Smith & Nephew - Earnings Call - H2 2024

Transcript

Deepak Nath (CEO)

Good morning and welcome to the Smith & Nephew Q4 and full year 2024 results presentation. I'm Deepak Nath, I'm the Chief Executive Officer, and joining me is our Chief Financial Officer, John Rogers. Looking at our full year numbers, I'm pleased to be able to report that the 12-Point Plan is delivering financial outcomes. Our operational and commercial actions have combined with a high cadence of innovation to produce consistently higher growth than in the past. Margin expansion is beginning to follow, driven by both operating leverage and productivity improvements, which are becoming more visible as macro headwinds ease. Better working capital discipline and asset utilization also mean that our profitability is coming with higher cash generation. Overall, for 2024, we delivered 60 basis points of margin expansion, 95% cash conversion, which is ahead of our target, and higher ROIC at 7.4%.

The fourth quarter was a good finish to the year with 8.3% underlying growth. Volumes were solid across most regions, and the company is now set up operationally and commercially to benefit from better demand, as we saw at the end of the quarter. That also meant we realized more of a benefit to our surgical businesses from the two extra trading days that we expected to see during the holiday season. Importantly, this growth did not depend on improvement in China, which increased as a headwind, just as we indicated with our Q3 trading update. Overall, China costs 280 basis points of group growth in Q4. We're now poised to deliver a further step up in returns in 2025. Our outlook is unchanged. We expect revenue growth of around 5% and significant trading margin expansion to between 19% and 20%.

This will come from continued operating leverage and as the cost savings from the optimization of our manufacturing network begin to benefit the P&L. In the early years of the 12-Point Plan, savings primarily went to offsetting macro headwinds. From here, higher savings and reduced headwinds mean we can deliver meaningful margin expansion. And I want to emphasize that 2025 is not the end point. We expect continued margin accretion in 2026 and in 2027, with many of the components of delivery that are already in place. I'll come back to these themes. So this next slide will be very familiar to you by now, but that reflects how fully the 12-Point Plan has been embedded in Smith & Nephew. The plan is how we've been improving performance, both for individual teams and for the company as a whole.

It also represents a more rigorous way of working that will continue beyond the specific initiatives. We're now at a point where the outcomes are becoming more visible. So before we get into the quarter's financials, I'd like to set out some of our key achievements of the plan. Firstly, we delivered a truly comprehensive program. The 12-Point Plan initiatives have covered all aspects of the business, with KPIs and targets that have been defined for each. We've also moved the organization to a global business unit model, further embedding the culture of accountability and helping us drive better commercial execution at pace. While there's still more to do, we're increasingly seeing the financial benefits come through across revenue, profitability, return on capital, and cash flow. On revenue, we've delivered four consecutive years of growth above our historical average.

That's backed up both by the operational improvements of the plan and also successive waves of innovation across our portfolio. On profitability, we've delivered 80 basis points of trading margin expansion since 2022, even in the face of some profound external headwinds, and we're set to deliver a step up in 2025 and in the years beyond. On returns, our ROIC is rising and should return to above our cost of capital in 2025. While on cash, inventory days are down, restructuring costs are down, and free cash flow was up to more than $500 million in 2024. We'll go into each of these in turn, starting with revenue. If I look back to 2019 and before, the company averaged around 3% underlying growth.

That was largely steady over time, but we were growing below our markets, and there was a clear opportunity if we could take that to a different level. Our priority was to reposition Smith & Nephew as a consistently higher growth business with the ability to drive leverage through the P&L. As I mentioned, 2024 was a fourth straight year of growth above that historical average. We've had to deal with some significant headwinds, such as supply chain challenges, our recon business taking time to improve, and VBP in our China recon and joint repair businesses. Even with all of that, we've delivered a clear acceleration, and we expect that to continue in 2025 with our guidance of around 5% revenue growth. This step change has been underpinned by improvements from the 12-Point Plan. Firstly, we fixed the foundations of product and capital supply.

Availability across our portfolio was at or above our target levels in 2024, having been below industry standards at the start of the plan. We've been able to bring down overdue orders by around 90% since 2022, and we're better placed to support our existing customers and pursue new business. We're also showing better commercial execution. Sports Medicine and AWM had already moved to consistent good delivery. When I get into detail quarter by quarter, you'll see that our U.S. Recon business has also shown progressive improvement as we've gone through 2024 and is on track to be in line with the market by the end of 2025. That's in line with our target. In orthopedics, trauma and extremities has been transformed into a high-growth platform through execution on key launches across the EVOS plating system and AETOS shoulder.

Innovation more broadly remains a key component of our growth story. In 2024, more than 60% of revenue growth came from products launched in the last five years. That means for consecutive years, around 3.5% of group growth have come from innovation. New products alone are taking us to above our historical growth, and we're producing successive waves of technology that keep coming over multiple years. First, we continue to add further legs of value to existing platforms, such as CORI and REGENETEN. For CORI, we've already added 10 new features since 2022. The combination of unique functionality and the flexibility to support a range of surgeon preferences have helped us drive adoption, with the installed base now exceeding 1,000 units. We're now building towards a fully enabled hip platform on CORI, with 3D navigation as the next element to come through.

Expansion to shoulder replacement is a further priority, where the anatomy of the shoulder is particularly well-suited to CORI's handheld milling. Pre-op planning with CORIOGRAPH will be the first step to come in 2025. For REGENETEN, the new tendon repair applications are already contributing, and we believe more than 10% of use is now outside of rotator cuff. We're still looking to bring this technology to more groups of patients, and we have recently received 510(k) clearance for use in extra-articular ligament repair. Second, another wave of launches is already underway. AETOS shoulder is a product we're very excited about. We've launched a short stem implant and plan to build out a complete platform. We have a stemless implant that's targeted for 2025, and I've already mentioned our work to bring shoulder replacement to CORI. We've also added CATALYST stem in the third quarter of 2024.

This is a new CATALYST optimized for the direct anterior approach, which represents around half of the U.S. market, growing double-digit. Early utilization has been running ahead of our plans with excellent customer feedback so far. You'll also see a further wave beginning to appear in 2025. At our capital markets day just over a year ago, we talked about a number of exciting new platforms, including cross-business unit digital capability. We're planning to show our first next-generation digital product at AAOS in San Diego, which will add video-based navigation to the arthroscopic tower and bring the more consistent patient outcomes and more efficient decision-making that we've seen before in orthopedics. We're also developing a new generation of IM nails in trauma. This is a $1.3 billion category globally, meaning we already have a good presence with INTERTAN and TRIGEN.

We're working on both tibial and hip fracture products, and we'll come back with more detail as we move towards launches. At the same time, we've significantly reshaped our company, both in our organizational structures and our cost base. In 2023, we began the realignment of our commercial model from franchises and regions to global commercial business units, with verticalized commercial teams for each of orthopedics, sports medicine, ENT, and AWM. I believe this is a better way of doing business. It drives greater accountability, faster decision-making and execution, and increased customer focus in every area of our portfolio. We're now positioned to capture that at Smith & Nephew with a single point of leadership for upstream and downstream marketing and sales, better alignment across regions and countries, and dedicated presence with full global P&L responsibility.

