Smiths Group (LSE: SMIN) led the FTSE 100 by midday Tuesday, on a day when most stocks in the top index were losing ground. Shares in the engineering group, bucking the trend, gained 4% as the biggest morning winner.
Smiths has traditionally been involved in a number of engineering sectors. That includes aerospace, defence, and medical equipment. The company has now confirmed the sale of Smiths Medical to ICU Medical, Inc. The division had been up for sale for a while, with a previous deal with TA Associates on the cards.
Then on 8 September, Smiths announced a new agreement with ICU that would realise greater value. The company put the net value at $2.4bn, approximately $0.4bn higher than the TA transaction.
The confirmation came on the same day Smiths released full-year results, headlined “Stronger H2 performance; good momentum“.
Underlying revenue fell 2% for the year, but it’s turning around. The second half came in flat, while the company recorded revenue growth in the final quarter. But even if revenue growth was not sparkling, Smiths’ conversion of it into profit looks good.
Operating profit gained 7%, with operating margin improving by 1.4 percentage points. At a time when a lot of FTSE 100 firms are suffering margin squeezes, that’s a welcome change. First-half underlying EPS increased by 8%, and the board has lifted the full-year dividend by the same proportion to 26p per share.
On the current Smiths share price, the dividend yield comes in at 1.8%. That’s a modest yield, but it’s covered more than 3.5 times by earnings. I’d much rather see a modest-but-well-covered dividend from a company with strong cash flow than a big yield from a firm under intense balance sheet pressure.
On the cash front, Smiths recorded free cash flow of £383m, an increase of 40%. Net debt stood at £1,018m at 31 July. That’s a net-debt-to-EBITDA multiple of 1.6x (even including one-off restructuring costs). For a £5.6bn company with annual revenue of £2.4bn, that’s good enough for me.
Lagging the FTSE 100
Why do I rate Smiths as an overlooked FTSE 100 stock? Well, I previously had the company pegged as one to watch in September. It seemed at the time that investors weren’t too please by the upcoming Medical division sale. The Smiths share price has dipped below the FTSE 100 over the past six months. And it’s still down 18% since pandemic week in February 2020. Perhaps it’s got something to do with valuation.
On depressed 2020 earnings, the stock had been looking a bit hotly valued in terms of its P/E ratio. Even on pre-pandemic 2019 earnings, the current Smiths share price suggests a multiple of above 20. But on the underlying earnings the company has just delivered, we’re looking at a P/E of only around 15 now.
Outlook vs risks
The company reckons it has good order book momentum, and it expects revenue to return to pre-Covid levels during the current year. With improved operational efficiency too, the current valuation looks good to me.
There’s a downside, though. In the UK we’re facing increasing supply chain problems. And our economy still looks a bit fragile, with inflation set to climb above 4%. Those uncertainties, I fear, might keep Smiths Group overlooked for a while longer. I’d buy today.
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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.