Financial review
Changes in Group composition
We continued to improve the portfolio and business mix through a number of acquisitions and disposals during the year. In November, Sartorius Bearing Technology, a leading provider of high performance rotating equipment for the oil and gas industry, was acquired for £13m. In November, Smiths sold its Marine Systems business for £44m, after a working capital adjustment. In December, Smiths acquired the majority ownership of the John Crane business in Japan for a consideration of £5m, increasing its ownership share from 49% to 70%. In February, the Heating Element division of Fast Heat was acquired for £9m: it manufactures a wide range of specialty heating elements for HVAC, industrial and medical applications. In April, John Crane acquired Indufil BV for £71m, a Dutch-based specialist in filters for the petrochemical and process industries. In May, Smiths Interconnect acquired Allrizon Tongguang, a communications equipment firm based in Shanghai which designs and manufactures radio frequency filters and products for the wireless telecommunications market. The acquisition of Fiber Composite Company Inc. (Fiberod), a Texas-based specialist provider of lifting equipment for the oil and gas industry, was completed in May. In July, Smiths Interconnect acquired Triasx Pty Ltd, a firm based in Brisbane that designs and manufactures complex radio frequency filter products for the wireless communications market.
Earnings per share
Basic headline earnings per share from continuing activities were 74.5p (2007: 47.0p) a rise of 59%.
On a statutory basis, the basic earnings per share from continuing activities were 63.0p (2007: 36.9p).
These comparisons are distorted by the effect of the share consolidation in June 2007 following the disposal of the Aerospace business. The average number of shares in issue during that year was a reflection of the capital structure appropriate to both the continuing and the discontinued business.
Exceptional and other items relating to continuing activities excluded from headline profits
These items amounted to £59m, compared to £88m in 2007. They comprised:
- £4m in respect of restructuring corporate and divisional headquarters; this cost is the initial part of a programme expected to cost approximately £48m;
- £9m for integration costs associated with the Medex acquisition (2007: £9m);
- £54m (2007: £101m) in connection with John Crane, Inc. asbestos litigation, including a £40m provision for adverse judgments (see litigation paragraph in the legal issues section);
- Amortisation of intangible assets acquired in business combinations of £19m (2007: £15m). The amortisation relates principally to technology and customer relationships; and
- Profit on disposal of businesses of £27m (2007: loss of £5m).
Exceptional items in 2007 included insurance commutation proceeds (£43m); profit on sales of TI Automotive shares (£24m) and other costs of £26m.
Financing losses amounted to £2m (2007: gain of £1m). These represent the results of derivatives and other financing instruments which are not hedge accounted under IFRS. Of this sum, nil (2007: £1.5m) was charged to operating profit.
Cash generation
Headline operating cash-flow was £273m, representing 72% of headline operating profit. This compares to operating cash of £259m in 2007 and cash generation of 75%. 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 £198m (2007: £205m).
Cash expenditure on exceptional items was £26m, compared with an £8m inflow in the previous year. The Group made special pension contributions of £34m (2007: £56m). Free cash-flow from continuing operations (after interest and tax but before acquisitions and dividends) was £91m.
Dividends paid in the year on ordinary shares amounted to £131m, compared with £182m in 2007.
Interest and other financing costs
For continuing operations, interest payable on debt, less interest on cash deposits, was £41m, compared with £36m in 2007. Net interest costs were 9.3 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 £42m in 2008, compared with £34m in 2007. As a result of the reduction in pension surplus, the amount in the coming year is likely to be approximately £35m lower.
Net debt
Net debt at year end was £771m, up from £590m at the start.
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 £86m in R&D on continuing operations, equivalent to 4% of sales. Of that total, £13m was funded by customers. The comparative figures for 2007 were £79m and £8m. 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.
Accounting policies
The accounts in this report are prepared under International Financial Reporting Standards (IFRS), as adopted by the European Union (EU). The accounting policies used in preparing these accounts are set out on the Accounting policies section.
Significant judgements, key assumptions and estimates
Applying accounting policies requires the use of certain judgements, assumptions and estimates. The most important of these are set out on the Accounting policies section.
The uncertainty affecting the estimation of provisions has increased following the commutation of certain insurance policies in respect of product liability. See the legal issues section for details.
Taxation
The tax charge for the year represented an effective rate for continuing operations of 24.0% on the headline profit before taxation, compared to 25.1% in 2007. The rate reduced due to taking advantage of global tax incentives, the tax-efficient use of capital and active tax compliance management. On a statutory basis, the tax charge on continuing activities was £75m.
The fundamental tenets of the Smiths approach to taxation are to enhance the Company's competitive position on a global basis, while engaging with tax authorities around the world on a basis of full disclosure, full co-operation and full legal compliance. The Board considers and approves the management of the Company's tax affairs in the context of the Company's commercial objectives.
Accordingly, Smiths seeks to build open relationships with tax authorities to bring about timely agreement of tax affairs and to remove uncertainty on business transactions.
In summary, the Company's taxation strategy is to mitigate the burden of taxation in a responsible manner for competitive advantage, and, in this way, to enhance long-term shareholder value.
Cost of capital and return on shareholders' funds
Smiths uses its weighted average cost of capital as one measure to appraise both internally-generated investment opportunities and acquisitions. During 2007, the Company's weighted average cost of capital (WACC) decreased from 9% to 8% as a result of the lower cost of equity.
The after-tax headline return on shareholders' funds for continuing operations, including goodwill set-off against reserves, was 16.7% (2007: 14.9%).
Retirement benefits
As required by IFRS the balance sheet reflects the net surplus or deficit in retirement benefit plans, taking assets at their market values at 31 July 2008 and evaluating liabilities at year-end AA corporate bond interest rates.