We've been operating in this structure for a year now and have continued to enhance accountability by fully allocating attributable costs. John will give examples of what we are already seeing from these changes, and I'm confident that the benefits will continue to accumulate. A second major change is how we've addressed the cost base. We started with an initial program of $200 million of savings at the beginning of the 12-Point Plan. In 2024, we built on that by applying a zero-based budgeting approach to identify further opportunities. Total gross cost savings are now expected to be between $325 million and $375 million, backed by a comprehensive and detailed set of plans across 40 different initiatives. The largest chunk is from manufacturing and procurement, but there are savings really right across all parts of our business. We've already made substantial cost savings since 2022 of around 410 basis points.

Much of it was needed just to offset external headwinds, which were either greater than expected at the start of the plan or, in the case of sports, VBP, not known at all. In particular, we faced above-normal inflation that we were not entirely able to offset through leverage, even with the higher level of revenue growth that we delivered throughout. However, our intense focus on costs has enabled us to still increase our profitability. In total, we faced almost 700 basis points of headwinds and still delivered 80 basis points of trading margin expansion since 2022. 2025 is a key year of delivery when we should see the more significant margin step up that we've been working towards. The elements of how we do that are largely in place with a further increase in cost saving and inflation naturally offset by growth leverage.

On costs, that includes the closure of four Orthopaedics facilities that will start to benefit the P&L in the second half of this year. We've also reduced our headcount by around 9% overall, with a significant portion coming in late 2024. So again, flowing through to the P&L this year. Inflation headwinds are also less impactful than in the early years of the plan, with the net of inflation and leverage being broadly neutral in 2024 and expected to be in balance again in 2025. And importantly, that is not the endpoint. We're well positioned for further expansion beyond 2025, enabled by better-aligned supply and demand capacity reductions through our manufacturing coming through in our manufacturing network and the timing of lower costs as they pass through inventory and reach our P&L.

Another important set of achievements is around our cash generation and returns profile, which is returning to a much healthier position. John will take you through the detail, but overall, we're seeing clear improvement across multiple metrics where we've had long-standing challenges, and there's still more to come in 2025. I'll now move on to the detail of the fourth quarter before passing on to John to cover our full year financials. Revenue was $1.6 billion, with 8.3% underlying growth, with 7.8% reported growth after a 50 basis point headwind from foreign exchange. As I mentioned, these growth rates reflect a strong December and include the benefit of two additional trading days. The overall acceleration was consistent across our business units, which all grew faster than in the first nine months of the year.

Looking by region, the U.S. was particularly strong, with 11.9% growth in the quarter, while other established markets grew by 8.2%. The 2.3% decline in emerging markets primarily reflected the continued headwinds in China across both recon and sports medicine joint repair. For the business units, I'll start with orthopedics, which grew at 6% in the quarter and 8.1% excluding China. A priority has been improving performance of U.S. recon and it's good to see that growth again improved sequentially in the quarter. Two extra trading days helped the reported numbers, but if you normalize for that by looking at average daily sales, growth still accelerated over Q3. OUS recon growth reflects the expected slow quarter in China. Our distribution partners have continued to reduce their holdings of implants following slow end customer demand earlier in the year.

Inventory in the channel has come down significantly, but is not yet at normalized levels. So as we indicated in November, the largely paused ordering is likely to continue through the first quarter of 2025. Excluding China, our OUS growth was much healthier at around seven points higher in knees and six points higher in hips. Other recon grew 23.9%, driven by robotic sales. CORI continues to stand out for its flexibility and broad functionality, and adoption is progressing well. We had a record number of new CORI placements in the quarter, and our global robots installed base, robotics installed base, was over 1,000 systems by year-end. As you know, our reporting practice in recon and robotics has been to recognize all of robotics capital, services, and consumables under other recon. During 2025, we'll change this to be more in line with our orthopedics peers.

Robotics consumables will move to being recorded under the procedure where they're used. Capital and services revenue will remain as part of other. There's some work to do first, but this change will increase the comparability of both our implants and our other revenue growth. Trauma and extremities grew 9.5%, which is a return to the segment's recent stronger growth profile after a slow Q3. The EVOS plating system continues to be the primary growth driver, and there's an increasing contribution from the ramp of the AETOS shoulder, which, although still at an early stage, provided around a quarter of the overall growth. I'll take a moment to look more closely at U.S. recon growth. Acceleration in consecutive quarters is what we said we expected with improved product availability and commercial execution under the 12-Point Plan.

The sequence of underlying growth rates is affected by trading dates, with two more days in Q4 2024 than in the prior year quarter, one more in Q2, and one fewer in Q1. The slide shows the growth and average daily sales as a way of adjusting for these trading day effects. There are two points I'd like to highlight. Firstly, while the curve flattens a little, there's still clear sequential improvement in both U.S. knees and hips. Secondly, these average daily sales growth rates are a more representative measure for how the business exited 2024 compared to the unadjusted growth rates. We're therefore using them as a starting point for thinking about the beginning of 2025, when both Q1 and Q2 will have one fewer trading day than in 2024.

Moving on to Sports Medicine and ENT, which grew at 7.8%, the segment as a whole continues to grow well, and consistent performance over several years means Sports Medicine now has a level of sales comparable to our Recon and Robotics businesses. Joint Repair grew 5.3% overall and 15.9% excluding China, with a more than 10 percentage point headwind from the impact of VBP. We will lap those price reductions in the middle of 2025. In the rest of the world, we had a particularly strong finish in the U.S., probably benefiting from the end-of-year copay effects. REGENETEN remains a key driver with strong double-digit growth seven years into our ownership. The broader segment is also starting to see a contribution for our developing foot and ankle business.

This is an attractive new category for us, and while it's closer in scale to hip repair than to the larger shoulder or knee category, it leverages our existing sports medicine commercial organization and is synergistic with some of our specialist trauma products. Arthroscopic enabling technologies grew 8.5% with growth across our arthroscopic tower and continued strong double-digit growth from WEREWOLF FASTSEAL. However, we anticipate a year of slower growth for AET in 2025. A China VBP process on mechanical resection blades and COBLATION wands is expected and likely to take effect in the second half of 2025. We expect a 2025 sales headwind of around $25 million, including both the direct price impact and expected channel adjustments ahead of that implementation.

This means that while it'll be noticeable in AET, it should be a smaller factor at group level than the joint repair process and is reflected in the guidance that John will set out in a moment. ENT grew 19.4% with multiple factors behind the stronger quarter. Q4 had a normal prior year comp after a more difficult comp in Q3. We saw some procedure volume catch-up after an unseasonably slow Q3 in our tonsil and adenoid business, and that's on top of the ongoing customer acquisitions that are part of the longer-term growth story. Growth has been volatile from quarter to quarter through 2024, and I would take the full year growth numbers of 7.3% as more representative of the fundamental business performance. I'll finish with the Advanced Wound Management segment, which delivered its highest growth quarter of the year at 12.2%.

Advanced Wound Care grew 1.9%, consistent with the year as a whole. Foams were again a higher growth category within AWC, which was led by ALLEVYN. Overall business unit growth came mainly from Bioactives and devices. Bioactives' growth of 20.3% was driven by skin substitutes and, in particular, the launch of GRAFIX PLUS. The ramp is following quite a common pattern in skin substitutes with an initial period of rapid growth that then quickly normalizes. We also saw strong growth in SANTYL late in the quarter, whereas we've said before, we see volatile stocking patterns. With all of that in mind, we expect Bioactives to return to low single-digit growth in 2025. I know there's a lot of interest in skin substitute LCDs, where implementation has been delayed and is now scheduled for April.

