group’s systems of risk management and internal control and for reviewing their effectiveness. These systems, which accord with the Turnbull Guidance, have been in place for 2005 and to the date of approval of the report and accounts and involve: the identification, evaluation and management of key risks through a Risk Committee, which reports to the Board annually; business reviews by the Board; and the review by the Audit Committee of internal financial controls and the risk management process. These systems are reviewed annually by the Board. Whilst not providing absolute assurance against material misstatements or loss, these systems are designed to identify and manage those risks that could adversely impact the achievement of the Group’s objectives.

 

Risk Committee

The Risk Committee comprises the members of GEC and is chaired by the Chief Executive. As an integral part of planning and review, management at each of the business units identify 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. Areas of potential major impact are reported to the Risk Committee at its meetings which are held twice a year.

 

The annual Group Risk Report of the Risk Committee to the Board details all principal risks categorised by potential financial impact on profit and share price. The most significant Group risks are reported to the Board quarterly, which include new key or significantly increased risks along with actions put in place to mitigate such risks. The principal risks are detailed in “Risk Factors” to be found on pages 23 to 26.

 

In 2005 the effectiveness of the business units’ systems to identify and manage material risk were evaluated and the findings reported to the Audit Committee. No material weaknesses were identified in these systems.

 

Disclosures Committee and Evaluation of Disclosure Controls and Procedures

The Disclosures Committee is chaired by the Chief Executive and also comprises the Finance Director and the Group Director of Corporate Affairs. The secretary is the Company Secretary. The Committee approves the releases of all major communications to investors, to the UK Listing Authority and the London and New York stock exchanges.

 

The Chief Executive and Finance Director have evaluated the effectiveness of the design and operation of the Group’s disclosure controls and procedures as at 31 December 2005. Based upon, and as of the date of, that evaluation, the Chief Executive and Finance Director concluded that the disclosure controls and procedures were effective, to ensure that information required to be disclosed in the reports which the Group files and submits under the Exchange Act in the US is recorded, processed, summarised and reported as and when required.

 

In the 2004 Annual Report management reported that it had identified certain adjustments that were needed to the UK/US GAAP reconciliations in prior years and that it had restated the reconciliations accordingly. Under US reporting these adjustments, when taken together, were indicators of a material weakness in the US GAAP disclosure controls. Management remediated this material weakness by appointing external specialist US GAAP advisors in February 2005 and by recruiting an additional internal accounting staff member to increase the resources focused on US reporting issues.

 

There has been no change in the Group’s internal control over financial reporting other than mentioned above that occurred during the period covered by this Annual Report that has materially affected, or is reasonably likely to materially affect, the Group’s internal control over financial reporting.

 

Codes of Business Principles

The Codes of Business Principles, which include a whistleblowing policy are available at www.smith-nephew.com and are available on request and apply to all directors, officers and employees. Any breaches of the Codes are reported to the Company Secretary who is obliged to raise the issue with the Chief Executive or Chairman and the Audit Committee. During 2005 and up until 24 February 2006 there have been no breaches of the Codes and no waivers have been put in place nor any amendments made to the Codes.

 

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Code of Ethics for Senior Financial Officers

The Board of Directors has adopted a Code of Ethics for Senior Financial Officers, which is available at www.smith-nephew.com and is available on request. It applies to the Chief Executive, Finance Director, Group Financial Controller and the Group’s senior financial officers. There have been no waivers to any of the Code’s provisions nor any amendments made to the Code during 2005 or up until 24 February 2006.

 

Activities of the Audit Committee for 2005

The Audit Committee’s remit, which is set out in its terms of reference, includes responsibility for:

 

  monitoring the integrity of the Company’s accounts, ensuring that they meet statutory and associated legal and regulatory requirements and reviewing significant financial reporting judgments contained in them;

 

  monitoring announcements relating to the Company’s financial performance;

 

  monitoring and reviewing the effectiveness of the Company’s internal audit function;

 

  recommending, for shareholder approval, the appointment, re-appointment and removal of the external auditors, as appropriate;

 

  approving the remuneration and terms of engagement of the external auditors;

 

  monitoring and reviewing the external auditors’ independence and the effectiveness of the audit process;

 

  pre-approval of the external auditors to supply non-audit services;

 

  monitoring the effectiveness of internal financial controls;

 

  reviewing the operation of the risk management process; and

 

  reviewing arrangements by which staff may raise complaints against the Company regarding financial reporting or other matters.

 

The Group has specific policies which govern:

 

  the conduct of non-audit work by the external auditors which 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; and

 

  audit partner rotation, which is 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 has expired since their previous involvement with the Group.

 

The Chief Executive, the Finance Director and other members of management attend the meetings when necessary and the external auditors have unrestricted access to the Audit Committee. The Audit Committee meets without management in attendance, when appropriate, and meets with the auditors, without management present, from time to time.

 

The principal activities of the Audit Committee during the year ended 31 December 2005 included:

 

  consideration of the quarterly, interim and preliminary results and the annual accounts;

 

  consideration of the proposed redenomination of the capital of the Company into US Dollars and the move to US Dollar reporting in 2006;

 

  consideration of the Group’s preparation for the introduction in 2006 of s404 of the Sarbanes-Oxley Act 2002;

 

  a review of the Group’s approach to internal financial control, its processes, outcomes and disclosures;

 

  a review of the Internal Review department’s activities for the year, together with its resource requirements and findings;

 

  a review of ‘whistleblowing’ procedures;

 

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  a review of the reports from the auditors, Ernst & Young LLP, on their professional and regulatory compliance in order to maintain independence and objectivity, including the rotation of partners;

 

  a review of the audit, audit-related and tax services provided by Ernst & Young LLP;

 

  review and the pre-approval of all services provided by the auditors during the year including all non-audit work performed by the auditors together with associated fees, to ensure that the objectivity and independence of Ernst & Young LLP as auditors of the Group was not compromised. Ernst & Young LLP provided no consultancy work;

 

  consideration of Ernst & Young LLP’s in-depth reports to the Committee on the scope and outcome of the annual audit and management’s response. Their reports included accounting matters, governance and control and accounting developments;

 

  a review of the effectiveness of the performance of Ernst & Young LLP effected by the completion of a questionnaire by the units audited within the Group and by the members themselves;

 

  recommending the re-appointment of Ernst & Young LLP as the Group’s auditors;

 

  confirmation that no concerns were raised with the Committee about possible improprieties in matters of financial reporting or other matters;

 

  reviewing the Committee’s terms of reference to ensure they reflect recent developments in corporate governance in the UK and the US;

 

  consideration of the Group’s risk management process; and

 

  an evaluation of its performance during the year, effected by means of a questionnaire and individual discussions.

 

The Committee may obtain legal and other independent professional advice, at the Company’s expense, as it deems necessary. During the year, no such advice was sought by the Committee.

 

Future Reporting Developments

On 2 March 2005 the SEC announced the postponement by a further year for foreign registrants of the deadline for compliance with s404 of the Sarbanes-Oxley Act of 2002. Management will be required to report on the Group’s internal controls over financial reporting for 2006. Work has been carried out during 2005 in preparation for reporting in accordance with the Act and will continue to be progressed during 2006.

 

Principal Accountant Fees and Services

Fees for professional services provided by Ernst & Young LLP, the Group’s independent auditors in each of the last two fiscal years, in each of the following categories were:

 

     2005

   2004

     (£ million)

Audit

   1.9    1.7

Audit-related

   0.3    0.5

Tax

   1.0    1.0

Other

     
    
  
     3.2    3.2
    
  

 

Audit fees include fees associated with the annual audit and local statutory audits required internationally. Audit-related fees principally include accounting consultation in relation to International Financial Reporting Standards, advice regarding the switch to US Dollar reporting and advice regarding compliance with Sarbanes-Oxley. Tax fees include tax compliance, tax advice and tax planning services. A more detailed breakdown of audit fees may be found in Note 37 of the Notes to the Accounts.

 

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SHAREHOLDERS

 

Shareholders

The Group issues a summary report on the year, the Summary Financial Statement, unless a shareholder requests the Group’s full Annual Report. Over 90% of non-US shareholders have chosen to only receive a copy of the Summary Financial Statement. In the US, the Group issues the Summary Financial Statement together with the full Annual Report to all shareholders. At the half year, an Interim Report is sent to all shareholders and quarterly reports are made available through Stock Exchange announcements and on the Group’s website. Copies of the full Annual Report, the Summary Financial Statement and the Interim Report are also available on the Smith & Nephew website along with press releases, institutional presentations and audio webcasts.

 

There is a regular dialogue with individual institutional shareholders, together with quarterly results telephone conference calls. To ensure that all members of the Board develop an understanding of the views of major shareholders, the executive directors review significant issues raised by investors with the Board. Non-executive directors are sent copies of analysts’ and brokers’ briefings and are offered the opportunity to attend meetings with major shareholders and are expected to do so if shareholders request a meeting. In 2005, no such request was received. There is an opportunity for individual shareholders to question the directors at the AGM, at which the level of proxy votes received are advised, and the Company regularly responds to letters from shareholders on a range of issues.

 

Share capital

All the Ordinary Shares, including those held by directors and officers, rank pari passu with each other. Following approval by shareholders at the Extraordinary General Meeting in December 2005, redenomination of the Ordinary Shares into US Dollars took place in January 2006. The new US Dollar Ordinary Shares carry the same rights as the previous Ordinary Shares. In order to comply with English law the Company has issued £50,000 of shares in Sterling. These were issued as Deferred Shares, which are not listed on any stock exchange and have extremely limited rights and therefore effectively have no value. These were allotted to the Chief Executive, though the Board reserves the right to transfer them to another member of the Board should it so wish.