The year-end retirement benefit position was:
2008 |
2007 |
|
Funded plans: |
||
UK plans - funding status |
106% |
113% |
US plans - funding status |
89% |
92% |
Other plans - funding status |
81% |
83% |
2008 |
2007 |
|
Surplus/(deficit): |
||
Funded plans |
102 |
297 |
Unfunded plans |
(113) |
(114) |
Total surplus/(liability) |
(11) |
183 |
Company contributions to the funded pension plans were £56m (2007: £103m including discontinued operations). In 2008, special contributions were made totalling £17m, including £4m in respect of the Aerospace disposal. In 2007, special payments of £56m were made including £21m in respect of the Aerospace disposal. During the year, the trustees of the TI Group Pension Scheme invested £250m in annuities from Legal & General which are matched with specific liabilities of the Scheme thereby mitigating the longevity risk in respect of specific pensioners.
Full details of retirement benefits are shown elsewhere.
Exchange rates
The results of overseas operations are translated into sterling at average exchange rates. The net assets are translated at year-end rates. The principal exchange rates, expressed in terms of the value of sterling, are shown in the following table.
2008 |
2007 |
||
Average rates: |
|||
US Dollar |
2.00 |
1.95 |
Dollar weakened 2.5% |
Euro |
1.35 |
1.48 |
Euro strengthened 8.8% |
Year-end rates: |
|||
US Dollar |
1.98 |
2.04 |
Dollar strengthened 2.9% |
Euro |
1.27 |
1.49 |
Euro strengthened 14.7% |
Dividend policy
An interim dividend of 10.5p per share was paid on 25 April 2008. A final dividend of 23.5p per share is proposed.
The Board intends to grow dividends consistent with increasing cover to around 2.5 times in the medium term. Dividend cover relative to headline earnings for the year ending 31 July 2008 was 2.2 times.
Goodwill and intangibles
Goodwill on acquisitions has been capitalised since 1998. Until 1 August 2004 it was amortised over a maximum 20-year period. Under IFRS goodwill is no longer amortised but instead is subject to annual reviews to test for impairment.
The goodwill balance was tested for impairment in 2008 and 2007.
Treasury
Smiths decentralises treasury management over its financial risks to its subsidiary businesses, within a strong control environment. The Board has approved a Treasury Policy, which governs the financial risk profile, and Treasury permits appropriate delegated authorities across the subsidiary companies. The Company uses financial instruments to raise money for its operations and to manage the related financial risks. Smiths neither speculates nor trades in derivative financial instruments and all financial instruments are properly recognised on the balance sheet. A treasury report is presented annually to the Audit Committee to confirm compliance with policy.
The objectives of the treasury function are to:
1. To deliver the liquidity requirements of the businesses cost-effectively.
The Group aims to minimise the level of surplus cash but, where surpluses arise, tight controls apply to ensure that they are securely placed with highly-rated counterparties and are available for redeployment at short notice. The Company is required under IFRS to show gross borrowings and cash under its cash pooling arrangements, despite these balances being netted for interest purposes, which exaggerates the Company’s surplus cash balance. Liquidity is provided to the Group by a committed revolving credit facility to 2012 which at 31 July 2008 was £450m undrawn. Local working capital needs and capital expenditure requirements are typically funded by local bank facilities.
2. To manage the central funding demands and provide a low cost of debt.
The Company’s funding requirements are largely driven by acquisition activity and met by centrally arranged debt finance. Smiths has net debt as at 31 July 2008 of £771m (2007: £590m) with average maturity of 4 years (2007: 5 years) and at an average effective interest rate after interest and currency swaps of 5.1% (2007: 5.8%). Through the use of interest rate swaps, Smiths maintains a broadly even mix of fixed and floating rate debt. Credit ratings have been held at BBB+/Baa2 (stable) with Standard & Poor's and Moody's respectively. Accordingly, this approach aims to reduce the cost of capital by optimising financial liabilities
3. To develop and maintain strong and stable banking relationships and services.
Smiths has a core group of 11 leading global banks and financial institutions that competitively tender for treasury business. Credit exposures to any one bank are carefully controlled.
4. To provide reasonable protection from foreign currency volatility.
Smiths has adopted hedge accounting for the majority of the Group's business at its larger sites, thereby mitigating the impact of transactional exposures in the income statement. Material cross-border sales or purchase contracts in foreign currencies are hedged at their inception by appropriate derivative financial instruments, principally forward foreign exchange contracts and swaps, with the Group's core banks as counterparties. Whilst the trends of foreign currency movements cannot be eliminated, this hedging programme reduces volatility, protecting cash-flow and margins.
Smiths protects its reserves from foreign currency fluctuations by ensuring that at least 75% of the total net overseas operational assets are offset either by borrowings in the respective currency or by currency swaps. This excludes goodwill which is only partly hedged. Overseas earnings are translated at average currency rates for the year, which smoothes the effect of currency volatility.
Therefore, treasury management in Smiths ensures a robust and prudent financial profile while driving value for shareholders, with the support of world-class banks.
Financial controls
While the Group's decentralised organisation delegates day-to-day control to local management, Smiths has comprehensive control systems in place with regular reporting to the Board. The Group has continuous formalised business risk management processes operating at each business unit.
The internal audit department reviews all units over a rolling three-year cycle, and its findings are reported to the Audit Committee. All acquisitions are reviewed within 12 months of acquisition, to verify compliance with Group procedures.
Further information regarding the Group's procedures to maintain strict controls over all aspects of risk, including financial risk, are set out in the Corporate governance report.