Profit warning detected at Smiths

A mix of cost overruns and legal disputes forced a profit warning out of engineering conglomerate Smiths Group (SMIN) earlier this month. Problems with three contracts won by the detection division's ports and borders business in 2008 and 2009 will leave underlying operating profit up to £15m short of current consensus forecasts of £575m.

That issues arose is no surprise. In May, Smiths cited the impact of government spending plans and airport infrastructure programmes on the timing of certain contracts. These hold-ups would cause a dip in second-half sales at the detection side, which makes X-ray machines and chemical detectors. It also admitted that "under-recovery of overheads" at new manufacturing sites would cap progress on margins. But now returns are likely to be way below the 13 per cent anticipated, and talk of slower-than-expected progress on cost-cutting suggests it will take time to remedy. However, Smiths has a broad portfolio of businesses producing mechanical seals, flexible hosing and medical devices, and little has changed there in the past two months. There has been little news on the sale of the medical business since the story broke in June, either. We may hear more when numbers for the year ended 31 July are published on 18 September, if not before.

RBC Capital Markets says…

Underperform. We consider Smiths shares to at least partly price in a break-up, which looks less likely following news of contract issues at the detection unit. We are not entirely confident that the issues are a one-off and have downgraded operating profits for the division to £65m this year and £75m in 2014 - down from £73m and £95m, respectively. As a result, we have lowered our target price to 1,150p. Given below-sector-average forecast earnings growth and significant pension and product liabilities, we consider a premium valuation unjustified. The shares might also suffer if Smiths keeps the medical side as break-up hopes would recede.

Investec Securities says…

Buy. Contract cost overruns are never good news - apart from the direct financial impact, they call into question a company's systems and conservatism. But the £15m hit for Smiths Detection looks like a one-off in a business that is now on an improving trend. It does not fundamentally change our view that this is a group containing high-quality operations, most of which are performing well against mixed market conditions. The impact on our valuation is offset by the sector re-rating, so we retain our 1,500p target and expect full-year underlying pre-tax profit of £489m, giving underlying EPS of 89.6p.