Qualiport

[ March 17, 2000 ]

Adding Value With Smiths

By James Carlisle (TMFJimmyC)

I've always had a soft spot for companies that make things. I find that they are easier to understand: you can see what they produce and you can see whether it does anyone any favours. The market hasn't had much time for manufacturing companies recently and they have been derated pretty much across the board. I think this provides some excellent buying opportunities, but the important thing, particularly for the Qualiport, is to find the quality companies.

In my opinion, one such company is Smiths Industries (LSE: SMIN). I'll start by revealing that I am, myself, a proud shareholder in this company. I seem to keep writing articles about companies that I have shares in. I'm sorry about this, but at least it shows that I'm genuinely writing about the companies which I like. Anyway, before I launch into the Qualiport criteria, I think it would be as well to provide a brief overview of Smiths' three operating divisions: aerospace, medical systems and industrial products.

In the year to July 1999, Aerospace contributed about 40% each of total group operating profit (£248m) and sales (£1,324m). It supplies a wide range of electronic equipment to the civil and defence aerospace industry. Production rates for civil jets reached an all time high last year and this is thought to be the top of the current cycle. However, systems for new-build civil aircraft represent only 20% of divisional sales and this is therefore not a major threat. The defence sub-division is about three times the size of the civil original equipment business and, according to the recent interim results announcement, sales here are "ramping up strongly". A slightly unfortunate choice of words, but encouraging nonetheless. This is particularly so, since much of this business has secure long term order books. On top of this, much of the defence business includes ongoing revenues from maintenance and service contracts.

Smiths Industries Medical Systems (28% of sales and 31% of profit in 1998/9, with operating margins of 20%) is an excellent business. Over the last few years, growth in this division had slowed to due to "changing purchasing practices in the US, the strength of sterling and economic conditions in the Far East". However, in 1999 the division made a strong recovery. In the six months to January 2000, sales and profits were up by 15% and 16% respectively. The products in this division fall into two broad categories.

The first of these is single use products for "anaesthesia and critical and respiratory care". The beauty of these products is that they have a very low cost relative to the importance of the job that they do. This provides the all-important pricing power (evidenced by the strong margins). The single use nature of the products provides a steady flow of sales.

The second product category is "infusion therapy and vital signs monitoring equipment". An example of this is the Level 1 blood and I.V. fluid warming devices. These provide a steady flow of warm fluids to a patient and can significantly reduce the effects of hypothermia. The cost savings of this (not to mention the obvious and direct benefits to the patients) are very high in relation to the cost of the equipment and, again, there is a nice source of repetitive business, because a new set of tubes are required for each new patient.

Industrial Products (32% and 29% respectively of 1998/9 sales and profits, with operating margins of 17%) also breaks down into two broad categories: "interconnect products" and "air movement systems".

The interconnect products business (which accounts for about 40% of the division) makes equipment that "connects and protects vital electrical and electronic circuits against hazards encountered in extreme conditions or where failure could be catastrophic". Again, we find that the cost of the products is small compared to the importance of the jobs they are intended to do, providing a degree of price protection. The main applications for these products are in aerospace and defence, telecoms and IT, rail transport, process plant, medical and industrial equipment. The telecoms sector in particular provides some excellent growth opportunities, with Smiths supplying a range of products which keep cellular telephone base stations running reliably. The company has recently been making acquisitions to build up this area and, with the anticipated investment in the third generation mobile phone networks in this country, apart from anywhere else, prospects here are excellent.

The air movement business (making up about 60% of the division) comprises a range of air conditioning units, fans and blowers ranging from one metre wide fume extractors to small dc motors to cool disc drives in computers. The most famous brand would be Vent-Axia. Some areas of this business undoubtedly have growth characteristics. For instance, many more houses around the world are these days being built with air conditioning. However, I've never been very happy with this division. It looks pretty capital intensive to me and I think the added value is fairly low. The performance ticks along OK, but I would far rather the company sold this sub-division off.

So, on the whole, the products that Smiths produces tend to exhibit a degree of pricing protection and repeat sales. The big question is, though, how well does all this translate into the Qualiport criteria?

