Smiths: faceless but reliable

Mention"Smiths" to the average Brit, and chances are he or she will think you're talking about the retailer WH Smith, - a company that's a sixth of the size of this Smiths. It's a pity the FTSE 100 engineering giant retains the indistinctive name of the Victorian watchmaker who founded it, as it has otherwise changed beyond recognition. Look past the faceless industrial façade, however, and newish chief executive Philip Bowman's plans for the group seem to be running like vintage Smiths clockwork.

The most striking illustration is the improvement in profitability since Mr Bowman unveiled a major efficiency drive in 2008. Take Smiths' most recent full-year results: excluding one-off charges, the group's profit margin widened by more than two percentage points to 17.8 per cent. This was particularly impressive as sales were only up 4 per cent. Profits increased even in those operating divisions whose revenues shrank.

There should be more gains to come. Margins will rise with the economic tide due to the inexorable effects of operational gearing - where costs adjust more slowly than sales. And Mr Bowman plans to take a further £17m of annual costs out of the business this year, for a one-off hit of £9m. The group's operating margin could hit 20 per cent this year or next.

That would leave Smiths' stock-market rating - currently about 13 times 2010-11's forecast earnings - looking increasingly anomalous. It is lower than the average rating for all engineering stocks, yet the group is now as high-tech and profitable as Halma and Spirax-Sarco, whose shares trade at a premium.

That reflects its conglomerate status, and dividends have been stagnant for four years as Smiths has fought to reform itself. But dividend cover has now returned to just shy of the stated target of 2.5 times earnings, and in September the board said it intended to adopt a "progressive dividend policy for future payouts". A re-rating could well follow.

True, Smiths remains a conglomerate, with little logic behind its diverse divisions. The current group was created a decade ago in the merger of two engineering behemoths, Smiths Industries and TI Group, the idea being to build a leader in aerospace. But the aerospace division was sold to General Electric (GE) of the US in 2007, leaving a shell of five once-peripheral businesses.

Yet there are two reasons why the conglomerate structure doesn't look as bad as it used to. First, the GE deal led to intense speculation that the whole group would be broken up, particularly as Mr Bowman subsequently arrived having sold the drinks conglomerate Allied Domecq for more than had seemed likely. The idea that cash would be returned to shareholders - as £2.1bn was after the sale to GE - pushed the shares to well over 20 times forward earnings in the dying days of the bull market. They have been substantially de-rated since. But once the turnaround is complete, the recovery underway and valuations higher, Mr Bowman's taste for deals may return.

Second, Smiths' performance during the latest recession reads like a case study for the benefits of diversification. Sales for 2009-10 fell across the three divisions that serve industrial markets: John Crane (mechanical seals for oil and gas), Interconnect (signalling technology for aerospace) and Flex-Tek (tubing for construction). But flat revenues in the medical business - the group's cash cow - and 13 per cent growth in the detection division, which makes the kind of security devices you see in airports, meant group sales were up.

Of course, the recovery will be equally patchy. Smiths won't benefit from the racy upgrades that have propelled industrial-machinery stocks to such heights this year - not least because it has nothing like the same exposure to emerging markets. A November trading update suggested the first half of this year will be a rough image of last year: healthy growth in the industrial divisions offset by weakness in detection and medical.