Our expectation is still that the overall effect on our business will be broadly neutral, with the benefit of good coverage for our portfolio likely to be offset by a smaller overall market size. We're not seeing the evidence of changes in the market in anticipation. Advanced Wound Devices' growth of 20.6% was mainly from our negative pressure wound therapy portfolio. We've talked more about what we're doing with RENASYS PICO Acceleration, which is also a big part of our plans, with the largest growth opportunities in surgical site complications and in chronic wounds. This remains a high-growth category, and we expect PICO momentum to continue into 2025. So with that, I'll hand over to John to cover the full year financials. John?

John Rogers (CFO)

Thank you, Deepak. Coming to the full year 2024 financials, full year revenue was $5.8 billion, up 5.3% versus 2023 on an underlying basis and up 4.7% on a reported basis. Note that excluding the headwinds from China, growth would have been plus 6.7% on an underlying basis. Performance was broad-based, with all three reporting segments contributing significantly to the overall group. As you can see in the chart, orthopedics grew 4.6%, sports medicine and ENT grew 6.2%, although again, excluding China, growth would have been 10%, and AWM grew 5.1%. We beat our revised Q3 expectations for the full year as a result of a very strong December, where we had somewhat discounted the benefit of the two extra trading days, which turned out to be good across our surgical businesses.

We set out the challenges in the Chinese market for both our orthopedics and sports businesses at our Q3 trading statement, and the Q4 China performance was in line with these expectations. Overall, a good set of growth figures, and particularly good to see that more than 60% of our growth is drawn from products launched in the last five years, as covered by Deepak. This gives us a degree of confidence coming into 2025. Looking at the trading P&L, gross profit was $4.09 billion, with a gross margin of 70.3%, which is 40 basis points below 2023. The gross margin pressure came in the second half of the year as we began to see the price impact of joint repair VBP in China. Trading profit was $1.05 billion, up 8.2% year on year.

Half-one trading margin expansion was 140 basis points, and the half-two margin went back 20 basis points due to the China headwinds, resulting in 60 basis points of trading margin expansion for the year to 18.1%, which is slightly above the guidance we gave with our Q3 trading update. If you unpack the 60 basis points of margin expansion, we saw a drag of 40 basis points on gross margin, offset by 100 basis points of positive leverage across our operating expenses as we benefited from operational savings. 40 basis points of that came from slightly lower R&D costs. At the half year, if you remember, we were down 7.5% year on year on our R&D spend. We expected to catch up some of this shortfall in the second half, but ended broadly flat in half two due to some efficiency savings being delivered.

We remain committed to our R&D spend and continue to look for ways we can drive efficiencies in this area. Our new product pipeline for 2025 is very exciting and a testament to the hard work by our R&D colleagues. Looking further down the P&L, adjusted earnings per share grew by 1.7% to $0.843. That's below the growth in trading profit due to the higher tax and interest expense that we set out in our technical guidance at the start of the year. Our tax rate was 19.1%, in line with the guidance of 19%-20%. IFRS earnings per share of $0.472 grew significantly faster, primarily due to the lower restructuring charges than in 2023, along with lower costs from the now completed EU MDR program and the provision release relating to metal on metal.

Our restructuring charges for the full year were $123 million, down from the $220 million in 2023. 12-Point Plan spend was $66 million, bringing spend to date to $253 million and leaving around $22 million of spend to come through in 2025 to total the $275 million we guided to. We also took a reduction in our headcount in November in order to accelerate operational savings coming into 2025, and we also closed a manufacturing facility that wasn't part of our original 12-Point Plan. The total cost of all of these programs over 2023, 2024, and 2025 is $324 million, and they deliver annualized benefits of $239 million, so about a one-and-a-half-year payback. Overall, we expect restructuring costs in 2025 to be around $45 million, including the remaining $22 million on the 12-Point Plan and around a third of the spend in 2024.

The full year dividend is proposed to be unchanged at $0.375 per share. Slide 21 shows a more detailed trading margin bridge. We absorbed headwinds of 130 basis points from input cost inflation and merit increases, 10 basis points from FX, and 90 basis points from China VBP pricing. These were more than offset by 130 basis points of revenue leverage from price and volume and 160 basis points of productivity improvements, delivering 60 basis points of margin improvement for the year. To help you reconcile what we said at the Q3 trading statement to our outturn, the margin headwind from VBP price was around 20 basis points higher than originally expected, with a further negative effect on volume leverage of about 10-20 basis points captured here in the revenue leverage bar and in line with the circa 40 basis points we guided to at Q3.

However, the better finish to the year, particularly in our higher margin U.S. business, has dropped through strongly to trading profit. The resulting leverage, combined with a little bit more upside on Forex, has offset the predicted China effect, bringing us back to our original guidance of 80%+ for the full year. The overall picture for the full year is that revenue leverage has broadly offset input cost inflation, which means that VBP aside, cost savings have been able to drop through to trading profit. Drilling down into the details of these efficiency savings, we are on track to deliver in line with what I set out at the interims. We have already made broad-based savings across all areas of the group, including manufacturing, procurement, and operating expenses.

We finished 2024 at a gross savings run rate of $210 million, and with significantly more to come in 2025 and beyond. Our ZBB implementation is on track across all BUs and central functions. Across our five work streams, 51 initiatives were mobilized, of which nearly half are now complete. Expected 2025 savings are slightly ahead of our initial diagnostics outlook, driven by amplifying and accelerating the headcount savings I referred to earlier in Q4 of 2024. We are currently embedding our ZBB approach into our standard processes and the 2026 budgeting process design. We've been working to reduce our headcount for some time, and we've made good progress. We finished the year with a total headcount around 9% lower than at the end of 2022 and with a bigger reduction in 2024 than 2023.

I referred already to the action taken in November 2024, with headcount reducing from Q4 of 2024 into Q1 and Q2 of 2025. The associated cost savings will mainly flow through to the P&L in Q2 and the second half, in line with the flow-through of savings from our manufacturing network optimization program supporting our margin expansion, particularly in the second half of the year. Our 2025 trading margin guidance is for 19%-20%. Overall, for the year, we are forecasting just over 100 basis points of headwind from China VBP, as I said, slightly higher in half one and easing off a little in half two. This is more than I indicated at the interims because of the volume impact I covered at our Q3 trading statement and the additional headwinds from China AET VBP in half two.

We expect input cost inflation and merit to be more than offset by revenue leverage supported by the significant cost savings driving margin expansion. As mentioned earlier, these operating savings are weighted towards the second half. The combination of this with the timing of the China VBP effects means we expect nominal margin expansion in half one, with a significant step up in the second half delivering a margin of 19%-20% for the full year. Going into 2026, we expect continued margin expansion as we annualize cost savings and continue to drive greater efficiencies in our business. Coming on now to our trading margin by business unit. As Deepak covered earlier, we have transitioned the organization to a global business unit model, further embedding the culture of accountability and helping us drive better commercial execution at pace.

At the interims, we committed to providing additional disclosure on the performance of our business units and to move to fully allocating attributable central costs. Slide 24 shows the margin by business units under the new methodology. The effect of the change has been similar across the business, with each segment's 2023 trading margin between 620 and 670 basis points lower than under the previous approach. All three business units delivered trading margin expansion in the year, with a 20 basis point increase for Orthopaedics, 120 basis points for Sports Medicine and ENT, and 50 basis points for Advanced Wound Management. In each case, we would also have seen margin expansion under the previous allocation approach. Broadly speaking, expansion came from OpEx savings and leverage across all three business units.