 

At the AGM, the Company will be seeking a renewal of its current permission from shareholders to purchase up to 10% of its own shares. No shares have been purchased, or contracted for or, are the subject of an option under the current expiring authority given by shareholders at the AGM of 5 May 2005. The shares acquired and referred to in the section “Share Capital” were acquired under powers that enable the Trustees of the Company’s Long-Term Incentive Plan to acquire shares.

 

Auditors

Ernst & Young LLP have expressed their willingness to continue as auditors and resolutions proposing their reappointment and to authorise the directors to fix their remuneration, which have been approved by the Audit Committee, will be proposed at the AGM.

 

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 SEC’s 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.

 

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REMUNERATION REPORT

 

For ease of reference the Remuneration Report is broken down into a number of different sections, of which Directors’ Emoluments and Pensions, Senior Management Remuneration and Directors’ Interests were subject to audit, and are as follows:

 

The Remuneration Committee

Remuneration Policy

The Principal Components of Remuneration

Total Reward Composition

Long-Term Incentive Plans pre 2004

2005 Remuneration Committee Initiatives

ShareSave Schemes

Pensions — UK

Pensions — US

Service Contracts

External Non-executive Directorships

Non-executive Directors

Directors’ Emoluments and Pensions

Senior Management Remuneration

Directors’ Interests

Total Shareholder Return

 

The Remuneration Committee

The Committee, which comprises Dr. Rolf Stomberg (Chairman), Dr. Pam Kirby, Warren Knowlton and Richard De Schutter, determines the compensation of executive directors and members of the GEC and the broad policy for executive remuneration. The Committee is assisted by Sir Christopher O’Donnell, Chief Executive, and Paul Williams, Group Human Resources Director, both of whom have advised on all aspects of the Group’s reward structures and policies but neither is present at any discussion concerning their own remuneration.

 

The Committee reviews:

 

  on an annual basis the remuneration, including pension entitlements, of executive directors and members of the GEC;

 

  the relationship between the remuneration of executive directors and that of other employees;

 

  the competitiveness of executive remuneration using data from independent consultants on companies of similar size, technologies and international complexity;

 

  the performance targets for the bonus plans and long term incentive plans and the performance against the targets;

 

  and determines the operation of and the participants in the long-term incentive plans, share option schemes and the performance related bonus plan;

 

  the operation of all of the Company’s share incentive schemes in respect of grant levels, performance criteria and vesting schedules; and

 

  plans for management succession.

 

The terms of reference, which are available on the company’s website at www.smith-nephew.com, enable the Committee to obtain its own external advice on any matter, at the Company’s expense. During the year, the Committee received information from a number of independent consultants appointed by the Company: Watson Wyatt on a broad range of remuneration issues; Towers Perrin and Hay Group on salary data, when considering base salaries of executive directors and members of GEC; and PricewaterhouseCoopers LLP on long-term incentive plan comparative performance. Watson Wyatt also acts as one of the retirement benefit consultants to the Group and PricewaterhouseCoopers LLP provides consultancy services to the Group including project and taxation advice.

 

Remuneration Policy

The remuneration policy, as approved by the Remuneration Committee, for 2005 and future years, is designed to ensure that remuneration is sufficiently competitive to attract, retain and motivate executive directors and GEC members of a calibre that meets the Group’s needs to achieve its business objectives. Remuneration includes base pay and benefits which are targeted at median competitive levels for acceptable performance and bonus

 

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schemes which are designed to motivate and reward for outperformance. 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. Major changes to the remuneration policy are discussed with the principal shareholders.

 

A share based incentive plan operates for executive directors, members of the GEC and the next level of senior executives. The plan comprises a performance share plan, share option plan and co-investment plan and increases the proportion of executive’s variable reward that is wholly dependent on the Group’s performance. Other levels of management are able to participate in the 2001 share plans.

 

Variable rewards will continue to be provided through a mix of performance related elements. The bonus plan relates to achievement of operational objectives for the financial year, the performance share plan will reward superior total shareholder return (“TSR”) relative to the Group’s competitors and FTSE100 companies, and share options will reward earnings per share (“EPSA”) and share price growth.

 

The Principal Components of Remuneration

The principal components of remuneration of executive directors and GEC members are: basic salary and benefits; performance related bonus; long-term incentives consisting of a performance share plan, co-investment plan and share options; and pensions.

 

(a) Basic Salary and Benefits

Basic salary reflects the responsibility of the position and individual performance. The Group also provides certain benefits such as private healthcare coverage and a company car or allowance in line with competitive practice.

 

(b) Performance Related Bonus

For executive directors, the Group operates an annual bonus scheme. In 2005, 75% of the annual bonus was based on annual growth in EPSA and 25% was based on improvement in return on operating capital employed (“ROCE”). The scheme is designed to encourage outstanding performance. Achievement of 14% EPSA growth and the budgeted improvement in ROCE would produce a bonus of 30% of annual salary. Achievement of 20% EPSA growth and ROCE 5% over budget would produce a maximum bonus of 100% of annual salary. Bonuses are not pensionable.

 

The actual bonus earned in 2005 represented 27.6% of annual salary as 14% EPSA growth was achieved, but the budgeted ROCE was not achieved. Under the Co-investment Plan, part of the annual bonus may be taken in shares.

 

For members of the GEC with corporate responsibilities, excluding executive directors, the 2005 annual bonus plan was linked to EPSA, ROCE and personal objectives. For those members with specific business unit responsibilities, targets are linked to EPSA and revenues, trading profit and ROCE of their respective business unit. As with executive directors, part of the annual bonus may be taken in shares.

 

(c) Long-Term Incentives

 

(i) Performance Share Plan

Annual awards over shares made under the 2004 Performance Share Plan only vest if defined levels of total shareholder return are attained over three years beginning in the year of award. There is no retesting.

 

The award shares are divided equally into two tranches, so as to measure TSR relative to the FTSE100, and to the major companies in the medical devices industry respectively. TSR performance of the Sterling priced ordinary shares against the FTSE100 companies and the US Dollar priced ADR TSR performance against major companies in the medical devices industry (the majority of which are US listed) were identified as the most suitable measures to encourage high levels of business performance and align the interests of the Group, its shareholders and senior executives.

 

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The medical devices companies for comparison for the 2005 award which the Committee considered appropriate to the Company are:

 

Arthrocare

   Guidant

Bard

   Johnson & Johnson

Baxter

   Medtronic

Becton Dickinson

   Nobel Biocare

Biomet

   Orthofix

Boston Scientific

   Stryker

Coloplast Group

   St Jude Medical

Conmed

   Synthes-Stratec

D J Ortho

   Wright Medical

Edwards Life Sciences Corp

   Zimmer

 

The shares of each tranche will vest if the Group’s TSR is ranked at the median level in that tranche. If, in relation to either tranche, the Group ranks at median, 25% of the award of that tranche will vest and if the Group is at the 75th centile, then all of the shares of that tranche will vest. Between the median and 75th centiles, the shares will vest on a straight-line basis. If the Group is above the 75th centile, then the number of shares increases above the award on a straight-line basis up to a maximum of 150% of the award if the Group is ranked at or above the 90th centile.

 

In relation to awards made to executive directors, the initial market value of the award shares is equivalent to their basic annual salary and in relation to awards made to other GEC members, the initial market value of the awards is equivalent to 75% of their basic annual salary.

 

The Remuneration Committee has the discretion to reduce the number or percentage of shares which vest if, notwithstanding the Group is ranked at or above the median level in respect of either tranche of award shares, the Remuneration Committee is of the opinion that the growth in the Group’s TSR achieved for either tranche is not a genuine reflection of the Group’s underlying financial performance. The Group’s TSR performance and its performance relative to the comparator group is independently monitored and reported to the Remuneration Committee by PricewaterhouseCoopers LLP.

 

(ii) Executive Share Options

In 2005, share options were granted under the 2004 Executive Share Option Plan and 2001 UK Approved Plan for UK resident executive directors and executives. Under the 2004 Plan, the maximum market value of options which may be granted each year is equivalent to the basic annual salary of the director or executive. Options are exercisable up to ten years from the date of grant and are only exercisable if graduated target levels of growth in EPSA over the three-year performance period are achieved, beginning with that in which the option is granted. Options were granted under the 2001 UK Approved Plan up to the value of £30,000 and formed part of the overall grant. Performance conditions for these awards were exactly the same as for the 2004 Plan.

 

The target levels of performance are set by the Remuneration Committee for each grant. For 2005 they were: 25% of the option shares will vest if growth in EPSA over the three-year period ending 31 December 2007 is 26% (i.e. 8% compounded annually) with 50% vesting if such growth is 48% (i.e. 14% compounded annually). Only if growth in EPSA over that period exceeds 73% (i.e. 20% compounded annually) will all of the option shares vest. Option shares will vest pro rata on a straight-line basis if growth in EPSA is between these levels. There is no retesting of performance conditions.

 

(iii) Co-investment Plan

The 2004 Co-investment Plan enables selected executives to take part of their annual bonus in the form of shares. The participant elects the level of bonus to be used for this purpose up to a maximum of one half of the annual gross bonus capped at 20% of basic annual salary for executive directors and members of GEC. The net amount of the gross amount elected will then be used to purchase shares.

 

For the 2005 award, and provided such shares are held for three years, and the participant remains employed within Smith & Nephew, the participant will be entitled to matching shares if the Company achieves a target level of growth in EPSA over that three-year period of 48% (i.e. 14% compounded annually). At this level, the participant is entitled to one matching share for every share acquired out of the gross equivalent amount of the net bonus used to acquire shares. If growth in EPSA is 60% or more (i.e. 17% compounded annually) the

 

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participant is entitled to two matching shares for each share acquired out of the gross equivalent amount of the net bonus applied to shares. There is no sliding scale nor pro-rata vesting of matching awards between these performance levels, nor is there any retesting.

