Smiths and the burden of regulation

Management spun the results as a “return to growth” but the market is more preoccupied with the sickly parts of the business. Hence, the shares were marked down as the troubled Smiths Medical division - which had already flagged a 2 per cent decline in underlying revenues for the year - posted a 4.4 percentage point decrease in the headline operating profit margin. That follows on from a sizeable contraction at the half-year mark, at which point we highlighted the difficulty in gauging the likely trajectory of margins at the division, particularly given the roll-out of new products (over 20 through the period) and hefty research and development (R&D) spending.

Ironically, in view of our possible non-deal exit from the EU, Smiths Medical finds itself in a related regulatory bind. Some of the division’s products have been suspended, albeit temporarily, from European markets as it has transitioned towards Notified Body for European Conformity registration. This process, along with commitments linked to the implementation of the new EU medical device regulation, will add £10m-£15m in costs in this financial year and next. Sensibly, in our estimation, management has continued to fund significant R&D expenditure as a proportion of sales – it’s playing the long game. As the regulatory burden eases and the new product lines gain traction, we believe the marginal profitability decline could reverse dramatically.

At least shareholders won’t have to worry unduly about the state of the balance sheet ahead of this reversal. Net debt fell by 7.7 per cent to £893m, equivalent to a manageable 1.4 times cash profits. Measures to de-risk the pension schemes have resulted in an improved surplus of £381m, while the cash position and ‘balance sheet optionality’ will benefit from a newly struck agreement to sell Smiths Medical’s sterile water business for $40m (£31m).