There was also some variation from mixed effects, notably in orthopedics, where the higher margin U.S. business grew below the international business, particularly in the first half of the year. For 2025, you should expect the bulk of margin expansion to come from orthopedics at over 200 basis points, with accretion of over 50 basis points coming from both sports medicine and AWM. With this fuller allocation in place, only $52 million has remained as truly central costs, and we anticipate these will be broadly flat year on year in 2025. The purpose of the change was to create transparency and accountability and our already positive behavioral changes as a result. We've seen greater scrutiny of spending plans, lower demand for new projects, and greater discipline in constructing robust business plans for new IT investment, as an example.

Accountability at the BU level also arises at the balance sheet as well as the P&L, in particular for our inventory balances, which, as you know, have been a priority under the 12-Point Plan. Slide 25 shows the development of DSI through the year, both for the group and for each of the business units. 507 overall inventory days at the end of 2024 was a 23-day improvement. Some initial build in the year was necessary to support launches, including AETOS and RENASYS EDGE. Then, as product shipments and set deployments ramped up, we saw DSI come down across all three business units in the second half.

There was still an overall increase in inventory for launch products for the full year, and this means that, as well as group DSI improving, our inventory mix has also improved, with units of the slowest turning quartile of SKUs down by 17% during the year. Longer-term improvement will be down to improved forecasting and better alignment of production plans with commercial needs at the SKU level, enabled by the improved SIOP process under the 12-Point Plan. There is still more work to do, including aligning our SIOP process with our financial forecasting in a truly integrated business plan. Inventory reduction remains a focus, and we expect further progress in 2025. The business is increasingly focused on driving improvement in capital returns.

We have made solid progress in 2024, delivering a 150 basis points improvement in ROIC to 7.4% at the group level, and we expect to see return to a level above our cost of capital in 2025. For the last two years, most of the ROIC improvement is being driven by operating margin expansion and particularly by restructuring charges coming down in orthopedics. For the longer term, we're also focused on driving better asset utilization and reduced inventory, as I've already covered. We expect a doubling of returns in our orthopedics business in 2025, with further progress in 2026 and beyond, and more measured progress in both our sports and wound business units in 2025.

This work, of course, is made more precise by our recent allocation of central costs to the business units and more granular allocation of capital and a greater focus on capital efficiency measures such as asset turns. We also remain focused on more disciplined capital allocation across our business units and greater focus on working capital, with significant improvements delivered in 2024, which is a useful segue to our cash flows for 2024, so moving on to cash flow, trading cash flow was $999 million for the year. 95% conversion was ahead of our target and well ahead of the 65% in 2023. The improvement came primarily from lower working capital costs, particularly from inventory and payables. Capital expenditure was also lower versus an elevated level of spend in 2023. Working capital remains a focus for 2025.

Free cash flow also improved to $551 million, helped by a $95 million improvement in the restructuring, acquisition, legal, and other line, reflecting the lower P&L restructuring cost of $123 million in the year that I mentioned earlier. We expect further improvement in free cash flow in 2025 to over $600 million, driven by further improving trading profit and restructuring costs that will be less than 1/2 of 2024 at around $45 million. Free cash flow will be an increasing focus in the business, as evidenced by a shift away from trading cash conversion to a free cash flow measure in the performance criteria used to incentivize our most senior people. Overall, our cash generation and returns profile is returning to a much healthier position. As I've set out, we're already seeing clear improvements across multiple metrics where we've had long-standing challenges, and there's more still to come.

As a result of our strong cash flow, net debt came down during the year to $2.7 billion, which is a decrease of $67 million. We expect the trends behind our improved free cash flow to continue in 2025, including good growth and margin expansion, lower working capital costs, and significantly lower restructuring costs. Capital allocation will become a more active consideration as a result. As a reminder, we are focused first on investing for organic growth, followed by acquisitions, paying a dividend, and lastly, returning any excess capital to shareholders. We finished 2024 with a leverage ratio of 1.9x Adjusted EBITDA, which is within our target of around 2x. For the use of excess cash, we'll continue to look at tucking in M&A in line with our policy and growth strategy.

I would note that at the current valuation of our equity, the financial return on share buybacks is a very relevant hurdle for M&A. I'll finish with our outlook for 2025. For 2025, we expect underlying growth of around 5%. That includes continued progress in U.S. Recon on an ADS basis, noting the swing from two extra days in Q4 to one fewer day in Q1 and Q2 of 2025. We also expect continued good growth in all of Sports Medicine ex-China, ENT, and AWM, including Bioactives returning to lower single-digit growth as the benefit of GRAFIX PLUS launch fades. China will still be a significant growth headwind, as Deepak highlighted. Our guidance includes a total headwind of around 150 basis points for the full year, but still results in solid underlying growth overall.

As previously indicated, we also expect a significant step up in profitability in 2025 with a trading margin between 19% and 20%. That step up will come from operating leverage, further operating cost improvements, and the benefits of network optimization program beginning to reach the P&L, particularly in the second half, and these effects will more than offset the headwinds from China and inflation. There are also significant phasing considerations in 2025. On growth, we expect that some of the strong finish to 2024, particularly in U.S. Sports Medicine, was supported by year-end patient copay effects that will normalize in Q1. Also, China Recon will remain slow in the first quarter, and the growth headwinds from Joint Repair VBP will roll off in the middle of the year.

In addition, we will have one fewer trading day compared to 2024 in each of Q1 and Q2, and then one extra day in Q4. Putting all of that together, we expect growth to be around 1%-2% in Q1 and then accelerate for Q2 and the second half. We also expect the trading margin to be stronger in the second half than in the first. As I've already commented, we expect greater margin seasonality than in 2024, with only nominal year-on-year expansion in the first half. And so the full-year margin expansion will be mainly driven by half two. As we did last year, we'll give more specific margin phasing detail with our Q1 trading update. And now I'll hand back to Deepak.

Deepak Nath (CEO)

Okay. Thank you, John. So I'm encouraged by how we're positioned coming out of 2024.

It's good to deliver on both growth and margin, but what's most encouraging is to see the 12-Point Plan benefits more visibly coming to fruition. We started out with a comprehensive program of actions, which first showed improvement in operational KPIs and is now delivering an inflection across the full range of financial outcomes. We know that there is still much more to do, but we're well positioned for a key year of delivery in 2025. On revenue, we're continuing to improve in U.S. recon. We're delivering successive waves of innovation, and we're demonstrating our ability to turn that into a level of growth that can drive natural leverage. We've also taken broad action on our cost base, with the result that there's a step up in savings across manufacturing and operating expenses poised to flow through to our P&L in 2025.

So I look forward to updating you through the year as we move towards our goals. But I'd like to finish today on a personal note. As you may know, Phil Cowdy has recently announced that he will retire later this year. Phil came to Smith & Nephew 17 years ago. He had more hair then and has been a pillar of the company across a number of roles. Most recently, he served as Chief Corporate Development and Corporate Affairs Officer, and for me, he has been an invaluable source of support and advice in my time as CEO. I'm sure you'll join me in wishing him all the best for retirement. Phil, thank you very much for all your tremendous contributions to the company over 17 years and now we can move on to questons. Jack.

Jack Reynolds-Clark (Analyst)

Hi there. Thanks for the questions. Jack Reynolds-Clark from RBC.