 

In the event of a change of control of the Company, the Remuneration Committee will determine what proportion of the awards or options will vest and what proportion of the matching shares will be transferred to the executives taking into account both the proportion of the performance period and the performance of the Company over that period. In the event that an executive resigns or if employment is terminated for cause, all the options lapse. If an executive retires or leaves for other reasons, the award is pro-rated for the proportion of the performance period then elapsed. The prorated award is still subject to the attainment of the performance criteria before vesting.

 

The following table provides a comparison of variable remuneration of executive directors and GEC members and the next level down (i.e. business unit management) shown as a percentage of salary. Except for the annual bonus, the components are measured over a three year period.

 

   

Annual bonus


 

Performance

Share Plan


 

Share Option

Plan


 

Co-investment

Plan


Executive Directors and GEC Members

  0% to 100%
depending on
performance
  Equal to 100%
of salary (75%
for GEC
members) for
75
th centile TSR
  Equal to 50% of
salary for EPSA
growth of 48%
  Maximum 20%
of salary with 1
to 1 matching
at EPSA growth
of 48%

GBU Executives

  0% to 80%
depending on
performance
  Equal to 35% of
salary for 75
th
centile TSR
  Equal to 50% of
salary for EPSA
growth of 48%
 

Maximum 18%
of salary with 1
to 1 matching

at EPSA growth

of 48%

 

Total Reward Composition

In 2005, excluding pension entitlements, the composition of remuneration for Sir Christopher O’Donnell was: base pay (fixed) 55%, annual bonus (variable) 15% and long-term incentives (variable) 30% and for Peter Hooley was base pay (fixed) 54%, annual bonus (variable) 15% and long-term incentives (variable) 31%.

 

Senior executives are expected to build and maintain a personal equity stake in the Company. Executive directors are required to accumulate a personal holding equivalent to 100% of basic salary within five years and members of GEC are required to accumulate a personal holding equivalent to 75% of basic salary within five years.

 

Long-Term Incentive Plans Pre 2004

The Performance Share Plan adopted in 2004 and described above replaced the long-term incentive plan (“LTIP”) established in 1997 for executive directors and members of the GEC and no further awards will be made under this LTIP.

 

(a) 1997 LTIP

The last award under the 1997 LTIP was made in 2003 and vested at the end of 2005. Under the plan, shares are transferred to participants depending on the Group’s performance relative to a group of 39 UK listed manufacturing companies with substantial international activities using TSR over a three-year period as the prime measure. The maximum value of shares awarded for executive directors has not exceeded the participants’ annual rate of basic salary at the date the award was granted, and for members of the GEC it has not exceeded 75% of their annual basic salary. Shares will only be transferred to the participants if the Group’s TSR performance is at or above the median performance of the comparator companies, and growth in the Group’s EPSA exceeds growth in the United Kingdom Retail Price Index (“RPI”) in the same three-year period. At the median level, 25% of the award shares will vest. If the Group’s performance is in the top quartile, all the shares will vest. For performance between the median and the top quartile, the proportion of shares vesting will vary on a straight-line basis. TSR subject to real EPSA growth was identified and selected as the performance condition that represented a fair measure of the Group’s performance and would reflect increases in shareholder value.

 

For the three-year plan period commencing 2003, the Group’s TSR of 41.06% was ranked 17th in the comparator group and the earnings per share performance criterion was met, enabling the plan participants to be eligible for 49% of the shares awarded conditionally in 2003. The remainder of the awards therefore lapse.

 

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In line with market practice in 1997 every encouragement was given to executive directors and senior managers to build up a significant shareholding in the Group. Accordingly, participants in the LTIP who have not left the Group, at the fifth and seventh anniversaries of the date of the award, are given one additional share for every five so retained. This provision was not continued in the 2004 Plans when a threshold stock requirement was incorporated.

 

The comparator group for the LTIP comprised the following companies:

 

Aga Foodservice Group

  Croda International   Invensys   Smiths Group

AstraZeneca Group

  De La Rue   Johnson Matthey   Spirax-Sarco Engineering

BAE Systems

  Delta   Laird Group   Spirent

Balfour Beatty

  Elementis   Low & Bonar   Tate & Lyle

BBA Group

  FKI   Morgan Crucible   Tomkins

BOC Group

  GKN   Pilkington   TT Electronics

Bunzl

  GlaxoSmithKline   Reckitt Benckiser   Unilever (UK)

Cadbury Schweppes

  Halma   REXAM   Weir Group

Charter

  ICI   Rolls-Royce    

Cookson Group

  IMI   Scapa Group    

 

The Group’s TSR performance and its performance relative to the comparator group was independently monitored and reported to the Remuneration Committee by PricewaterhouseCoopers LLP.

 

(b) 2001 Share Option Plans

The 2001 UK Approved Share Option Plan, the 2001 UK Unapproved Share Option Plan and the 2001 US Share Plan are now, in the main, for the benefit of those executives not eligible for the 2004 share incentive plans. Each year the Remuneration Committee determines the maximum value of options to be granted to executives by reference to multiples of salary.

 

With the exception of the 2001 US Share Plan, the exercise of options is subject to EPSA growth of not less than RPI plus 3% per annum, on average, in a period of three consecutive years. From 2005, the retesting of the performance conditions no longer applies. Performance conditions were selected to be in line with market practice at the time. The awards made in 2003 will vest in 2006 as EPSA growth over the three year performance period exceeded the RPI +3% target. Options granted under the 2001 US Share Plan, in line with US market practice, are not subject to performance targets but are exercisable cumulatively up to a maximum of 10% after one year, 30% after two years, 60% after three years and the remaining balance after four years.

 

Executive share options under all 2001 schemes are not offered at a discount to the market value at the time of grant and would vest on a change in control.

 

2005 Remuneration Committee Initiatives

During 2005, the Committee reviewed the current share incentive plans in respect of grant levels, performance criteria and vesting schedules and determined that they remained appropriate.

 

With the transition to IFRS at the beginning of 2005 the Committee was satisfied that the performance measures remained consistent with those under UK GAAP as the impact of IFRS on EPSA and other measures was minor. Likewise the Committee considered that the redenomination of the share capital of the Company into US Dollars, effected on 23 January 2006, will not warrant any changes to the performance criteria of the share incentive plans as the overall effect on the performance measures would be minor. The annual bonus plans would be unaffected in the longer term but the Remuneration Committee will review the transition to reporting in US Dollars in 2006.

 

The Remuneration Committee has determined that there was a need to increase the maximum multiples of annual remuneration applied to awards under the 2001 Share Option Plans to keep in line with competitive practice and to minimise the increasing risk of executive attrition. These option plans are seen as an essential part of the remuneration package for executives not eligible for the 2004 share incentive plans. Accordingly the maximum multiples applied were increased from one times to one and a half times annual remuneration in the UK and from one and a half times to two and a quarter times annual remuneration in the US.

 

The Remuneration Committee has also agreed, for the same attrition risk reasons in the US, to change the original 2004 guidance that participants in the 2004 Share Plan would no longer receive awards under existing

 

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discretionary share plans. For 2006 and future years US participants of the 2004 share incentive plans will also be eligible for awards under the 2001 US Share Plan subject to the explicit approval of the Remuneration Committee.

 

The Remuneration Committee has also considered the implications of the impending changes to UK pensions taxation and has agreed that: a) an earnings cap on final pensionable salary calculated in the same way as the UK Inland Revenue earnings cap will be retained in the defined benefit plans to limit the defined benefit obligations; b) there will be no future service accruals under the supplementary unfunded arrangement and an equivalent non-pensionable non-bonusable salary supplement will be paid instead and; c) a non-pensionable, non-bonusable salary supplement of 30% of basic salary will be offered as an alternative where an executive does not wish to take further pension provision (either defined benefit or defined contribution).

 

ShareSave Schemes

UK executive directors and members of GEC are eligible to contribute to the Smith & Nephew Employee Share Option Scheme (ShareSave) and US members of the GEC are eligible to participate in the Employee Stock Purchase Plan.

 

Pensions — UK

UK based executive directors and members of GEC have a normal retirement age of 62. Those in service pre-2003 participate in the defined benefit Smith & Nephew UK Pension Fund and UK Executive Pension Scheme, under which pension has been accrued in the year at an annual rate of one-thirtieth of final pensionable salary up to a limit based on service of two-thirds of final pensionable salary, subject to Inland Revenue constraints. Pensions in payment are guaranteed to increase by 5% per annum or the rate of inflation in the UK, if lower. Death in service cover of four times salary and spouse’s pension at the rate of two thirds of the member’s pension are provided on death.

 

Those commencing employment post 2002 participate in the defined contribution plan to which a company contribution of 30% of pensionable salary is made. Death in service cover of seven times salary (of which four times is provided as a lump sum) is provided on death. A supplementary unfunded defined contribution arrangement partially compensates for the UK Inland Revenue earnings cap on final pensionable salary.

 

Pensions — US

US based executive directors and members of GEC participate in either the defined benefit Smith & Nephew US Pension Plan or the defined contribution US Savings Plan 401(k) Plus. Any new executives would enter the US Savings Plan 401(k) Plus. Under the US Pension Plan, pensions accrue at an annual rate of approximately one-sixty second of final pensionable salary up to a limit based on service of 60% of final pensionable salary. The plan also provides for a spouse’s pension at the rate of one half of the member’s pension on death. Normal retirement age under the plan is 65. A supplementary defined benefit plan is used to enable defined benefits to be payable from age 62 without reduction for early retirement. A supplementary defined contribution plan is used to compensate for the earnings cap imposed by the US Internal Revenue Code and to provide additional retirement benefits.

 

The Remuneration Committee considers pension consequences and costs to the Company when determining basic salary increases for executive directors’ and members of GEC.

 

Service Contracts

All appointments of executive directors are intended to have twelve month notice periods, but it is recognised that for some new appointments a longer period may initially be necessary for competitive reasons, reducing to twelve months thereafter.

