Smiths Group (SMIN) looks ripe for a break-up. We've said so before, but the recession and a big deficit in its pension funds kept things quiet. Now that Invensys and others have shown these needn't be an obstacle, interest is swirling again. The fundamentals are attractive, too. So, even after a good run, shares in Smiths are worth buying.
- Break-up potential
- Pension issues solvable
- Possible earnings beat at medical
- Further cost savings to come
- Uncertainty over US government spending
- US medical devices tax
Chief executive Philip Bowman admits Smiths is an eclectic mix. Yes, each division is profitable and diverse enough to lessen the chances of a share price shock, but, be in no doubt, Mr Bowman will sell at the right price. Pension issues scuppered the £2.45bn sale of the medical division two years ago, but, as Invensys showed last month, a pension-fund deficit no longer acts as a 'poison pill' to deter bidders.
By the end of July, low interest rates had tripled Smiths' pension deficit to £620m. But analysts at Deutsche Bank reckon Smiths may only have to stick an extra £370m into the pension fund to secure a sale of the medical division - hardly a deal-breaker. What's more, a rise in bond yields of a percentage point or so could wipe out the deficit, according to Nomura. A government review of pension fund accounting methods might even do the job.
Granted, selling the medical division, or the other big profit generator, John Crane, which supplies mechanical seals and bearings to oil companies, would still take some work. But Smiths could easily offload a smaller division. "Flex-Tek is an absolute gem and could be sold without ruffling any feathers," says Sandy Morris, an analyst at broker Jefferies.
Away from the talk of break-up, there is a strong investment case for Smiths anyway."I'd sooner bat off the fundamentals than the easy-come, easy-go furore that's accompanied the Invensys deal," says Mr Morris. And it's easy to see why.
Management kept forecasts for 2012-13 unchanged after underlying revenue grew in all divisions during the three months to October, and underlying operating profit rose everywhere except medical, held back by higher sales and marketing spend. Aerospace and US housing work mean Flex-Tek, which supplies hoses, should continue to do well and orders for x-ray machines and other kit are flooding in at the detection division.
SMITHS GROUP (SMIN) | ||||
|---|---|---|---|---|
| ORD PRICE: | 1,205p | MARKET VALUE: | £4.74bn | |
| TOUCH: | 1,204-1,205p | 12-MONTH HIGH: | 1,232p | LOW: 925p |
| DIVIDEND YIELD: | 3.1% | PE RATIO: | 13 | |
| NET ASSET VALUE: | 248p | NET DEBT: | 81% | |
| Year to 31 Jul | Turnover (£bn) | Pre-tax profit (£m) | Earnings per share (p) | Dividend per share (p) |
|---|---|---|---|---|
| 2009 | 2.66 | 371 | 70.8 | 34.0 |
| 2010 | 2.77 | 373 | 75.3 | 34.0 |
| 2011 | 2.84 | 398 | 77.8 | 36.3 |
| 2012 | 3.03 | 366 | 65.4 | 38.0 |
| 2013* | 3.12 | 425 | 93.7 | 37.8 |
| % change | +3 | +16 | – | -1 |
Normal market size: 2,000 Matched bargain trading Beta: 1.0 *Deutsche Bank forecasts (earnings are not comparable with historic figures) | ||||
Of course, cuts to US government spending pose a threat, especially to military clients of both the detection division and Interconnect, which supplies electronic components. The US public sector may contribute a fifth of Smiths' sales; include government customers elsewhere and it's more than a third. Still, it was over 50 per cent five years ago and, according to Deutsche Bank, a fresh set of financial targets and clarity on US government spending could push the share price way past 1,300p.
Expect Smiths' underlying operating profit margin to stay above 18 per cent this year, too, and keep rising thereafter. Big cost savings will help - £70m is in the bag already and detection will find another £40m by 2014. And price increases at the medical division should offset a 2.3 per cent tax on US medical devices introduced on 1 January. Moreover, US airports will soon need to upgrade security screening kit installed in a hurry after 9/11. True, that may be a couple of years out, but it gives Smiths time to get US approvals and test its new high-speed explosive detection system elsewhere. When the tenders are put out, Smiths should be in pole position.