I have three, please. First on China. So what gives you the confidence that orthopedics is going to recover towards the end of Q1? Kind of how much visibility do you have into or on market, end market demand? Also on China, within sports, are you seeing kind of volumes tick up as you had previously expected? Second question was just on U.S. hips and knees. So could you just remind us at this point kind of what gives you confidence that the geography will kind of now grow in line with the market come the end of 2025? Just give a bit of confidence there. Then the final question is on R&D. So obviously, you said that R&D would tick up in H2. And I think there's been a bit of kind of nervousness that R&D is being used perhaps to kind of manage margins.

Could you just kind of give us a bit of confidence again that that is not the case or that won't be the case in 2025?

Deepak Nath (CEO)

Great. Thanks for the questions, Jack. So first, with China, we had indicated in Q3 that we had seen a softening in end user demand. So there's in China, just to remind you, there's a tender business, and then there's an off-tender business. It's the same price, but you've got committed volumes in the tender business and free float in terms of volumes in the off-tender business. What we have seen is softening of demand in that off-tender business. So ordering had stopped because the inventories were built up in the channel. And as I indicated, we're seeing the inventories come down, but we expect in Q1 that some of that to continue and to recalibrate.

And so as we commented, Q4 of 2024 played out as we had indicated that it would. And nothing that we've seen so far indicates that Q1 will be any different. So Q1 should be the low watermark in terms of inventories coming down to equilibrate. From there on out, it will be our ability to service the market. And I'll remind you that we've got committed volumes for tenders at a price that we know. So that's how we expect the recon part to play out. With sports, in the first half of the year, it will be essentially the sports VBP on joint repair playing through. And then in the second half of the year, we will have lapped that. What will come concomitantly is VBP for AET that we expect to kick into gear in the second half of the year.

As with the Joint Repair and as with Orthopaedics, there'll be adjustments in the channel as we lead up to that. So putting all of these effects together, we feel confident in having pegged how that's going to play out, having been shaped by the experiences over the last few years. Our guidance actually contemplates the combination of these two effects. So that's China. Do you have anything to add, John?

John Rogers (CFO)

Well, I was just going to say just in terms of the actual numbers that we've got assumed in our budget for 2025 for China, the first half on Orthopaedics, we are predicting it's going to be down sort of 60%-75%. So we're fully baking in the experience that we saw through at the end of 2024. And we do expect to see some of that recovery come through in the second half. I think we're being very sensible about the numbers we're using. On sports medicine, again, we're reflecting the Q3 and Q4 performance of 2024 coming through into 2025. The first half will be down almost 50% against our budget. I think we've been sensible using the history that we've seen in the second half of 2024 to build that into our forecast for 2025. And that's fully baked into our guidance for the full year.

Deepak Nath (CEO)

Your second question about U.S. hips and knees, the confidence comes from us having executed multiple elements of our transformation program over the last couple of years. The first is improving supply, which is a substrate to this whole thing. As I've commented on previous calls, U.S.-specific SKUs were the last to recover. We didn't plan it that way, but this is how things unfolded.

Hips recovered before knees did from a supply standpoint. But as we commented, in 2024, we're now back to our target levels. So that's the first part. Secondly, concomitantly, we've been improving our commercial execution. There's multiple facets to that. It's leadership. It's our organization or selling organization. We've made some improvements in how we're set up, how we've performance managed, and also the process that we use for performance management in orthopedics. We're just fine on the other parts, but we had improvements to make in those areas. All of those we've been driving at. The upshot of it is, as I look at customer churn, through 2023 and 2024, the story was we lost more customers than we gained. Now, as we exited 2024, that balance is now in favor of us winning more customers than we've lost.

And that gives us a more stable account base as we've reduced churn. And on the back of a portfolio that we still have work to do to add to that portfolio, but we've got a portfolio and a strategy for commercializing that portfolio that I feel good about. CATALYST Stem will be a great growth driver because we are now able to fully participate in the direct anterior approach, which is the high growth part of hips. We've got CORI now that's got tremendous functionality, truly setting the standard in terms of robotics for knees. And there's more to come in hips. So I look at the growth drivers from a product standpoint, the improvements we've made to commercial execution and supply as a substrate.

All of those translate into confidence that I feel that we're going to continue this improvement trajectory that you clearly see that we've laid out. So that's the U.S. question.

John Rogers (CFO)

And maybe just as well, again, just to build on the numbers there. So as Deepak's chart showed at the end of the year, we were exiting at circa 2% ADS growth. We will deliver sort of slightly ahead of that in Q1. Not much, though. But then we'll see that grow to 3%-4% by the end of the year. And therefore, in line with the market, which is consistently with what we've said now for the last 12 months or so that we expect to get to market growth by the end of 2025.

Deepak Nath (CEO)

Regarding R&D, as I've commented multiple times, including today, innovation is a key part of our growth story. We've called out that 60% of our growth revenue growth came from new products. That's on top of nearly 50% in 2023 where revenue growth came from new products. So this is an important part of what we do. If I wanted to make our margin number by cutting R&D, we would have done that two years ago. Right? So that is not a lever we're looking at. But when you look at year-on-year comparisons, of course, R&D looks down. The primary part of that is one-time effects. And those were related to some productivity measures that we took, and actually EU MDR that was obviously a one-time thing that rolled off into 2024. We haven't cut any programs. In fact, I've added programs despite the margin pressure that we feel.

So all of the shoulder programs on CORI, that was added on top of when we started the 12-Point Plan program. Rounding out the portfolio of shoulder, while we had aspirations for that, what we've actually done is accelerated our implant program. And on the knee side, we've actually accelerated some programs within that as we look to make our portfolio more competitive. So in terms of the substance of what we're looking to do in R&D, which is the programs, I feel very good about the level of funding that we've got and really the level of innovation that's gone into those programs. And you can see the track record. You can measure that in terms of revenue growth contribution. You can look at it in terms of number of products launched.

You can look at it in terms of the number of firsts in terms of category-creating products we've brought to bear. All of those tell the story of innovation. We're a medtech business. Innovation is key to us, and we do punch above our weight class. So that's the reassurance that I hope I can provide around R&D. And then the 4% reduction year-on-year in R&D is just a natural consequence of where the spend occurs within our R&D programs. It isn't coming from cutting programs, but it's as we go through different milestones, the spend level tends to vary. So we aren't backing into the R&D number based on a margin target, but rather driven by what we think we need in terms of programs to be successful.

John Rogers (CFO)

And also, when you look at the margin accretion for the year of the 60 basis points, we get 60 basis points of improvement coming through from our improved SG&A spend. So one would argue that the key leverage here is the cost savings that we've delivered coming through, providing that margin accretion. And we'll see more of that, of course, in 2025. So it's not R&D. It's the SG&A reduction that's driving our margin expansion.

Jack Reynolds-Clark (Analyst)

Great. Thanks a lot.

Estelle Pang (Analyst)

Hi. This is Estelle Pang from Bernstein. And I'm asking the question on behalf of Lisa Clive. So the first one is, can you discuss your effort to reduce SKUs in hips and knees? Is a significant reduction required to get orthopedics to structurally higher mid to high teens EBIT margin?

Or perhaps another way of saying it, how much is your large number of platforms in both hips and knees contributing to the low margin profile of the Recon business? And the second question related to margins. So most of your margin improvement is clearly coming from orthopedics. Can you give us a bridge in terms of rough proportion of uplift in this division that will be coming from a reduction in COGS, operating leverage, or any particular areas of cost savings? And the last one, could you discuss the competitive dynamics in the Chinese market, specifically your Chinese Recon business? So after the large decline in Q3 and Q4, have you lost shares in the market, especially to local players? And have you seen the buy local campaign? Has the trend notably accelerated, or is it just an aberration? Thank you.

