Conglomerates have a reputation for lumbering forward. The chief task of Smiths Group has been proving that anaemic revenue growth is a thing of the past and half-year trading figures have added weight to the argument that the FTSE 100 engineer has turned a corner. Organic revenue growth of 13.5 per cent was ahead of the medium-term target of between 4 per cent and 6 per cent. Guidance for this year has been raised again to at least 8 per cent.
True, some of that top-line growth reflects easier comparators. Take the detection business, which makes sensors used in airport security scanners and which benefited from a recovery in air travel. Or John Crane, which makes parts used by the energy industry, a sector booming on the back of soaring commodities prices.
But Smiths has helped itself, too. About two percentage points of the group’s organic growth came from new product launches in the latest six months. That alone would outstrip the growth it managed to turn out at the top level in seven of the ten years leading up to 2020. Then there is the move to side-step into adjacent markets, such as pushing John Crane into hydrogen and carbon capture, or Smiths Detection’s foray into parcel delivery. The sale of its poor-fitting medical division, which was completed at the start of last year, removed another drag on revenue growth.
There is plenty of room for bolt-on deals. Net debt stood at £429 million at the end of January, representing only 0.8 times adjusted profits before taxes and other charges. That is a way below a target ceiling multiple of two. Not that there are plans to lever-up substantially in light of a darker economic backdrop.
Yet investors have been reluctant to award the conglomerate a higher price. The shares are stuck trading at almost 18 times forward earnings, a touch lower than the pre-pandemic level and scarcely higher than the average since the sale of its medical division was announced just over 18 months ago. That also represents a discount to engineering peers such as Halma or Spirax-Sarco Engineering, both of which are valued at earnings multiples of more than 20.
An element of recessionary risk is one factor holding the shares back. Its Flex-Tek business could be particularly exposed. The division, which provides components that heat and move fluids and gases, generates roughly 65 per cent of its sales from the North American construction industry. That translates to roughly £257 million, or 17 per cent of the group total. Demand from the construction sector has started to slow since the end of January.
The next job for Paul Keel, the Smiths boss, is providing more tangible proof that the group can push margins closer towards the company’s target. That could convince the market to award the group a price. The operating margin still lingers below a target of between 18 per cent and 20 per cent that it hopes to hit over the next three to five years, at 16.1 per cent over the latest six months.
The interconnect division, which provides parts for signal transmission and electrical connection, and the detection businesses are the outliers, recording margins of 16.6 per cent and 10.5 per cent, respectively, over the first half of the year. A further recovery in flying this year should help sales volumes to recover for the latter. Cost inflation has already been offset by higher prices.
Selling more equipment than aftermarket services has been a weight on the margin during the first half. For John Crane alone, the gross margin is between two and two and a half times higher for aftermarket sales than the products the business makes. In the longer term, selling more kit produces a greater pool of potential service business to sweep up later.
If Smiths shows that it can repeat the same progress made in the top line in the margin and its cash conversion, the shares could break free of their discount.
ADVICE Buy
WHY Shares look too cheap given sales growth progress
JD Wetherspoon
JD Wetherspoon is in greater need than most of inflation pulling back. The budget pub chain’s low-margin, high-volume business model has left it acutely exposed to the double hit of higher energy and wage costs and lower customer numbers.
Being cheap is the chain’s chief selling point, so it has to proceed more cautiously than its peers in putting up prices. Yet the group’s valuation leaves little room for error. Even based upon forecasts for the next financial year, the shares trade at almost 28 times forward earnings, a premium to the long-running average.
This financial year is the first fully free of pandemic restrictions. Analysts have forecast an operating profit of £96.5 million for this year, against one of £25.7 million last year, as sales volumes recover, even if that is still below a 2019 level of £132 million.
How achievable is the consensus profit forecast for this year? Over the first six months of this year, operating profit was only £37.4 million. As Jefferies points out, hitting expectations would require a sizeable improvement in the operating margin to just over 6 per cent over the second half of the financial year, compared with 4.1 per cent in the first six months.
Trading figures in recent weeks are a tentative indication that the group might be able to convince customers to swallow higher prices without suffering a collapse in sales volumes. Like-for-like sales over the past seven weeks were 9.1 per cent higher than in the same period before the pandemic, an acceleration on the 5 per cent increase over the first six weeks of the year. But that is a short measure of performance. The return of more workers to towns and city centres since the latter part of last year and the busier warmer months will help sales. Energy costs are fixed until the end of October, at which point falling wholesale prices could limit the impact of any increase in bills. Nevertheless, the cost of living caveats remain, which the shares’ pricey valuation takes little account of.
ADVICE Avoid
WHY The shares’ valuation looks too optimistic