 

Sir Christopher O’Donnell, appointed to the Board of Directors in September 1992, has a service agreement with the Company dated January 1992 which expires on his 62nd birthday in October 2008. Peter Hooley, appointed to the Board of Directors in April 1991 has a service contract with the Company dated January 1992 which expires on his 62nd birthday in June 2008 although he has informed the Board that he wishes to take early retirement during 2006. Both service agreements are terminable by the Company on not more than twelve months notice and by the executive director on six months notice. There is no enhancement of termination rights on a change of control of the Group. During 2005 termination of the contract by the Group, except for ‘cause’, would entitle the executive directors to twelve months’ basic salary, bonus at target of 30%, a contribution of 30%

 

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of salary to reflect the loss of pension benefits, an amount to cover other benefits and a time apportionment of the performance share plan entitlement. The Committee has determined not to amend the contracts of the current executive directors for mitigation, but it does have discretion to require mitigation for newly appointed directors.

 

David Illingworth, appointed to the Board of Directors in February 2006, has a letter of appointment with the Company with a normal retirement age of 62. Upon appointment to the Board, his services are terminable by the Company on 24 months notice (as is common competitive practice with very senior appointments), such period reducing to 12 months within 24 months from the date of appointment to the Board, and by him on six months notice. There is no enhancement of termination rights on a change of control of the Group. Termination of the contract by the Group, except for ‘cause’, would entitle him to 24 months’ (reducing to 12 months within 24 months from date of appointment to the Board) basic salary, bonus at target of 50%, a contribution to reflect the loss of pension benefits, an amount to cover other benefits and a time apportionment of the performance share plan entitlement.

 

External Non-executive Directorships

Non-executive directorships provide executive directors with valuable experience beneficial to the Company. Such appointments are subject to the approval of the Nominations Committee and are restricted to one appointment for each executive director. All fees receivable by a director are paid to the Company.

 

Non-executive Directors

Non-executive directors do not have service contracts but instead have letters of appointment. Non-executive directors are normally appointed for three terms of three years terminable at will, without notice by either the Group or the director and without compensation. The Chairman has a three month notice period. The remuneration of the non-executive directors is determined by the Nominations Committee who aim to set fees that are competitive with other companies of equivalent size and complexity. Non-executive directors are expected to accumulate a personal holding in the Company equivalent to once times the annual basic fee, within three years.

 

The Chairmen of the Audit and Remuneration Committees and the Senior Independent Director receive an extra £7,500 for their additional responsibilities. In 2005, Dr. Rolf Stomberg waived his extra fee entitlement due to him as Senior Independent Director.

 

Directors’ Emoluments and Pensions

 

   

Salaries

and

fees


  Benefits(i)

  Bonus

 

Total

emoluments

excluding

pension

entitlements


 

Pension

entitlements


 

Total

including

pension

entitlements

2005


 

Total

excluding

pension

entitlements

2004


 

Total

including

pension

entitlements

2004


    (£ thousands)

Chairman (non-executive):

                               

Dudley G. Eustace

  250   1     251     251   191   191

Executive Directors:

                               

Sir Christopher O’Donnell

  679   15   190   884   50   934   904   954

Peter Hooley

  364   18   102   484   112   596   491   589

Non-executive Directors:

                               

John Buchanan (appointed 3 Feb 2005)

  90       90     90    

Dr. Rolf W. H. Stomberg

  53       53     53   45   45

Warren D. Knowlton

  53       53     53   40   40

Richard De Schutter

  45       45     45   35   35

Dr. Pamela J. Kirby

  45       45     45   35   35

Brian Larcombe

  45       45     45   35   35
   
 
 
 
 
 
 
 

Total

  1,624   34   292   1,950   162   2,112   1,776   1,924
   
 
 
 
 
 
 
 

(i) Includes cash allowances and benefits in kind.

 

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Table of Contents

(a) Pensions

 

   

Accrued

pension

as at

1 Jan

2005


 

Increase in

accrued

pension

excluding

inflation


 

Accrued

pension

at

31 Dec

2005


 

Transfer

value of

accrued

pension

at 1 Jan

2005


 

Directors’

contributions

during

2005


 

Increase in

transfer

value over

year less

directors’

contributions


 

Transfer

value of

accrued

pension

at 31 Dec

2005


        (£ per annum)       (£)   (£)   (£)   (£)

Sir Christopher O’Donnell

  245,000   42,000   295,000   3,644,000   33,000   976,000   4,653,000

Peter Hooley

  36,000   3,000   39,000   550,000   5,000   94,000   649,000

 

An amount of £108,000 (2004 — £94,000) was provided under the supplementary unfunded defined contribution arrangement for Peter Hooley, bringing his total benefit under the plan to £602,000 (2004 — £494,000). The increase in the transfer value is as a result of a change in the underlying factor to reflect current market conditions, the unwinding of the previous year’s salary increase within the definition of final pensionable salary, the accrual of an additional one year of service and the increase in pension as a result of the salary increase granted during the year.

 

No amounts have been paid to third parties in respect of directors’ services and no excess retirement benefits or compensation have been paid to past directors.

 

(b) Directors’ Share Options

 

    

Options

1 Jan

2005


   

Granted

during
the year


    Exercised

    Exercise
price


  

Market

price at

date of

exercise


  

Profit on

exercise


  

Options

31 Dec

2005


  

Average

exercise

price


  

Range of

exercisable

dates of

options

held at

31 Dec 2005


     (Number)     (Number)     (Number)     (p)    (p)    (£)    (Number)    (p)    (Date)

Sir Christopher O’Donnell

   113,140 (i)                    113,140    574.5    5/07-5/14
         121,951 (iv)                121,951    533.0    5/07-3/15
     3,192 (ii)       (3,192 )   296.0    508.0    6,767         
     305,861 (iii)   151,892 (v)                457,753       7/03-8/12
    

 

 

           
  
         

Total

   422,193     273,843     (3,192 )             6,767    692,844          
    

 

 

           
  
         

Peter Hooley

   60,050 (i)                    60,050    574.5    5/07-5/14
     37,500 (i)   64,727 (iv)   (37,500 )   194.3    536.0    128,138    64,727    533.0    5/07-3/15
     2,404 (ii)                    2,404    394.0    11/07-4/08
     429,804 (iii)   110,775 (vi)   (257,614 )      527.0    1,357,535    282,965       4/12-8/12
    

 

 

           
  
         

Total

   529,758     175,502     (295,114 )             1,485,673    410,146          
    

 

 

           
  
         

(i) Options granted under Executive Share Option Plans. In 2004 options were granted at an exercise price of 574.5p which at 31.12.2005 was higher than the then share price.
(ii) Options granted under the UK ShareSave schemes.
(iii) Nil cost options acquired through vesting of LTIP awards.
(iv) Options granted on 14 March 2005 at an exercise price of 533.0p.
(v) Comprises vesting of 2002 LTIP award (120,879 shares) and award of fifth anniversary bonus shares (31,013 shares).
(vi) Comprises vesting of 2002 LTIP award (70,818 shares) and award of fifth anniversary bonus shares (19,383 shares) and award of seventh anniversary bonus shares (20,574).

 

The range in the market price of the Company’s Ordinary Shares during the year was 451.5p to 558.0p and the market price at 31 December 2005 was 535.5p. The total profit on exercise of options during the year was £1,492,440 as set out above (2004 — £2,770,214: Sir Christopher O’Donnell £2,338,858 and Peter Hooley £431,356).

 

David Illingworth, who was appointed to the Board in February 2006, was granted 50,000 share options at 516.5p per share under the 2001 US Share Plan on 15 February 2006. A further 3 tranches of 50,000 options will be granted in 6 monthly intervals. Each award vests after 6 months dependent on achievement of Group trading profit targets.

 

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Table of Contents

(c) Long-Term Incentive Plan Awards

 

    

Number

of shares

awarded

at 1 Jan

2005


   

Awards

during

the year


   

Market

price


  

Vested

award


  

Market

price at

date of

award

5 April

2002


  

Market

price at

date of

vesting


  

Number

of shares

awarded

at 31

Dec

2005


  

Latest

performance

period


     (Number)     (Number)     (p)    (Number)    (p)    (p)    (Number)     

Sir Christopher O’Donnell

   260,488 (i)          120,879    407.3    530.0    139,609    31.12.2006
     113,140 (ii)   121,950 (ii)   533.0             235,090    31.12.2007

Peter Hooley

   149,888 (i)          70,818    407.3    530.0    79,070    31.12.2006
     60,050 (ii)   64,726 (ii)   533.0             124,776    31.12.2007

(i) Awards under previous Long-Term Incentive Plan.
(ii) Awards under 2004 Performance Share Plan. Subject to attainment of performance conditions, a further 50% of the award may vest.

 

(d) Co-investment Plan Awards

The number of matched shares to be allocated to each Executive Director is subject to the growth in EPSA over a three-year period. Details of the Plan can be found on pages 60 and 61.

 

    

Shares

acquired

with

maximum

allowable

net bonus

1 Jan 2005


  

Shares

acquired

with

maximum

allowable

net bonus

2005


  

Total

Matched

Shares

at 1 x gross

bonus


  

Total

Matched

Shares

at 2 x gross

bonus


Sir Christopher O’Donnell

   13,057    14,092    46,339    92,678

Peter Hooley

   6,979    7,479    24,594    49,188

 

Senior Management Remuneration

The Group’s administrative, supervisory and management body (‘the senior management’) comprises, for US reporting purposes, members of GEC.

 

In respect of the financial year 2005 the total compensation (excluding pension emoluments but including payments under the performance related bonus plans) paid to members of GEC for the periods during which they served in that capacity was £3,924,000, the aggregate increase in accrued pension benefits was £85,000, the aggregate payment to defined contribution plans was £21,000 and the aggregate amounts provided for under the supplementary schemes was £411,000.

