Ever since Tom Peters and Robert Waterman coined the phrase “stick to the knitting” (meaning focus on what you know best) in their seminal 1982 book In Search of Excellence, conglomerates have steadily been dismantled. Non-core assets have been sold, with the proceeds re-invested into areas in which firms possess key skills and defendable positions. So it is a bit of a surprise to come across a firm like this. Not only is it a diversified engineering business, but it’s also growing rapidly, in good financial shape and a member of the FTSE 100.
Smiths Group (SMIN, 917p), tipped as a BUY by The Independent and The Daily Telegraph
Smiths has four divisions – aerospace, detection, medical and speciality engineering – all with leading technologies in their respective markets. This was borne out by last week’s full-year results. Sales at £3.5bn rose by 17%. Profit margins before interest payments and tax (EBIT) improved to 14.7% with earnings per share up 23% to 64.8p, putting the shares on a 2005/2006 p/e of 14.
The figures could have been better had research and development costs not risen 35% to drive future expansion. The dividend was also raised to 31.4p, marking 36 years of consecutive growth and offering an attractive yield of 3.4%.The outlook from CEO Keith Butler-Wheelhouse was encouraging. “From a sales standpoint, the markets we serve are very robust. In addition, we’ll see margin improvement again in the coming year, supported by the continuous move to low-cost countries.”
With this type of track record and quality of earnings, I would not be surprised if some of the larger private-equity funds were not already running the slide-rule over Smiths. I’ll explain why by looking at its sum-of-the-parts valuation.
Smiths Aerospace is the largest division, with sales of £1.3bn. It is a tier-one supplier to the world’s major aircraft and engine manufacturers, such as Boeing, Airbus and Rolls-Royce. Although exposed to the delayed Airbus A380, otherwise known as the superjumbo, Butler-Wheelhouse said that “this program will have minimal profit effect in the early years. On the other hand, the Boeing 787, which we’ve invested in heavily, has gone extremely well.”
And the outlook for the sector is buoyant. “For both military and commercial aircraft, we see continued strength at least through 2009.” With this level of earnings visibility, I think the unit is worth some £2.3bn, representing a 2005/2006 EBIT multiple of 15 times, which is in line with its peers.
Likewise, Smiths Detection is another long-term growth engine. It delivers
high-tech security solutions based on the identification of explosives, chemical and biological agents, illegal substances, weapons and contraband. Its products serve the border control, ports, military, airports and emergency response markets. Eighty-five per cent of turnover is Government-related. At 13 times EBIT, the division is worth around £1bn.
Although offering slightly lower growth rates, both the speciality engineering and medical units are also leaders in their fields. At 12 times EBIT, they are worth about £1.8bn and £1.6bn respectively.
So after subtracting £1bn of debt, I could see the cash-rich private-equity brigade targeting the stock at £10 a share, or a 10% plus premium to current levels. It also ignores any upside that might be created via synergies were Smiths to be privatised and be sold off piecemeal.
The main risks this year lie in higher raw-material costs and a possible devaluation in the US dollar. Nevertheless, Smiths is a top-notch company, offering patient investors potential double-digit returns over the longer term.