Deepak Nath (CEO)

Thanks for the questions. I'll take the first and the third one. I'll have John address the second point. I'll take those first, first and third. In terms of SKU reduction, that is an element of our plan. Actually, it was one of the sub-sub items of the 12-Point Plan where we have actually, over the last few years, significantly reduced the amount of SKUs. And those are primarily in Asia and certain emerging markets where we've seen the benefit of those. Right? In terms of platforms, that's a much trickier bit to execute because you've got a customer account base that you've got to protect. And it's not always easy to transition from one platform to the other. The good news here is we've already made good progress. It's important over the longer term.

But in order to achieve where we need to get to in 2025 and 2026 and 2027, it's not the biggest lever that will get us there. Does it afford challenges for us from a scale efficiency standpoint? Yes, it does. But in the end, we've got other levers that we are pulling in order to deliver the margin expansion. So that's a short answer to the SKU story. Good progress has delivered what we expected to deliver going forward. It's a part of the plan, but it's not the biggest part of the plan in terms of margin expansion. On the third part with China, you asked about recon, but this is a little bit also in sports. We have lost share.

Part of what we see the government doing is, in addition to addressing the cost base or healthcare spend, where VBP is a vehicle for controlling that, there's clearly a push to support local manufacturers. Right? And so we should expect that some of them will step in and start to play a bigger role in the market. And we have seen that come through. And largely, our recon business or some of the volume impact that we've talked about in the past really comes from local players being more competitive in that free float segment that I talked about earlier in recon. So it is true that that is a bigger factor of our losing share. In sports, maybe the effect is not quite as pronounced, but it is the same dynamic nonetheless.

There's a price impact, and we expect local players to come in and step into that. Had we undercalled that a bit in sports? Yeah, we had. But we've been shaped by the experience, particularly as we discussed in Q3. That's the third question. John, you want to take the second question on the margins?

John Rogers (CFO)

Yes. So on margin expansion by business unit, just to contextualize, obviously, we outturned 2024 at 11.5% margin for our orthopedics business, 24% for sports, and 23.7% for wound. Now, we will expect both wound and sports to accrete by 50 basis points plus. So we will expect to see margin expansion come through there. But clearly, starting at a fairly high level, that will be more muted. However, in our orthopedics business, we will expect at least a step up of 200 basis points from the 11.5%.

So at least 13.5%, hopefully getting towards 14%. The key drivers behind that are twofold, the first of which is obviously operational leverage coming through growing our top line and recovery in our U.S. orthopedics business, as we've already talked about. And the second one, which of course is a big chunk of that, will also come from savings, particularly the closure of the four manufacturing units that supported that business and the benefits that those savings coming through in the second half of the year. So two big levers on orthopedics to deliver that 200 basis points of margin expansion, operational leverage, and manufacturing cost savings.

Robert Davies (Analyst)

Morning, Robert Davies from Morgan Stanley. Two questions. One was just on the headcount reductions, obviously being quite a notable sort of step down. I noticed your one-off costs were not quite so big in 2025 as 2024.Just maybe give us a bit of context on where you are in the headcount reduction program, what's left, where are those people actually coming out of? And then the second one was just around potential tariff risks across different parts of your business. Perhaps you could give us a little color on that. Thank you.

Deepak Nath (CEO)

On headcount, so most of the headcount reduction comes from the factory closures, which is part of the network optimization efforts. That's almost all in Orthopaedics, where we had more capacity than we needed. But as part of the broader cost savings programs, we've actually gone after efficiencies right across the group. So significant in SG&A. Initially, it was as we transitioned into the business unit model that was back in 2023. But there's actually significant SG&A-related headcount savings as well.

And then in 2024, you noted the step up in reduction, if you will. We had to make some difficult decisions there. We've actually pulled forward some of the things we had planned for in 2025 into 2024 as we grappled with the additional headwinds. So relative to where we started the 12-Point Plan, inflation's been higher for longer. And VBP impact in sports, which we didn't have at the time we announced the program. And not only in Joint Repair now coming into AET, has meant we've had to go deeper than we originally set out to do in the 12-Point Plan. The Zero-Based Budgeting approach was one of the vehicles we used to get there. But we've largely done the big bulk of what we set out to do. 2025 is the year when the benefits of those actions will flow through into the P&L.

So that's the headcount, both in terms of where it is and how we're thinking about this phasing or sequence of it. In terms of tariffs, obviously, the headline is it's a dynamic picture. Right? It's hard to know how things will actually settle out. When you look at what's been announced so far, this is primarily on China. That is within the realm of what we had contemplated and within the realm of what we expect. And I'll also remind you that tariffs in China is not a new thing. We've had to navigate that also in the past administration. The topic of reciprocal tariffs and the impact of that at this point, it's hard to know how that's actually going to play out. The headline for us is we've got a team looking at it.

In terms of the U.S., the largest proportion of our U.S. business is served through manufacturing plants in the U.S. So we are reasonably well covered there. But where we expect the impact, to directly answer your question, would be primarily in our wound business, where we've got a significant presence in China in terms of manufacturing. But having said that, all of our scenario analysis we've done leads us to believe within the realm of the impact will be in the realm of what we expect. But the headline, again, is this dynamic, and hard to know how it's going to play out exactly.

John Rogers (CFO)

And just to build for a second on Deepak's comments on the headcount. So we're not sort of planning any major sort of headcount reduction plans in 2025 per se. That said, this whole philosophy of ZBB that we've embedded in 2024, we want to make sure it becomes in our DNA and our way of working. And so as we set our budgets for the 2026 year, we're always, always looking for opportunity to make ourselves more efficient. And there are still opportunities, I believe, in the business where we can drive efficiency through. But it will be done through incremental, continuous improvement, as opposed to maybe step change, one-off programs that we've done in 2024.

Robert Davies (Analyst)

Thanks, John.

Deepak Nath (CEO)

Question.

Seb Jantet (Analyst)

Hi, Seb Jantet with Panmure Liberum. Two questions, if I can. Just first of all, just want to talk about pricing a little bit. And just want to get a sense of what you've baked into your kind of forecast for pricing in some of the major markets, kind of obviously VBP aside. And then secondly, in terms of guidance, you've given yourself quite a big window to drive through for this year. So I'm kind of wondering kind of what are the levers that might leave you at the kind of the bottom end or top end of that? Is that a revenue outperformance story? Is that cautious guidance on cost savings? Just trying to get a handle on kind of on where we are on that.

Deepak Nath (CEO)

In terms of pricing, historically, we're kind of a 1%-2% price erosion type of company. It's very fairly typical in the med tech sector. Over the last couple of years, we've been doing better than that. We've been flat, maybe a percent, a little over percent up. And that's largely because we've been able to pass through our inflation-related cost increases to our customers.

As you know, in med tech, historically, it's not something that you can easily do. What I've commented in the past is we don't expect that to continue out into the future. Our long-term plan basically takes into account going back to normal levels of price erosion, which is around 1%-2%. Now, we're not going to get there all in one year. We already saw that 2024 was worse, I should use my adjective correctly, was closer to normal than 2023 was. We expect 2025 to be even closer to normal than that, but not quite at normal. Right? That's the way to think about that process. There's dynamics in terms of within orthopedics, how the mix shift from hospital into ASCs and so forth and how that plays out. But generally speaking, our long-term plan is based on going back to normal price levels.

Before I get to the second question, you want to chime in, John?