 

During 2005 members of GEC were granted options over 478,943 shares under the Executive Share Option Plans, over 440 shares under the employee ShareSave schemes and awarded 318,236 shares and 17,420 ADSs under the 2004 Performance Share Plan and 66,418 shares and 3,247 ADSs under the Co-investment Plan. As of 24 February 2006 members of GEC (comprised of 13 persons) owned 576,146 shares and 12,033 ADSs, constituting less than 1% of the issued share capital of the Company. Members of GEC also held, as of this date, options to purchase 2,773,095 shares; 444,999 shares awarded under the LTIP; and 603,334 shares and 39,896 ADSs awarded under the Performance Share Plan and 246,802 shares and 19,129 ADSs awarded under the Co-investment Plan.

 

Directors’ Interests

Beneficial interests of the Directors in the Ordinary Shares of the Company are as follows:

 

     24 February 2006 (i)

   31 December 2005

   1 January 2005

     Shares (ii)

    Options

   Shares (ii)

   Options

   Shares (ii)

   Options

     (Number)

Dudley G. Eustace

   66,319        66,109       51,064   

John Buchanan

   60,000        20,000         

Sir Christopher O’Donnell

   197,012     692,844    197,012    692,844    178,061    422,193

Sir Christopher O’Donnell

   50,000 (iii)              

Peter Hooley

   227,340     410,146    227,340    410,146    219,861    529,758

Brian Larcombe

   5,000        5,000       5,000   

Dr. Pamela J. Kirby

   8,500        8,500       3,500   

Dr. Rolf W. H. Stomberg

   13,092        13,092       13,014   

Warren D. Knowlton

   27,001        27,001       27,001   

Richard De Schutter

   250,000        250,000       250,000   

 

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(i) The latest practicable date for this Annual Report.
(ii) Holdings of the directors together represent less than 1% of the Ordinary Share Capital of the Company.
(iii) Following the redenomination of Ordinary Shares into US Dollars, on 23 January 2006, Sir Christopher O’Donnell was issued with 50,000 £1 Deferred shares. These shares are not listed on any Stock Exchange and have extremely limited rights attached to them. See page 174 for a full explanation of these shares.

 

In addition to the above, on 22 February 2006, Sir Christopher O’Donnell became entitled to 22,108 Ordinary Shares and Peter Hooley to 13,818 Ordinary Shares on the fifth anniversary of the 2001 LTIP award; and on 2 March 2006, Sir Christopher O’Donnell will become entitled to 68,408 Ordinary Shares and Peter Hooley to 38,744 Ordinary Shares in respect of the 49% vesting of the 2003 long-term incentive plan award. The remainder of the 2003 awards therefore lapse. On 9 February 2006, Dudley Eustace purchased 210 Ordinary Shares at 493.25 pence per share as a reinvestment of a dividend and on 13 February 2006 John Buchanan purchased 40,000 shares at 518.00 pence per share.

 

The register of directors’ interests, which is open to inspection at the Company’s registered office, contains full details of Directors’ shareholdings and share options.

 

Total Shareholder Return

Schedule 7A to the Companies Act 1985 requires a graph to be published showing the Company’s TSR against the TSR performance of a broad equity market index. As a component company of the FTSE100 index, a graph of the Company’s TSR performance compared to that of the TSR of the FTSE100 index is shown below:

 

LOGO

 

By order of the Board, 2 March 2006:

 

Paul Chambers

Secretary

 

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Table of Contents

ACCOUNTS

 

Directors’ responsibilities for the accounts

   69

Independent auditors’ UK report

   70

Independent auditors’ US report

   71

Group income statement

   72

Group balance sheet

   73

Group cash flow statement

   74

Group statement of recognised income and expense

   75

Notes to the group accounts

   76

Parent company auditors’ report

   134

Parent company balance sheet

   135

Notes to the Parent company accounts

   136

Restatement of financial information under IFRS

   143

 

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DIRECTORS’ RESPONSIBILITIES FOR THE ACCOUNTS

 

The directors are responsible for the preparation of the Annual Report, including the remuneration report, in accordance with relevant UK legislation and other requirements including those International Financial Reporting Standards adopted for use in the European Union. As a consequence of the Company’s Ordinary Shares being traded on the New York Stock Exchange (in the form of American Depositary Shares) the directors are responsible for the preparation and filing of an annual report on Form 20-F with the US Securities and Exchange Commission. The directors are required to prepare accounts for each financial year that give a true and fair view of the state of affairs of the Company and of the Group as at the end of the financial year and of the results of the Group for the year. In preparing the accounts, appropriate accounting policies based on International Financial Reporting Standards adopted for use in the European Union have been used and applied consistently, and reasonable and prudent judgements and estimates have been made. Applicable International Financial Reporting Standards have been followed and complied with.

 

The directors are responsible for keeping proper accounting records which disclose with reasonable accuracy at any time the financial position of the Company and of the Group and enable them to ensure that the accounts comply with UK legislation and International Financial Reporting Standards adopted for use in the European Union. The directors have satisfied themselves from internal forecasts and available bank facilities that the Group continues as a going concern.

 

The directors are also responsible for the maintenance of the Group’s system of internal financial controls. These are designed to give reasonable assurance that proper procedures exist for the maintenance of adequate accounting records, safeguarding the assets of the Group and for preventing and detecting fraud and other irregularities. To this end, the Company has identified and documented appropriate internal financial control standards. Annual budgets are prepared and approved by the directors, and the directors have reserved capital expenditure and treasury authority levels to the Board and its delegated committees. The Group operates a system of regular monthly reporting including revised profit and cash forecasts. Business risks are identified and monitored on a regular basis. The Group operates an internal audit function which monitors the adequacy of internal financial controls and systems and compliance with Group standards. The internal auditor provides a report to the Audit Committee annually and the Audit Committee reviews the operation and effectiveness of internal financial controls and reporting of the Group.

 

A copy of the Annual Report is placed on the Smith & Nephew website. It should be noted that information published on the internet is accessible in many countries with different legal requirements. Legislation in the UK governing the preparation and dissemination of accounts may differ from legislation in other jurisdictions.

 

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I NDEPENDENT AUDITORS’ UK REPORT

 

Independent Auditors’ Report to the Shareholders of Smith & Nephew plc

 

We have audited the Group accounts of Smith & Nephew plc for the year ended 31 December 2005 which comprise the Group income statement, Group balance sheet, Group cash flow statement, Group statement of recognised income and expense, and the related Notes 1 to 39 and Note 51. These Group accounts have been prepared under the accounting policies set out therein.

 

We have reported separately on the Parent company accounts of Smith & Nephew plc for the year ended 31 December 2005 and on the information in the Remuneration Report that is described as having been audited.

 

This report is made solely to the Group’s members, as a body, in accordance with Section 235 of the Companies Act 1985. Our audit work has been undertaken so that we might state to the Group’s members those matters we are required to state to them in an auditors’ report and for no other purpose. To the fullest extent permitted by law, we do not accept or assume responsibility to anyone other than the Group and the Group’s members as a body, for our audit work, for this report or for the opinions we have formed.

 

Respective Responsibilities of Directors and Auditors

The directors’ are responsible for preparing the annual report and the Group accounts in accordance with applicable United Kingdom law and International Financial Reporting Standards as adopted by the European Union as set out in the Statement of Directors’ Responsibilities.

 

Our responsibility is to audit the Group accounts in accordance with relevant legal and regulatory requirements and International Standards on Auditing (UK and Ireland).

 

We report to you our opinion as to whether the Group accounts give a true and fair view and whether the Group accounts have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation. We also report to you if, in our opinion, the directors’ report is not consistent with the Group accounts, if we have not received all the information and explanations we require for our audit, or if the information specified by law regarding directors’ remuneration and transactions is not disclosed.

 

We review whether the corporate governance statement reflects the company’s compliance with the nine provisions of the 2003 FRC Combined Code specified for our review by the Listing Rules of the Financial Services Authority, and we report if it does not. We are not required to consider whether the Board’s statements on internal control cover all risks and controls, or form an opinion on the effectiveness of the Group’s corporate governance procedures or its risk and control procedures.

 

We read other information contained in the annual report and consider whether it is consistent with the audited Group accounts. The other information comprises the “Directors’ Responsibilities for the Accounts”, the “Financial Summary”, the “Description of the Group”, the “Operating and Financial Review”, the “Liquidity and Prospects”, the “Corporate Governance Statement” and the unaudited part of the “Remuneration Report”. We consider the implications for our report if we become aware of any apparent misstatements or material inconsistencies with the Group accounts. Our responsibilities do not extend to any other information.

 

Basis of Audit Opinion

We conducted our audit in accordance with International Standards on Auditing (UK and Ireland) issued by the Auditing Practices Board. An audit includes examination, on a test basis, of evidence relevant to the amounts and disclosures in the Group accounts. It also includes an assessment of the significant estimates and judgements made by the directors in the preparation of the Group accounts, and of whether the accounting policies are appropriate to the Group’s circumstances, consistently applied and adequately disclosed.

 

We planned and performed our audit so as to obtain all the information and explanations which we considered necessary in order to provide us with sufficient evidence to give reasonable assurance that the Group accounts are free from material misstatement, whether caused by fraud or other irregularity or error. In forming our opinion we also evaluated the overall adequacy of the presentation of information in the Group accounts.

 

Opinion

In our opinion the Group accounts:

 

  give a true and fair view in accordance with IFRSs as adopted by the European Union of the state of the Group’s affairs as at 31 December 2005 and of the profit for the year then ended; and

 

  have been properly prepared in accordance with the Companies Act 1985 and Article 4 of the IAS Regulation.