1. A well-managed company

Smiths Industries was put on the map by Sir Roger Hurn who left the company in 1996. It is fair to say that he has an enormous reputation and he is now Chairman of Marconi (LSE: MNI), Deputy Chairman of Glaxo Wellcome (LSE: GLXO) and Chairman designate of Prudential (LSE: PRU). Although not strictly relevant, I mention all this for two reasons. Firstly, to a large extent, he has made Smiths what it is today by making the decisions to buy the companies which now make up the business. More important than this, though, is that he selected the new Chief Executive Keith Butler-Wheelhouse to take his place. With the greatest possible respect to Mr Butler-Wheelhouse, the greatest single thing that I can find to recommend him is that he was chosen by Roger Hurn. This is what has always made me comfortable with his appointment and, sure enough, since taking over he has not put a foot wrong. His previous career had him in charge of Saab Automobile and, before that, head of the Delta Motor Corporation in South Africa.

2. Strong, and ideally increasing, margins

Well, I'm pleased to say that it's pretty much full points here. The group operating margin over the last five years has improved from 15.7% in 1994/5, to 16.7% in 1995/6, 18.1% in 1996/7, 18.7% in 1997/8 and 18.7% in 1998/9. In the six months to 2000, margins were 17.4%, but then they were 17.0% in the first half of 1998/9 and still ended at 18.7% for the year. I must confess that I don't know where this apparent seasonality comes from. Anyway, margins over the five years have been strong and show a positive trend.

3. Strong brand name and competitive advantage

This is a slightly tricky one to tie down because few of us knowingly use Smiths products. We therefore have to rely on reports of brand strength from within the industries that the company supplies to. In defence, for instance, the US Department of Defense is very careful about who it lets in on many of its projects. The fact that Smiths has a presence on many of these indicates strong brand support and also barriers to entry. The company also has very large market shares in much of the electronics that controls Boeing and Airbus aircraft. These are the sort of collaborative projects which it is very difficult for newcomers to break into.

In medical systems, the accounts emphatically state that its single use products are "premium products for which medical specialists express a strong brand preference". Looking at the 20% margins of this division, I don't doubt it. It is also fairly easy to imagine doctors getting attached to a particular brand of wound drainage catheter. I'm being serious! With this sort of thing, you're likely to be happy with what you know. This comes down to the low price of the product compared with the importance of the job that it is doing. How much you pay for the product is not the decisive factor in buying it. It comes down to being confident that the product will work.

This is also a vital factor in the interconnect business. When you are buying equipment which "protects vital electrical and electronic circuits against hazards encountered in extreme conditions or where failure could be catastrophic", price is not the first thing on your mind. If you are happy with a product and confident in its ability to do its job, then you'll pay extra for it. The evidence is that there are many people happy with Smiths' products and happy to pay premium prices for them.

4. A company which you understand and which has predictable earnings

Well, I don't really know what makes good aircraft actuators, or cellular mobile base station interconnect equipment, but I don't think that's the point. Anyway, I have to say I've never agreed with this approach. I genuinely understand the products of very few businesses. What is important is that you can understand the utility that a company's products has for its customers. I couldn't make a pizza, but I know a nice one. The utility of Smiths' products is perfectly easy to understand. The predictability comes from the order book, and maintenance and service contracts in the aerospace division and the repeat sales of the medical systems business. The forward sales of the industrial business are less easy to predict. However, the prospects here, especially with the building up of the telecoms business, are good.

5. A company with a proven past growth record

Under Sir Roger Hurn, Smiths was something of a stock market darling. I'm afraid I can't find any direct evidence of this but, if memory serves me right, growth throughout this period was around 15% per annum. The five year summary included in the 1998/9 accounts shows pre-exceptional earnings per share growth of 19.2% for the year to July 1996, followed by 16.1%, 13.4% and 8.9% to July 1999. This is an annualised growth rate of 14.4%. Not bad at all, even if the trend has been falling. The climate over the last few years has not been friendly to UK engineers and I would say that this performance actually demonstrates quite a lot of resilience.

6, 7 and 8. Minimal working capital, high return on equity and strong cash generation

The company's accounts show that on average, over the last 5 years, every £1 of sales has generated about 18p in operating profit, about 19p in operating cash flow and about 10p in free cash flow. The same £1 of sales is supported by about 28p in working capital and 88p in "shareholder investment".

