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Smiths for income

A recent flow of positive news suggests Smiths' downtrodden shares may have reached a turning point.
December 17, 2015

A much-needed pension shake-up and better trading prospects across some of its core divisions suggest Smiths' (SMIN) prospects could be turning up as its new boss gets to work. Shares in the sprawling engineering conglomerate have tanked in the past two years, as difficult end markets and a big pension deficit proved hard to manage. But with these issues now easing - and the shares languishing on a forward PE multiple of 11 times - the high-yielding maker of everything from industrial valves to X-ray scanners suddenly looks attractive and raises prospects that a long-mooted break-up could finally be in prospect.

IC TIP: Buy at 930p
Tip style
Income
Risk rating
High
Timescale
Medium Term
Bull points
  • Pension deficit headache cleared up
  • Decent dividend now secure and expected to grow
  • Break-up potential re-emerges
  • Better trading prospects
Bear points
  • Profit machine John Crane hit by depressed oil price
  • US economy uncertainty

News that Smiths has tidied up its retirement obligations represents a major breakthrough which has turned us from sellers of the stock to buyers. A recent valuation of the engineer's UK scheme put the group's actuarial deficit at £285m, down £250m since the last valuation in 2012. This means annual contributions will fall from £60m to £24m by 2017, freeing up £36m of free cash flow a year, which compares with free cash flow of £158m in 2015.

 

Management plans to use these extra funds to invest in the business and grow the dividend, which is forecast to provide investors with a handsome yield of 4.4 per cent this year, rising to 4.6 per cent. Expectations of dividend growth are also underpinned by solid cover, which is expected to remain above two times in coming years.

Resolving the pension deficit could also trigger the long-awaited break-up of the company. While some investors say the group's diversified portfolio leaves it better protected than many industrial peers, others complain that Smiths' disparate collection of companies enjoy scant synergies. The latter sentiment prompted previous chief executive Philip Bowman to explore ways to offload some units but the pension mess and other issues such as asbestos liabilities thwarted those attempts.

With the pension issue cleared, new boss Andrew Reynolds Smith may re-evaluate the potential to sell some assets. He is expected to update investors on strategy during the first half of next year. Having previously held a number of senior positions at GKN (GKN), the new chief's engineering background should also help to drive improvements across the business.

Better trading in the three months to November, together with renewed hope that some of the core businesses are finally turning a corner, could assist with these efforts. The medical arm, which accounted for 29 per cent of last year's sales and 30 per cent of profit, is expected to benefit from investments made in new product launches. Meanwhile, the detection unit, which makes high-tech radars and accounted for 16 per cent of sales and 10 per cent of profit last year, is expected to benefit from more stringent regulatory standards for screening in the transportation industry. Tightening security standards in a world of growing terrorist threats should provide a boost, too - shares in Smiths immediately jumped following the Paris attacks.

Unfortunately, the same can't be said for the group's most profitable business, John Crane, which accounted for 31 per cent of last year's revenue and 41 per cent of profit. The business's seals to extract and transport oil and gas safely at extreme pressures have been in short demand since the value of brent crude tumbled. After-market work is showing some resilience, though, and this accounts for more than half of divisional revenue. What's more, management has introduced a cost-saving programme. The £33m savings made so far have helped to keep operating margins steady and, with more to come, could contribute towards positive earnings momentum over the next few years.

SMITHS (SMIN)
ORD PRICE:930pMARKET VALUE:£3.8bn
TOUCH:929-930p12-MONTH HIGH:1,243pLOW: 917p
FORWARD DIVIDEND YIELD:4.5%FORWARD PE RATIO:10
NET ASSET VALUE:359p*NET DEBT:57%

Year to 31 JulTurnover (£bn)Pre-tax profit (£m)**Earnings per share (p)**Dividend per share (p)
20133.1143592.739.5
20142.9530281.740.3
20152.9032586.141.0
2016**2.8935382.641.8
2017**2.9843290.742.7
% change+3+22+10+2

Normal market size: 2,000

Matched bargain trading

Beta: 1.10

*Includes intangible assets of £1.5bn, or 384p a share

**JPMorgan Cazenove forecasts, adjusted PTP and EPS figures