 

Ernst & Young LLP

Registered Auditor

London, England

2 March 2006

 

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INDEPENDENT AUDITORS’ US REPORT

 

Report of Independent Registered Public Accounting Firm to the Board of Directors and Shareholders of Smith & Nephew plc

 

We have audited the accompanying Group balance sheets of Smith & Nephew plc as of 31 December 2005, 2004 and 2003 and the related Group income statements, Group statements of recognised income and expense and Group cash flow statements for each of the three years in the period ended 31 December 2005. These accounts are the responsibility of the Company’s management. Our responsibility is to express an opinion on these accounts based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Group’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Group’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the accounts referred to above present fairly, in all material respects, the consolidated financial position of Smith & Nephew plc at 31 December 2005, 2004 and 2003, and the consolidated results of its operations and its consolidated cash flows for each of the three years in the period ended 31 December 2005, in conformity with International Financial Reporting Standards adopted by the European Union which differ in certain respects from United States generally accepted accounting principles (see Note 39 of the Notes to the Group Accounts).

 

As discussed in Note 51 of the Notes to the Group accounts, the Group changed its method of accounting for derivative financial instruments in 2005.

 

Ernst & Young LLP

London, England

2 March 2006

 

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G ROUP INCOME STATEMENT

 

     Years ended 31 December

 
     2005

    2004 (i)

    2003 (i)

 
     (£ million, except per Ordinary Share
amounts)
 

Revenue — (Note 3)

   1,407     1,249     1,179  

Cost of goods sold

   (361 )   (335 )   (345 )

Selling, general and administrative expenses

   (689 )   (598 )   (547 )

Research and development expenses

   (67 )   (66 )   (67 )
    

 

 

Trading profit — (Note 3)

   290     250     220  

Restructuring and rationalisation expenses — (Note 5)

   (47 )        

Acquisition related expenses — (Note 5)

           (22 )

Macrotextured claim — (Note 6)

       (80 )    

Amortisation of acquisition intangibles — (Note 14)

   (6 )   (5 )    
    

 

 

Operating profit — (Notes 3 and 4)

   237     165     198  

Interest receivable — (Note 7)

   15     17     11  

Interest payable — (Note 7)

   (10 )   (13 )   (16 )

Other finance costs — (Note 8)

   (3 )   (2 )   (4 )

Fair value of hedge of anticipated sale proceeds of joint venture — (Note 8)

   1          
    

 

 

Profit before taxation

   240     167     189  

Taxation — (Note 9)

   (70 )   (45 )   (56 )
    

 

 

Profit from continuing operations

   170     122     133  

Discontinued operations:

                  

Share of results of the joint venture — (Note 16)

   17     16     13  

Share of results of associated undertaking — (Note 10)

           3  

Net profit on disposal of associated undertaking — (Note 10)

           23  
    

 

 

Profit from discontinued operations

   17     16     39  
    

 

 

Attributable profit for the year (ii) (iii)

   187     138     172  
    

 

 

Earnings per Ordinary Share — (Note 12)

                  

Including discontinued operations:

                  

Basic

   19.9 p   14.8 p   18.5 p

Diluted

   19.8 p   14.6 p   18.4 p

Excluding discontinued operations:

                  

Basic

   18.1 p   13.1 p   14.3 p

Diluted

   18.0 p   12.9 p   14.2 p

Discontinued operations:

                  

Basic

   1.8 p   1.7 p   4.2 p

Diluted

   1.8 p   1.7 p   4.2 p

(i) Except for IAS 32 and 39, as restated for the adoption of International Financial Reporting Standards (Note 51).

 

(ii) A summary of the adjustments to attributable profit for the financial year that would be required had accounting principles generally accepted in the US been applied rather than IFRS is set out in Note 39 of the Notes to the Group Accounts.

 

(iii) All attributable profit is attributable to equity holders of the Parent Company.

 

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G ROUP BALANCE SHEET

 

     At 31 December

 
     2005

    2004 (i)

    2003 (i)

 
     (£ million)  

ASSETS

                  

Non-current assets:

                  

Property, plant and equipment — (Note 13)

   343     290     266  

Intangible assets — (Note 14)

   392     375     287  

Investment in joint venture — (Note 16)

       121     121  

Investments — (Note 15)

   6     5     5  

Non-current receivables — (Note 19)

       2     2  

Non-current asset derivatives — (Note 20)

       24     21  

Deferred tax assets — (Note 24)

   76     67     43  
    

 

 

     817     884     745  

Current assets:

                  

Inventories — (Note 18)

   355     285     231  

Trade and other receivables — (Note 19)

   361     298     268  

Current asset derivatives — (Note 20)

   6     22     32  

Cash and bank — (Note 20)

   88     33     26  
    

 

 

     810     638     557  

Held for sale — Investment in joint venture — (Note 16)

   127          
    

 

 

TOTAL ASSETS

   1,754     1,522     1,302  
    

 

 

EQUITY AND LIABILITIES

                  

Equity attributable to equity holders of the parent:

                  

Called up equity share capital — (Note 25)

   115     115     114  

Share premium account — (Note 26)

   170     159     152  

Own shares — (Note 28)

   (2 )   (4 )   (2 )

Other reserves — (Note 26)

   14     1     1  

Accumulated profits — (Note 26)

   566     431     345  
    

 

 

Total equity (ii)

   863     702     610  

Non-current liabilities:

                  

Long-term borrowings — (Note 20)

   123     153     109  

Retirement benefit obligation — (Note 34)

   111     147     141  

Other payables due after one year — (Note 22)

   9     14     4  

Provisions — due after one year — (Note 23)

   28     32      

Non-current liability derivatives — (Note 20)

       2     5  

Deferred tax liabilities — (Note 24)

   31     40     38  
    

 

 

     302     388     297  

Current liabilities:

                  

Bank overdrafts and loans due within one year — (Note 20)

   132     32     97  

Trade and other payables — (Note 22)

   263     231     204  

Provisions — due within one year — (Note 23)

   53     50     20  

Current liability derivatives — (Note 20)

   17     13     5  

Current tax payable

   124     106     69  
    

 

 

     589     432     395  
    

 

 

Total liabilities

   891     820     692  
    

 

 

TOTAL EQUITY AND LIABILITIES

   1,754     1,522     1,302  
    

 

 

 

The accounts were approved by the Board and authorised for issue on 2 March 2006 and are signed on its behalf by

 

Dudley Eustace Chairman Christopher O’Donnell Chief Executive Peter Hooley Finance Director


(i) Except for IAS 32 and IAS 39, as restated for the adoption of International Financial Reporting Standards (Note 51).
(ii) A summary of the adjustments to equity that would be required had accounting principles generally accepted in the US been applied rather than IFRS is set out in Note 39 of the Notes to the Group Accounts.

 

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GROUP CASH FLOW STATEMENT

 

    Years ended 31 December

 
    2005

    2004 (i)

    2003 (i)

 
          (£ million)        

Net cash inflow from operating activities

                 

Operating profit

  237     165     198  

Depreciation, amortisation and impairment

  99     70     60  

Loss on sale of property, plant and equipment

  2     3     2  

Share based payment expense

  7     6     6  

Increase in inventories

  (48 )   (60 )   (10 )

Increase in trade and other receivables

  (29 )   (41 )   (23 )

(Decrease)/increase in trade and other payables and provisions (ii)

  (64 )   85     (17 )
   

 

 

Cash generated from operations (iii)

  204     228     216  

Interest received

  15     17     11  

Interest paid

  (10 )   (13 )   (16 )

Income taxes paid

  (62 )   (38 )   (52 )
   

 

 

Net cash inflow from operating activities

  147     194     159  

Cash flows from investing activities

                 

Acquisitions

  (14 )   (37 )   (4 )

Cash acquired with acquisitions

      2      

Disposal of associated undertaking

          52  

Dividends received from the joint venture

  14     14     7  

Trade investments

          (1 )

Capital expenditure

  (111 )   (102 )   (73 )

Disposal of property, plant and equipment

  1     1     2  
   

 

 

Net cash used in investing activities (iv)

  (110 )   (122 )   (17 )

Cash flows from financing activities

                 

Proceeds from issue of ordinary share capital

  11     8     9  

Own shares purchased

      (4 )   (1 )

Cash movements in borrowings due within one year — (Note 29)

  9     (62 )   (48 )

Cash movements in borrowings due after one year — (Note 29)

  10     1     (53 )

Settlement of currency swaps — (Note 29)

  (2 )   40      

Equity dividends paid

  (50 )   (47 )   (45 )
   

 

 

Net cash used in financing activities

  (22 )   (64 )   (138 )

Net increase in cash and cash equivalents

  15     8     4  

Cash and cash equivalents at beginning of year — (Note 29)

  23     14     10  

Exchange adjustments — (Note 29)

      1      
   

 

 

Cash and cash equivalents at end of year — (Note 29)

  38     23     14  
   

 

 


(i) As restated for the adoption of International Financial Reporting Standards (Note 51).

 

(ii) Includes £49m (2004 — nil, 2003 — nil) of special pension fund contributions and £4m (2004 — £2m, 2003 — £10m) of outgoings on restructuring, rationalisation, acquisition integration and divestment costs.

 

(iii) After £26m (2004 — £17m, 2003 — nil) unreimbursed by insurers relating to macrotextured knee revisions. £17m was spent in 2003 on Centerpulse costs.

 

(iv) Discontinued operations accounted for £14m (2004 — £14m, 2003 — £59m) of investing activities.

 

(v) The significant differences between the cash flow statement presented above and that required under accounting principles generally accepted in the US are set out in Note 39 of the Notes to the Group Accounts.