Those profit and cash margins are strong, consistent and demonstrate a high level of conversion of profit into cash. Free cash flow per share of 37.5p gives each share, at a price of 804p, a "free cash flow yield" of 4.7%. I'd say that that was pretty juicy. Net debt has recently risen to about £250m following several acquisitions. However, the interest is covered about 12 times by operating profit and 6 times by free cash flow.

The one problem with these figures are the figures for working capital and "shareholder investment". This can be a problem with manufacturing businesses. However, I think it only really becomes a problem when the cash margins are poor. If Smiths increases sales by £1, then it generates a further 18p of operating cash, this year, next year and onwards and to support this extra £1 in sales, there is a one off absorption of 28p to working capital and 88p to "shareholder investment" (a figure provided in the accounts as a proxy for shareholders equity). This high figure for shareholder investment is the major problem and this has kept the pre-tax return on this shareholder investment figure at only 20% or so for the last five years (although the trend has been upwards from around 18% to 22%). 20% is OK, but far from brilliant.

I do, however, have a problem with their calculation of shareholder investment as it includes a great deal of purchased goodwill. This has averaged around 70% of the shareholder investment figure and therefore makes a huge difference to return on equity. Purchased goodwill is being written off over 20 years, according to accounting standards. However, I would say that this should be written off over the average asset life of the assets in the businesses acquired (about ten years for Smiths' existing businesses). After all, it is after this point that the purchased assets are entirely replaced by replacement capital expenditure and the equity therefore no longer contains this goodwill element. In my opinion, a different treatment of this figure would boost return on equity towards 30%. Unfortunately, there isn't sufficient information to do the sums accurately.

9. Identifiable future growth prospects

I expect this to come partly organically and partly through acquisitions funded by cash. The most obvious area for growth is the telecoms interconnect business and this is the area that the company is aiming to build up. In addition to this, the defence business is apparently "ramping up strongly" and the medical systems business is making a strong recovery after a quiet phase. There are plenty of growth opportunities here in the developed and developing world. It is certainly hard to see expenditure on medical equipment falling.

Consensus broker's forecasts are for 10.4% this year (to July 2000) and 9.9% next year. I would say that the forecast for this year is fair. However, the company has stated that it expects the recent acquisitions (£250m spent so far this year) will be contributing more than their funding costs before the year end. On this basis, I would say that 9.9% growth for the year to July 2001 may well come in too low.

Personally, I would say that 10% is a conservative growth rate for the foreseeable future, 12% would be fair and 15% optimistic.

10. A company which is attractively valued

At 804p, Smiths is on a historic price to earnings (P/E) ratio of 15.3. On the consensus forecasts, this falls to 13.9 this year and 12.6 next. Again at 804p, the historic yield is 2.7%, the yield to July this year would be 3.0% and to July 2001, it would be 3.3%.

I would say that this is an attractive valuation for a company with reasonably predictable growth in the 10% to 15% range. If we assume that the share's dividend yield of 2.7% remains the same, then we only need the dividend to grow by an average of 12.3% per annum to deliver the Qualiport's targeted 15% long term growth rate. The combination of Smiths Industries' excellent track record and prospects makes this look very achievable.

So, Fools, sorry if that was a bit long-winded: thanks for bearing with me to the end, anyway. The big question is, does Smiths have the necessary qualities to improve (or, perhaps, complement -- for it is still early doors) the Qualiport's performance? We're waiting to hear from you over on the Qualiport message board.

Related Links

• Smiths Industries Website

Note
The Qualiport was launched on December 19th 1997 with an initial investment of £4040.63, all in Rentokil Initial. Further cash was added as holdings in Emap, Marks & Spencer and Unilever were bought during 1998. The vagaries of the value per share accounting method caused percentage return calculations for calendar 1998 to be somewhat distorted. To avoid confusion and somewhat misleading figures, the Qualiport's returns are being measured from 1/1/99, at which point the total portfolio value, including cash, stood at £16,809.60. An additional £2000 cash is added to the portfolio on April 1st and October 1st each year. The total cash investment in the portfolio to date has been £20,184.62. To access the Qualiport's total trade history, click here.