Smiths focused on organic growth

Shares in Smiths Group (SMIN) have been in uptrend for the past 12 months and the market reacted positively to interim figures that trumped consensus, and prompted management to increase full-year guidance to at least 8 per cent organic revenue growth, with “moderate margin improvement”.

All four business units drove revenues through the first half, with accelerated growth on the back of product development and commercialisation initiatives, such as Smith Detection’s next-generation smart tray return system and Flex-Tek’s novel flexible air management system. Progress has largely been “in-house”, so management stressed the importance of the 13.5 per cent organic growth rate in revenue, together with an identical increase in the research and development budget. And leaving aside non-recurring items or items considered non-operational in nature, headline operating profits grew by 27.4 per cent, while return-on-capital-employed ticked up by 120 basis points to 15.2 per cent.

It’s worth noting that the organic growth is split evenly between price and volume effects, the latter obviously a pointer to market gains. All the group’s major end markets were in positive territory. Revenue at “general industrial”, which accounts for 42 per cent of the group total, increased by 15.4 per cent, driven by John Crane’s products in sectors such as life sciences, pulp & paper and chemical processing, while Flex-Tek’s construction products were also in strong demand. Admittedly, US construction markets have started to slow, but activity in the civil aviation industry is steadily building after several years of disruption.

Goldman Sachs recently initiated coverage, concluding that the group is “entering a new growth phase, following fundamental changes in the group’s leadership, strategy, and portfolio”. The interim figures appear to bear this out, but It’s possible that supply chain difficulties could hinder margin expansion through the remainder of this year. The group, therefore, has bolstered inventories to reduce any chance of disruption and ensure that production can readily meet the order backlog. The move effectively constrained the cash conversion rate, but it is part of an overall effort to drive organic growth and aftermarket volumes.

JPMorgan Cazenove gives adjusted EPS of 90.3p for 2023, rising to 94.7p in the following year.  

Smiths entered the second half with a strengthening order book and improved prospects at John Crane and Detection. Net debt, at 0.8 times cash profits, is more than manageable, providing management with “optionality” on the M&A front, although the focus is squarely on organic growth at this stage. A forward rating of 19 times adjusted earnings places the group mid table in terms of peer rankings. But we think the Goldman Sachs' appraisal is accurate, so the asking price isn’t unrealistic. Buy.

Last IC View: Buy, 1,495p, 26 Sep 2022