 

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GROUP STATEMENT OF RECOGNISED INCOME AND EXPENSE

 

     Years Ended 31 December

 
     2005

    2004 (i)

    2003 (i)

 
           (£ million)        

Cash flow hedges:

                  

— gains taken to equity

   2          

— transferred to the income statement for the year

   7          

Exchange differences on translation of foreign operations

   10         1  

Actuarial losses on defined benefit plans

   (10 )   (15 )   (22 )

Tax on items taken directly to or transferred from equity

   2     6     7  
    

 

 

Net income recognised directly in equity

   11     (9 )   (14 )

Attributable profit for the year

   187     138     172  
    

 

 

     198     129     158  

Restatement for the effects of IAS 32 and 39 (ii)

   (5 )        
    

 

 

Total recognised income and expense for the year

   193     129     158  
    

 

 


(i) Except for IAS 32 and IAS 39, as restated for the adoption of International Financial Reporting Standards (Note 51).

 

(ii) On 1 January 2005 the balance sheet was restated for the effects of IAS 32 and 39.

 

(iii) The statement of comprehensive income required under accounting principles generally accepted in the US is set out in Note 39 of the Notes to the Group Accounts.

 

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NO TES TO THE GROUP ACCOUNTS

 

1. General Information

 

Smith & Nephew plc (the “Company”) is a publicly limited company incorporated in the United Kingdom under the Companies Act 1985. In these accounts, “Group” means the Company and all its subsidiaries. The principal activities of the Group are described in “Description of the Group — Business Description”.

 

Presentation of financial information

From 1 January 2005, as required by the European Union’s IAS Regulation and the Companies Act 1985, the Group has prepared its accounts in accordance with International Financial Reporting Standards (“IFRSs”) as adopted by the European Union (“EU”). IFRSs as adopted by the EU differ in certain respects from IFRSs as issued by the International Accounting Standards Board (“IASB”). However the Group accounts for the years presented would be no different had the Group applied IFRSs as issued by the IASB. References to “IFRS” hereafter should be construed as reference to IFRSs as adopted by the EU.

 

2. Accounting Policies

 

The significant accounting policies adopted in the preparation of the Group’s accounts are set out below:

 

Basis of Preparation

The preparation of accounts in conformity with IFRS requires management to use estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the accounts and the reported amounts of revenues and expenses during the reporting period. Although these estimates are based on management’s best knowledge of current events and actions, actual results ultimately may differ from those estimates.

 

Consolidation

The Group accounts include the accounts of Smith & Nephew plc (the “Company”) and all the subsidiaries and associated undertakings for the periods during which they were members of the Group.

 

A subsidiary is an entity controlled by the Group. Subsidiaries are included in the Group accounts from the date that the Group obtains control. Intercompany transactions, balances and unrealised gains and losses on transactions between group companies are eliminated on consolidation.

 

On acquisition, identifiable assets and liabilities (including contingent liabilities) of subsidiaries are measured at their fair values at the date of acquisition with any excess of the cost of acquisition over this value being capitalised as goodwill.

 

Interest in Joint Venture

A joint venture is a contractual arrangement whereby the Group and other parties undertake an economic activity that is subject to joint control. The Group’s interest in the results and assets and liabilities of its joint venture, which is a jointly controlled entity, are included in the accounts using the equity method of accounting.

 

Interest in Associated Undertaking

Entities in which the Group has a beneficial interest of 50% or less in the equity capital and where the Group exercises significant influence over commercial and financial policy decisions are associated undertakings. The Group’s interest in the results and assets and liabilities of the associated undertaking are included in the accounts using the equity method of accounting.

 

Non-Current Assets Held for Sale

Non-current assets are classified as held for sale if their carrying amount will be recovered principally through a sale rather than from continued use. Assets held for sale are valued at the lower of their carrying

 

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2. Accounting Policies—(continued)

 

amount and fair value less costs to sell. IFRS 5: Non Current Assets Held for Sale and Discontinued Operations, which determines when an entity ceases to be consolidated, has been applied with effect from 1 January 2005.

 

Revenue

Revenue comprises sales of products and services to third parties at amounts invoiced net of trade discounts and rebates, excluding taxes on revenue. Revenue from the sale of products is recognised upon transfer to the customer of the significant risks and rewards of ownership. This is generally when goods are despatched to customers except that sales of inventory located at customer premises and available for customers’ immediate use are recognised as soon as notification is received that the product has been implanted or used. Appropriate provisions for returns, trade discounts and rebates are deducted from revenue. Rebates comprise retrospective volume discounts granted to certain customers on attainment of certain levels of purchases from the Group. These are accrued over the course of the year based on estimates of the level of business expected and adjusted at the end of the year to reflect actual volumes.

 

Foreign Currencies

Balance sheet items of foreign operations and foreign currency borrowings are translated into Sterling at year end rates of exchange. Income statement items and the cash flows of overseas subsidiary undertakings and associated undertakings are translated at average rates for the year.

 

Goodwill and fair value adjustments arising on the acquisition of a foreign entity are treated as assets and liabilities of the foreign entity and translated at the closing rate.

 

Transactions in foreign currencies are initially recorded at the exchange rate ruling at the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are retranslated at the rate of exchange ruling at the balance sheet date.

 

The following are recorded as movements in other reserves: exchange differences on the translation at closing rates of exchange of overseas opening net assets; the differences arising between the translation of profits at average and closing exchange rates; and, to the extent that the hedging relationship is effective, the difference on translation of foreign currency borrowings or swaps that are used to finance or hedge the Group’s net investments in foreign operations. All other exchange differences are dealt with in arriving at profit before taxation. On disposal of a foreign operation, the deferred cumulative amount recognised in equity relating to that particular foreign operation, net of related movements on hedging instruments, would be recycled from equity into income.

 

Taxation

The charge for current taxation is based on the results for the year as adjusted for items which are non-assessable or disallowed. It is calculated using rates that have been enacted or substantively enacted by the balance sheet date.

 

Deferred taxation is accounted for using the balance sheet liability method in respect of temporary differences arising from differences between the carrying amount of assets and liabilities in the accounts and the corresponding tax bases used in computation of taxable profit.

 

Deferred tax liabilities are recognised for all taxable temporary differences except in respect of investments in subsidiaries and associates where the Group is able to control the timing of the reversal of the temporary difference and it is probable that this will not reverse in the foreseeable future; on the initial recognition of non-deductible goodwill; and on the initial recognition of an asset or liability in a transaction that is not a business combination and that, at the time of the transaction, does not affect the accounting or taxable profit.

 

Deferred tax assets are recognised to the extent that it is probable that future taxable profit will be available against which the temporary difference can be utilised. Their carrying amount is reviewed at each balance sheet date on the same basis.

 

Deferred tax is measured on an undiscounted basis, and at the tax rates that are expected to apply in the periods in which the asset or liability is settled. It is recognised in the income statement except when it relates to items credited or charged directly to equity, in which case the deferred tax is also dealt with in equity.

 

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2. Accounting Policies—(continued)

 

Deferred tax assets and liabilities are offset when they relate to income taxes levied by the same taxation authority and when the Group intends to settle its current tax assets and liabilities on a net basis.

 

Advertising Costs

Expenditure on advertising costs is expensed as incurred.

 

Intangible Fixed Assets

Goodwill recognised under UK GAAP prior to the date of transition to IFRS is stated at net book value as at this date. Goodwill recognised subsequent to 1 January 2003, representing the excess of purchase consideration over fair value of net assets acquired, is capitalised. Goodwill is not amortised but is reviewed for impairment annually.

 

Purchased intangibles, including purchased patents, know-how, trademarks, licences and distribution rights are capitalised at cost and amortised on a straight line basis over their estimated useful economic lives. The amortisation of intangibles acquired as part of a business combination is presented separately after trading profit but before operating profit. The estimated useful life of an intangible asset ranges between 3 and 20 years depending on its nature.

 

Research and Development

The Group considers that the regulatory, technical and market uncertainties inherent in the development of new products means that development costs should not be capitalised as intangible fixed assets until products receive approval from the appropriate regulatory body. Substantially all development expenditure is complete by the time the product is submitted for regulatory approval. Consequently expenditure on research and development is expensed as incurred.

 

Property, Plant and Equipment

Property, plant and equipment is stated at cost less depreciation and provision for impairment where appropriate. Freehold land is not depreciated. Freehold buildings are depreciated on a straight-line basis at between 2% and 5% per annum. Leasehold land and buildings are depreciated on a straight-line basis over the shorter of their estimated useful lives and the terms of the leases. Plant and equipment is depreciated over lives ranging between three and 20 years by equal annual instalments to write down the assets to their estimated disposal value at the end of their working lives.

 

Finance costs relating to the purchase of fixed assets are not capitalised.

 

Impairment of Assets

Goodwill arising on acquisition is allocated to cash-generating units (equivalent to the reported business segments). The recoverable amount of the cash-generating unit to which goodwill has been allocated is tested for impairment annually or when events or changes in circumstances indicate that it might be impaired.

 

The carrying values of property, plant and equipment, and intangible assets with finite lives are reviewed for impairment when events or changes in circumstances indicate the carrying value may be impaired. If any such indication exists, the recoverable amount of the asset is estimated in order to determine the extent of impairment loss. Where it is not possible to estimate the recoverable amount of an individual asset, the Group estimates the recoverable amount of the cash-generating unit to which it belongs.

 

Leasing Commitments

Leases are classified as finance leases whenever the terms of the lease transfer substantially all the risks and rewards of ownership to the Group. All other leases are classified as operating leases.

 

Assets held under finance leases are capitalised as property, plant or equipment and depreciated accordingly. The capital element of future lease payments is included in borrowings and interest is charged to profit before taxation on a reducing balance basis over the term of the lease.

 

Rentals payable under operating leases are charged to income on a straight line basis over the term of the relevant lease.

 

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2. Accounting Policies — (continued)

 

Investments

In 2003 and 2004 trade investments were stated at cost less provision for any permanent diminution in value. From 1 January 2005, after initial recognition at fair value plus transaction costs, these are designated as available for sale financial assets. Investments in unlisted equity instruments are measured at cost as management believe that their fair value cannot be reliably measured. Losses relating to impairment are recognised as an expense immediately.