John Rogers (CFO)

Yeah, just to give you a little bit of color on that. So 2024 pricing was roughly, if the group level was up around 1.5% or so. And if you stripped out China, roughly 2%. So as Deepak says, elevated levels. For 2025, for the group level, we expect it to be roughly flat. And next China would be roughly up 50 basis points. So as Deepak says, we're expecting that benefit from price to come off significantly in 2025. That's fully baked into our forecast and our guidance for the year.

Deepak Nath (CEO)

So regarding margin, I wouldn't anchor to either the low end or the high end of that range. So the intent here actually is not necessarily to be more conservative in our forecasts.

I mean, coming off of a margin target that we have in 2025 is not an easily done thing. It was a very painful thing for me personally to have to come off of that. Having said that, what you also don't want to do is put forward something and then have to revise it again. Right? So what we're dealing with is significant uncertainty around China. Bottom line, the reason for this range is China. We've commented on how sports joint repair played out a little differently than we had set out. So the range we've provided takes that into account. But it also takes into account AET, which is the other part of sports that's come through. So that range gives us the ability to kind of deliver within that.

But like I said, I wouldn't anchor to either the low end or the high end of that range. And as we progress through the year, certainly at Q1, we'll be able to kind of tighten up that range for you, recognizing what John said in his remarks, which is this will be another year where, for a variety of reasons, it's going to be a story of Q2 or H2 kind of margin step up. And that's been generally how the last two years have played out. H1 kind of looks kind of ho-hum year on year. And the benefits come through in H2. That's been the story of 2023. It was a story in 2024. The factors have been different in each of those years, but that'll be how 2025 plays out as well.

John Rogers (CFO)

If you think about the three key levers for margin in 2025 being operational leverage, China effects, and cost savings, obviously there's a scenario if we don't recover US ortho to the extent that we have said we will, that will mean we're at the bottom end of our range. If we do recover or do better, that will mean we're at the top end of our range. On China, we've baked in 100 basis points of margin dilution, 110 basis points of margin dilution in our bridge. That reflects both the sales reductions that I talked about earlier across both orthopedics and sports. So I think we've baked that in. But there's always uncertainty around that, of course. It's very difficult to forecast. But we've baked that in.

And then the cost savings, I feel pretty confident on the cost savings to the degree that we've got sort of 51 programs that drive those cost savings, half of which are already embedded and complete, the other half of which are close to complete. So we've got pretty good visibility of the cost savings. So I think in order of risk, you've got the operational leverage piece, then China, and then cost savings where we've got pretty good visibility. But the mix of those will determine the bottom and the top end of the range.

Deepak Nath (CEO)

That's great. Thanks, John. So one to two more questions to the room. We've got a bunch queued up over the phone. David, and then David, and then we'll come back.

David Adlington (Analyst)

Thanks. David Adlington from JPMorgan. Just in terms of on the inventory side, maybe for John, any targets you're willing to share in terms of how much you might reduce inventory this year? And then related to that, how we should be thinking about free cash flow evolving from last year, because last year was obviously very good. And then just on margins, obviously cost savings coming through, getting some top-line leverage. How are you thinking about margins beyond 2025 and how much you might need to reinvest versus allowing it to drop through? Do you want to take the other two?

Deepak Nath (CEO)

Look, on inventory, we're not going to give specific targets. I think we said we've made good progress this year. You've seen it both at group level. And more importantly, I think at every single business unit level, we've made good progress on DSI.

We also make the point that the quality of our inventory is better. So we've had a build-up of inventory, obviously, for new product launches. But that's meant that the stuff that doesn't turn very quickly, we've actually reduced the number of those units by about 17%. So we're both improving the day sales inventory and also the quality of our inventory. I think in terms of targets for 2025, we're not going to be specific on that. But you've seen the direction of travel, and we want to try and maintain that direction of travel through 2025. How does that all impact on our free cash flow? Well, we've said free cash flow will be north of $600 million for the year versus the $551 million in 2024. I'd like to beat that.

I think we've built some. There's a little bit of a step up in the CapEx as a consequence of our new facility that we're installing in Melton in the northeast. But I think we should be aiming to try and be driving north of 600 and maybe getting to 650 in terms of free cash flow for the year. That should see our leverage reduced from the 1.9x we exited this year down to 1.6x at the end of 2025. That's the direction of travel that we're going in. In terms of margin beyond 2025, look, we're not going to sit here and give guidance for 2026 and 2027. But we said frequently that you saw the cost savings come through for this year at 210 over the last two years.

We should be trying to get that to close to north of 300 coming through in 2025. We've said 325-375 overall. So some of that will come through in 2026 and 2027. Some will be new savings. Some will be annualization of 2025 savings. But we do expect our margin to accrete through 2026 and 2027.

Kane Slutzkin (Analyst)

Morning. Kane Slutzkin, Deutsche Numis. Just on robotics, we haven't spoken too much about CORI. I'm just wondering, you've obviously got Mako and ROSA in the large footprint space. But just in the terms of any color you can share on the competitive landscape in the small footprint space where CORI plays, whether it be J&J or THINK Surgical or the other ones, just any sort of commentary there. It sounds like you're gaining some decent momentum.

Deepak Nath (CEO)

Yeah. First of all, very pleased with the traction we're getting with CORI.

We're not dissecting the market into small footprint, large footprint. It's the robotics market that enables surgeons to implant knees or hips or shoulder. What I'm pleased about is not only the gross number, but where we're actually placing CORI. We're placing them in academic medical institutions where historically we've been under-indexed. We're placing them in the ASC at a slightly higher proportion than our overall share, speaking to the broad value proposition that CORI has. What I'm also pleased with is the level of utilization. We could be running a place-first type of strategy. That's not what we're doing. We're actually placing them where there is demand. Where we place them, the utilization is at a nice level. Very pleased with the traction that we're getting. As we indicated since 2022, we've invested in fully featuring CORI. We started out, for example, with a milling-based approach.

We've got feedback from the market. The surgeon preferences range from cutting and milling. So we brought forward cutting functionality onto CORI, which we had originally not started off with. It's the only platform. And actually taking a step back, CORI has some features that only it has. Right? CORI is the only platform that's able to do revisions because we offer both image and image-free kind of solutions. Right? We were the only platform that's able to do soft tissue balance before the surgeon ever cuts. So each one of these things aren't on their own going to move the needle one way or another. But the combination is what we're looking for. And it's starting to play itself out that way. And as I commented around CORI's applicability for shoulder, at the start of the 12-Point Plan, we didn't think about having that program.

But we actually pulled it in because we see the potential for the footprint that CORI has. It's not a large installed base. It's a handheld kind of thing. It lends itself to the shoulder space. We are on the arthroplasty side, a relatively small player in shoulder. So it's not just about having CORI, but we've got to have a full implant portfolio. And as you know, we're on a path. Right? We're in the early stages of launch of AETOS shoulder. And that's going to play itself out. So this is a platform that we expect to build on. We've got great proof points already to build on it. And so overall, I feel good about how we're positioned competitively within orthopaedics robotics.

Kane Slutzkin (Analyst)

Thanks. John, just maybe a quick one for you. Just on slide 26 on the ROICs, you're probably not going to want to answer this post-2025. But just, I mean, you haven't put the numbers in, but it looks as if Ortho is doubling its ROIC.

John Rogers (CFO)

That's correct.

Kane Slutzkin (Analyst)

Yeah. Sorry?

John Rogers (CFO)

Yeah. We're just wondering. We're expecting to double the ROIC.

