Business review
Group activities
Smiths is a global applied technology business serving detection, medical devices and specialty engineering markets.
Strategy
Smiths is committed to creating long-term value for shareholders by building and sustaining strong businesses in growth sectors.
The Group’s objective is to create value from organic growth and from reinvestment of self-generated cash-flow. Adjustments are made to the business mix through both acquisitions and disposals to enhance value for shareholders.
Changes in Group composition
In line with the strategy of enhancing value for shareholders, in May 2007 Smiths Aerospace and Times Microwave Systems Inc. (previously reported as part of Specialty Engineering) were sold to General Electric Company (GE). See elsewhere in this report for details of this disposal. These businesses are treated as discontinued and disclosed as such in the Consolidated income statement with comparative figures adjusted accordingly.
Details of other changes in Group composition in the year are set out in the relevant divisional paragraphs below.
Performance of continuing operations
The continuing operations comprise the Detection, Medical and Specialty Engineering divisions.
The key Smiths performance indicators, which are closely monitored throughout the year and measured against pre-set targets, are:
- sales and headline profits;
- cash generation; and
- return on investment.
The table below shows the overall performance of continuing operations.
|
|
2007 |
2006 |
Movement |
|
Sales |
2,161 |
2,180 |
(1)% |
|
Headline: |
|
|
|
|
– operating profit |
348 |
345 |
1% |
|
– pre-tax profit |
344 |
316 |
9% |
|
– earnings per share |
47.0p |
41.5p |
13% |
|
Cash generation |
75% |
82% |
|
|
Return on shareholders’ funds (More) |
14.9% |
|
|
Compared with sterling, the average exchange rate of the US dollar fell by 9% year-on-year and the average euro exchange rate fell by 1.5%.
Headline figures
Headline profit is presented because Smiths believes it provides valuable additional information on underlying trends. It is used by management to monitor the performance of the business. Normal restructuring costs are charged against headline profit, while the following items are excluded:
- exceptional items (including impairments);
- amortisation of intangible assets acquired in a business combination;
- profit or loss on disposal of businesses; and
- other financing gains and losses.
Sales
Sales were £2,161m, 1% lower than the £2,180m recorded in 2006.
The translation of sales of overseas business units at this year’s average exchange rates reduced sales by £120m. On an underlying basis excluding the effect of acquisitions and disposals (£9m) and currency translation, sales increased by 5%.
The United States remains the Group’s largest market. By destination, it accounted for 44% of sales while UK/Europe accounted for 31% and the rest of the world for 25%.
Details of sales by division are given on the divisional pages.
Profit
Headline operating profit increased by £3m to £348m. Headline operating margin increased to 16.1% (2006: 15.8%).
The net impact of acquisitions and disposals on headline operating profit was £1m. The effect of currency translation held back year-on-year headline profit growth by £21m. The growth excluding the effect of acquisitions, disposals and currency translation is 7%.
The operating profit of the continuing business on a statutory basis, after taking account of the items excluded from headline figures, is £257m (2006: loss of £8m).
Headline pre-tax profit increased by £28m to £344m. This was largely due to a £17m reduction in net interest charges and a £9m increase in the net finance credit from the pension schemes.
Profit before tax for continuing operations on a statutory basis is £256m (2006: loss of £37m).
Cash generation
Generation of above-average free cash-flow contributes to additional growth by providing resources for the growth of the business both organically and by acquisition. Performance is evaluated by measuring the ratio of operating cash-flow to headline operating profit. For this purpose, operating cash-flow is measured before the cash impact of exceptional items and special pension payments and after expenditure on property, equipment, software and development costs. Following sale of the aerospace business, a target conversion rate of approximately 90% was set for the remaining business in a normal year.
The operating cash-flow on this basis was £259m, representing 75% of headline operating profit. This compares to operating cash of £283m in 2006 and cash generation of 82%. The cash generation outcome this year reflects investment in capital projects and increased working capital to support business growth in the new year.
On a statutory basis, net cash inflow from continuing operations was £205m (2006: £139m).
Cash expenditure on exceptional items was £27m, compared with £17m in the previous year. The Group made special pension contributions of £56m (2006: £61m) mainly relating to Aerospace. Free cash-flow from continuing operations (after interest and tax but before acquisitions and dividends) was £101m.
Dividends paid in the year on ordinary shares amounted to £182m, compared with £167m in 2006. Details of the return of £2.1 billion to shareholders are set out in the aerospace disposal section.
Aerospace in total, net of the return of cash, contributed £337m cash inflow. During the year, the continuing Group spent £35m (2006: £54m) on acquisitions.
Earnings per share
Basic headline earnings per share from continuing activities were 47.0p (2006: 41.5p), a rise of 13%.
On a statutory basis, the basic earnings per share from continuing activities were 36.9p (2006: loss of 18.2p).
These measures are distorted this year by the effect of the share consolidation in June following the disposal of the aerospace business. The average number of shares in issue during the year was a reflection of the capital structure appropriate to both the continuing and the discontinued business.
Interest and other financing costs
For continuing operations, interest payable on debt, less interest on cash deposits, was £36m, compared with £53m in 2006. The £17m movement reflects the cash inflow following the aerospace sale. Net interest costs were 9.5 times covered by headline operating profits.
The Group accounts for pensions using IAS19. As required by this standard, a finance credit is recognised reflecting the expected return on pension scheme assets and a finance charge is recognised reflecting the unwinding of the discount on the future pension liability. The net financing income for continuing operations was £34m in 2007, compared with £25m in 2006.
Exceptional and other items relating to continuing activities excluded from headline profits
These items were £88m, compared with £353m in 2006. These comprised:
- £9m for integration costs associated with the Medex acquisition (2006: £19m);
- Impairment of goodwill and other assets (£10m) principally in respect of the automotive seals business and a loss on disposal of businesses of £5m (2006: profit of £18m);
- £13m in respect of costs written off following the decision not to proceed with the detection joint venture with GE;
- £43m proceeds from insurance commutation (see litigation elsewhere in this report);
- £101m provision for John Crane litigation costs and net £3m provision for other litigation (see litigation elsewhere in this report);
- A profit of £24m in respect of TI Automotive shares;
- Amortisation of intangible assets acquired in business combinations of £15m (2006: £13m). The amortisation relates principally to technology and customer relationships. Amortisation of intangible assets acquired in business combinations of £15m (2006: £13m). the amortisation relates principally to technology and customer relationships.
Exceptional items in 2006 included £325m in respect of the write down of TI Automotive shares and £12m for the settlement of a product liability class action.
Financing gains amounted to £1m (2006: loss of £2.3m). These represent the results of derivatives and other financing instruments which are not hedge accounted under IFRS. Of this sum, £1.5m (2006: £1.8m) was charged to operating profit.
Net debt
Net debt at year end was £588m, down from £923m at the start. Contributing to the net debt reduction were the Aerospace disposal and the related return of cash.
Research and development
Investment in research and development (R&D) drives future performance and is a measure of the Group’s commitment to the future organic growth of the business.
Smiths invested a total of £79m in R&D on continuing operations, equivalent to 4% of sales. Of that total, £8m was funded by customers. The comparative figures for the continuing activities in 2006 were £80m and £12m. Under IFRS, certain of these development costs are capitalised. The gross capitalisation is shown as an intangible asset. Where customers contribute to the costs of development, the contribution is included as deferred income and disclosed within trade and other payables.
R&D is discussed further on the divisional pages.