 

Inventories

Finished goods and work-in-progress are valued at factory cost, including appropriate overheads, on a first-in first-out basis. Raw materials and bought in finished goods are valued at purchase price. All inventories are reduced to net realisable value where lower than cost.

 

Orthopaedic instruments are generally not sold but loaned to customers and distributors for use in orthopaedic surgery. They are recorded as inventory until they are deployed at which point they are transferred to property, plant and equipment and depreciated over their useful lives.

 

Derivative Financial Instruments

In 2004 and 2003 currency swaps to match foreign currency net assets with foreign currency liabilities were translated into Sterling at year-end exchange rates. Changes in the principal values of currency swaps were matched in reserves against changes in the values of the related assets. The fixed rate element of currency swaps and interest rate swaps transacted to protect interest costs and interest income were accounted for as hedges. Changes in the values of interest rate hedges were recognised against interest in the period relating to the hedge.

 

From 1 January 2005, derivative financial instruments are recorded initially at fair value and then for reporting purposes remeasured to fair value at subsequent balance sheet dates.

 

Changes in the fair value of derivative financial instruments that are designated and effective as cash flow hedges of forecast third party and intercompany transactions are recognised directly in equity until the associated asset or liability is recognised. Amounts deferred in this way are recognised in the income statement in the same period in which the hedged firm commitments or forecasted transactions are recognised in the income statement.

 

Currency swaps to match foreign currency net assets with foreign currency liabilities are fair valued at year end. Changes in the principal values of currency swaps that are designated and effective as net investment hedges are matched in equity against changes in value of the related assets.

 

Ineffective hedges and changes in the fair value of derivative financial instruments that do not qualify for hedge accounting are recognised in the income statement as they arise.

 

Hedge accounting is discontinued when the hedging instrument expires or is sold, terminated or exercised, or no longer qualifies for hedge accounting. At that point in time, any cumulative gain or loss on the hedging instrument recognised in equity is retained there until the forecast transaction occurs. If a hedged transaction is no longer expected to occur, the net cumulative gain or loss recognised in equity is transferred to the income statement for the period.

 

Retirement Benefits

The Group’s major pension plans are of the defined benefit type. For these plans, the employer’s portion of past and current service cost is charged to trading profit, with the interest cost net of expected return on assets in the plans reported within other finance costs. Actuarial gains or losses are recognised directly in equity such that the balance sheet reflects the entire scheme’s surplus or deficit as at the balance sheet date. Where defined contribution plans operate the contributions to these plans are charged to trading profit as they become payable.

 

Share Based Payments

The Group operates a number of executive and employee share schemes. For all grants of share options and awards, the fair value as at the date of grant is calculated using an option pricing model and the corresponding expense is recognised over the vesting period.

 

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2. Accounting Policies — (continued)

 

Contingencies and Provisions

In the normal course of business the Group is involved in numerous legal disputes. Provision is made for loss contingencies when it is deemed probable that an adverse outcome will occur and the amount of the loss can be reasonably estimated. Where the Group is the plaintiff in pursuing claims against third parties legal and associated expenses are charged to the income statement as incurred. Contingent assets are not recognised in the accounts.

 

The Group operates in multiple tax jurisdictions around the world and records provisions for taxation liabilities and tax audits when it is considered probable that a tax charge will arise and the amount can be reasonably estimated.

 

3(a). Business Segmental Analysis — Information required under IFRS

 

For management purposes, the Group is organised into three business segments — Orthopaedics, Endoscopy and Advanced Wound Management. These business segments are the basis on which the Group reports its primary segment information.

 

     2005

     2004

     2003

 
     (£ million)  

Revenue

                    

Orthopaedics

   698      589      525  

Endoscopy

   334      305      300  

Advanced Wound Management

   375      355      354  
    

  

  

     1,407      1,249      1,179  
    

  

  

There are no sales between business segments.

 

     2005

     2004

     2003

 
     (£ million)  

Trading profit

                    

Orthopaedics

   167      138      119  

Endoscopy

   70      61      60  

Advanced Wound Management

   53      51      41  
    

  

  

     290      250      220  
    

  

  

Operating profit by business segment reconciled to attributable profit for the year

 

Orthopaedics

   162      54      102  

Endoscopy

   61      60      55  

Advanced Wound Management

   14      51      41  
    

  

  

Operating profit

   237      165      198  

Net interest

   5      4      (5 )

Other finance costs

   (2 )    (2 )    (4 )

Taxation

   (70 )    (45 )    (56 )

Discontinued operations

   17      16      39  
    

  

  

Attributable profit for the year

   187      138      172  
    

  

  

 

Items between operating profit and attributable profit for the year can not be allocated segmentally.

 

Impairment losses of £19m (2004 — nil, 2003 — nil) have been recognised in restructuring and rationalisation expenses within operating profit and are allocated as follows: endoscopy £3m (2004 — nil, 2003 — nil) and advanced wound management £16m (2004 — nil, 2003 — nil). Other significant non-cash expenses which have been recognised within operating profit are £24m of restructuring and rationalisation expenses in 2005 and £67m for the non-cash element of the macrotextured provision in 2004. These can be allocated in 2005 as follows: endoscopy £5m and advanced wound management £19m (2004 — orthopaedics — £67m).

 

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Table of Contents
3(a). Business Segmental Analysis — Information required under IFRS — (continued)

 

     2005

   2004

   2003

     (£ million)

Capital expenditure

              

Orthopaedics

   79    71    42

Endoscopy

   17    15    15

Advanced Wound Management

   15    16    16
    
  
  
       111      102        73
    
  
  

 

Capital expenditure comprises additions of property, plant and equipment and intangible assets (excluding goodwill). In addition, in 2003, £1m of additions to investments related to orthopaedics.

 

Depreciation and amortisation

              

Orthopaedics

   51    43    33

Endoscopy

   16    14    14

Advanced Wound Management

   13    13    13
    
  
  
         80        70        60
    
  
  

 

Amounts comprise depreciation of property, plant and equipment, amortisation of other intangible assets and amortisation of acquisition intangibles as follows:

 

Depreciation of property, plant and equipment

   69    59    55

Amortisation of other intangible assets

   5    6    5
    
  
  
     74    65    60

Amortisation of acquisition intangibles

   6    5   
    
  
  
         80        70        60
    
  
  

 

Balance Sheet

              

Assets:

              

Orthopaedics

   720    590    405

Endoscopy

   363    321    326

Advanced Wound Management

   374    344    328
    
  
  

Operating assets by segment

   1,457    1,255    1,059

Investment in joint venture

   127    121    121

Unallocated corporate assets

   170    146    122
    
  
  

Total assets

   1,754    1,522    1,302
    
  
  

Liabilities:

              

Orthopaedics

   166    195    83

Endoscopy

   72    55    58

Advanced Wound Management

   115    77    87
    
  
  

Operating liabilities by segment

   353    327    228

Unallocated corporate liabilities

   538    493    464
    
  
  

Total liabilities

   891    820    692
    
  
  

 

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Table of Contents
3(a). Business Segmental Analysis — Information required under IFRS — (continued)

 

Unallocated corporate assets and liabilities comprise the following:

 

     2005

   2004

   2003

     (£ million)

Non-current asset derivatives

      24    21

Deferred tax assets

   76    67    43

Current asset derivatives

   6    22    32

Cash and bank

   88    33    26
    
  
  

Unallocated corporate assets

   170    146    122
    
  
  

Long-term borrowings

   123    153    109

Retirement benefit obligation

   111    147    141

Non-current liability derivatives

      2    5

Deferred tax liabilities

   31    40    38

Current liability derivatives

   17    13    5

Bank overdrafts and loans due within one year

   132    32    97

Current tax payable

   124    106    69
    
  
  

Unallocated corporate liabilities

   538    493    464
    
  
  
     2005

   2004

   2003

     (numbers)

Average number of employees

              

Orthopaedics

   3,581    3,016    2,727

Endoscopy

   1,788    1,644    1,635

Advanced Wound Management

   3,249    3,206    3,089
    
  
  
     8,618    7,866    7,451
    
  
  

 

3(b). Geographical Segmental Analysis — Information required under IFRS

 

     2005

     2004

     2003

 
     (£ million)  

Revenue by geographic market

                    

United Kingdom

   131      123      99  

Continental Europe

   310      287      271  

United States

   694      609      595  

Africa, Asia, Australasia and Other America

   272      230      214  
    

  

  

     1,407      1,249      1,179  
    

  

  

Revenue by geographic origin

                    

United Kingdom

   257      243      197  

Continental Europe

   341      314      302  

United States

   853      745      724  

Africa, Asia, Australasia and Other America

   254      213      200  
    

  

  

     1,705      1,515      1,423  

Less: intragroup sales

   (298 )    (266 )    (244 )
    

  

  

     1,407      1,249      1,179  
    

  

  

Capital expenditure by geographic origin

                    

United Kingdom

   20      10      10  

Continental Europe

   13      15      8  

United States

   63      60      47  

Africa, Asia, Australasia and Other America

   15      17      8  
    

  

  

     111      102      73  
    

  

  

 

Capital expenditure comprises additions of property, plant and equipment and intangible assets. In addition, in 2003, £1m of additions to investments related to the United States.

 

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3(b). Geographical Segmental Analysis — Information required under IFRS — (continued)

 

     2005

   2004

   2003

     (£ million)

Assets by geographic origin

              

United Kingdom

   329    309    206

Continental Europe

   188    162    145

United States

   764    638    586

Africa, Asia, Australasia and Other America

   176    146    122
    
  
  

Operating assets by segment

   1,457    1,255    1,059

Investment in joint venture

   127    121    121

Unallocated corporate assets (see page 82)

   170    146    122
    
  
  

Total assets

   1,754    1,522    1,302
    
  
  

Long lived assets by geographic origin

              

United Kingdom

   241    227    143