Kane Slutzkin (Analyst)

Yeah, double ROIC. Assuming obviously you're working your way up to market growth, you haven't fully annualized that number clearly. But just in 2026, assuming you do get there, should we assume that the ROICs will exceed WACC in post-year? And sort of if it doesn't, how long do you give yourselves?

John Rogers (CFO)

So look, I'm not going to get drawn on when we'll sort of cross the cost of capital line in Ortho. But our expectations would suggest it's sometime between 2026 and 2027. So we'll see how we progress this year. But certainly a big step up in 2025, so doubling in 2025. And then with a view to getting to our cost of capital sometime in 2026 and 2027.

Deepak Nath (CEO)

The key driver there is U.S. recon performance. And so what you look for is continued improvement. And obviously, we've seen sequential improvement here in 2024. We expect to build on that in 2025. So that'll be the key kind of lead indicator of how we're going to do on ROIC. So we want to take on the phone. So I think we've got Graham Doyle on the phone. So we want to get to him first.

Graham Doyle (Analyst)

Thanks, guys. Morning. And thanks for taking the questions. Just two for me. One on China and one on the Ortho margin. Just on China, in terms of, I suppose, the Ortho and sports med business, I'm specsing the question now. Is there a path where you basically just shut this business down? Presumably, we're not in margin-accretive territory today. So just your thoughts on that and what would be a go, no-go decision. And then on the plant closure, so those are coming through. And we're obviously seeing better profits coming through in U.S. Ortho in particular. Is there anything we need to think about in terms of the cost of the inventory you hold today and when this kind of better or lower cost inventory comes through? And then just as a sense for us, how much more profitable is U.S. Ortho given the fixed cost there?

Because if we think about the Q4 benefit and the context of the guide cut in late October and obviously the change there, and then we think about the better momentum continuing to 2025, it's just to get a sense of how much more profitable is this than, say, some of the other businesses that have been growing in the last two or three years. Thank you very much.

Deepak Nath (CEO)

Okay. You were acoustically hard to hear in the second part of the question. So I'll do my best in terms of what I understood it to be. But going to the first thing about China, so China orthopedics today at VBP price levels is not a profitable business for us. Well, why are we in it? First, it's giving ourselves the opportunity to see how the market evolves. And in particular, how robotics gets adopted in that market.

And in order for us to do that, you need to maintain a certain level of presence and actually direct some efforts in developing the robotics market. And so depending on how that develops, China could get back to not what it was in terms of attractiveness from a profitability standpoint, but to a better place than it is today. So we're in orthopedics today to see how that market actually develops. In sports, it's a better picture from a profitability standpoint post the price cut. I mean, obviously, it is a straight impact to bottom line. Right? So there is no, although we've adapted the channel to take VBP pricing into account, it's pretty much a good flow-through impact. But it's in a better place than Ortho is. So that's how to think about the sports business versus the Ortho business in China.

In terms of go, no-go decision, we decided to enter into the current round of the Recon tender. And that was in March of 2024. Originally, it was intended to go for two years. I mean, there's some indications that they may extend that out to three years. So the go-no-go decision would be essentially we'd want to participate in the next round of tender. Right? And that depends on how the market evolves between now and then. So that's the short answer to how we think about go-no-go. In terms of the cost of inventory, as you know, a significant part of the value of the inventory number is from the revaluation of inventory. And it's a fairly complicated picture.

But suffice it to say, as we go into 2026 and 2027, as inflation and the impact of inflation recedes, you should start to see what has been a significant headwind turn into a more neutral picture as it comes into our P&L. And John, did you catch his question on the 2025 guide? I didn't catch the question. But I just sort of got a build on the last one. On the plant closures, just to be clear, we're already starting to see in cash terms the benefit of those plant closures coming through in terms of our cost of production. But as Deepak says, so that's moving in a positive direction. At the moment, it's being offset by the inventory revalue, and hence why the gross margin moved backwards slightly year on year, but also the China pricing effects.

Over time, it takes about a year or so in our Ortho business for the benefits of those lower production costs to flow through that inventory. And that's why we're saying the second half of this year is when we're going to see that benefit come through. So it's not like we're not enjoying the lower cost today. It just takes about 12 months or so to flow through into the P&L. That's what gives us pretty good visibility on the numbers as we come through the second half. So I just want to make that point clear. And I didn't catch the second question. You might have to.

Okay. We need to get to another phone. But Graham, is a 30-second kind of repeat of the second part of your question?

Graham Doyle (Analyst)

That's great. Thank you very much, guys. Appreciate it.

Deepak Nath (CEO)

Thanks, Graham. So we go to Hassan from Barclays.

Hassan Al-Wakeel (Analyst)

Hi. Can you hear me?

Deepak Nath (CEO)

We can.

Hassan Al-Wakeel (Analyst)

Perfect. Thank you. Hassan Al-Wakeel from Barclays. Three for me, please. Firstly, just on Q1 and the lower growth here, what could this look like ex-China? And how should we think about group growth in Q2 and whether you expect that to be within the guidance range? Just trying to understand how back-end loaded the year is from a growth perspective. And then secondly, related to this on margins, it's not unusual to have 300 basis points of margin differential between H1 and H2. But should we expect a more pronounced difference given the softer first half growth expectations? And then finally, just on the additional VBP in AET, thank you for quantifying. Could you walk us through some of the underlying assumptions in terms of price reduction and volume changes that you've baked in?

What is left in sports medicine in China that hasn't yet had VBP? And how are you thinking about risks here over time? Thank you.

Deepak Nath (CEO)

Okay. Maybe I'll take the last one first and then the next to last. And John, you can take the quarterly phasing. In terms of AET, as we indicated in terms of the top-line impact, we called out about $25 million of impact of AET. It is significantly smaller than our joint repair business. For AET, it's a big part. But for a group level, it's not as big a portion. Once VBP gets hit with AET or hits AET, there's essentially that covers the range of impact for the China sports medicine business. There's not really a lot left after this. There's a bit of capital. But that's about it.

In terms of the type of margin step-up H1 to H2 that we're expecting, what's implied in our models is not an unprecedented level of H1 to H2 margin step-up in order to deliver the margin guidance that we've indicated, and as you can probably do the math, if you go back to several years in terms of the delta between H1 and H2 margins, what we're expecting in 2025 is within kind of the range of what we've seen. So you want to address the quarterly phasing.

John Rogers (CFO)

Yeah. I'll just come very quickly to the last one. Just on the $25 million that we've guided to on AET, that's roughly split. About $15 million of that is price and volume. And about $10 million is channel adjustments. So that gives you a little bit of flavor as to the shape of that impact.

The half-one, half-two split, I'd look to 2023. That's a good benchmark in terms of the level of step-up. In terms of the question around China, so if we look at our overall growth ex-China, it is up. Obviously, there's about 140 basis points of difference for the full year between our in China and our group ex-China growth. So China does have quite a big drag on the business. In terms of our ADS growth ex-China, we should be looking at around 5% or so for Q1. Q2, we should be looking at around 8% or so. Similar for Q3. Then a little bit of a step-down in Q4. So again, it's phased through the year. We are expecting around 4% ADS growth ex-China in Q1. Hope that gives you a bit of color.

Deepak Nath (CEO)

Good. So I think we'll need to leave it here in the interest of time. And thank you again for your interest and engagement. And looking forward to coming back in a couple of months' time to give you a sense for how Q1 progressed. So thank you very much.