The industrial conglomerate Smiths Group has been suffering from a credibility problem. The drawn-out disposal of its misfit medical business helped claw some back, but management’s ability to grow the top line is less convincing.
Over the past five years the shares have gone sideways and underperformed the FTSE 100 index by a wide mark. Compare Smiths’ performance to UK-listed peers and the group’s deficiency is more stark. Over the same timeframe, the shares have delivered a total return of just under 4 per cent, versus 180 per cent and 159 per cent generated by FTSE peers Spirax Sarco and Halma. It also trails that of smaller industrial specialists like IMI and Spectris.
Weak and inconsistent organic growth means Smiths, which makes everything from airport scanning devices to mechanical seals used in energy systems, has been punished with a lower valuation. Even with the cash generated from the sale of its medical business, the group’s enterprise value of 11 times earnings before interest, taxes, depreciation and amortisation (ebitda) trails Halma and Spirax Sarco.
Consistently hitting an organic revenue growth target of 4-6 per cent would earn Smiths more credit. Offloading the medical device business, announced less than three months after the chief executive Paul Keel took the helm, should lift revenue and profits. And it has given the balance sheet a boost, with a net cash position of £262 million far superior to a crisis-time target leverage ratio of just under one.
After returning around $1 billion to shareholders via a share buyback programme, the sale still leaves the group with plenty of cash to plough into product launches and bolt-on deals within higher growth markets. Completed deals include the $107 million acquisition of Royal Metals, a maker of heating, ventilation and air conditioning products, and spending on research and development has been increased by 8 per cent.
Over the first half of the year, organic revenue improved by 3.4 per cent, but that was against a prior year when revenue fell 5 per cent. Guidance for the full year, which will also incorporate a tougher baseline for the second half, is for 3 per cent organic. Investor patience is likely to be thin: Smiths has had several false starts. A patchier performance from some divisions means calls from investors to break up its sprawling operations further might emerge. In fact, it seems ripe for intervention.
The lower margin detection business, which accounts for just over a quarter of group revenue, could be a candidate. It gains around 60 per cent of revenue from the aviation sector, so the collapse in the market during the pandemic caused revenue here to shrink. But a poor performance from this business pre-dates coronavirus, with underlying revenue shrinking 2 per cent during 2019 and growing only 1 per cent in 2018. During the past decade, that business has only recorded underlying annual revenue growth above 1 per cent in four years.
Inflation is a natural challenge; so too are potential component shortages. Thus far, Smiths has managed both. During the first half Smiths recovered cost increases, partially through putting up prices. That meant the underlying operating margin improved to 15.9 per cent, from 14.4 per cent the year before and against a longer-term target of between 18 and 20 per cent.
Conglomerates often attract discounts but Smiths has hardly endeared itself to investors by repeatedly delivering anaemic organic growth. It hardly inspires confidence in management’s ability to sustainably squeeze more revenue from the same four core businesses.
ADVICE Avoid
WHY The shares are not cheap by historical standards and a track record of inconsistent top line growth doesn’t inspire confidence
Chesnara
Rumbling equity markets have a curious impact on insurers such as Chesnara. Falling markets might dampen cash generation but can boost the Solvency II position as less capital is required to be held against assets that are lower in value.
Even if volatility persists, the group’s ability to meet shareholder expectations for another dividend increase this year looks secure enough. As well as the punishment that might be meted out to the shares if the payout is not raised, existing cash reserves, cash generation and the regulatory capital position are the main things management considers when setting the dividend.
The state of play looks good for Chesnara, which buys up closed books of insurance policies, on all counts. Cash generation from the underlying business was roughly double what it was the previous year at £53 million, equivalent to 156 per cent of the cost of the dividend. At 152 per cent, the Solvency II ratio is also well within the target range of 140 to 160 per cent.
You can see why Chesnara has become popular with income investors. Another 3 per cent boost to the dividend for last year to 22.6p represents a dividend yield of 7.5 per cent at the current share price, and yet the shares still trade at a 28 per cent discount to the insurer’s economic value at the end of last year, even though that gap has narrowed in recent months. Panmure Gordon, the broker. forecasts a payment of 23.3p for this year.
Completing more M&A deals is vital for the longer-term sustainability of the dividend. Insurers running closed books have to work hard to keep churning out cash. Those books throw off cash as policies mature and capital held by the insurer against said policies unwinds.
After issuing more debt this year, part of which was used to fund the acquisitions of Sanlam Life & Pensions and Robein Leven, the insurer has internal resources to fund a deal of £100 million-plus, according to Steve Murray, chief executive. Opportunities have already presented themselves, he says, even this early on in the year.
ADVICE Buy
WHY Reliable and generous dividend for income investors
