Business review: Smiths Detection

Stephen Phipson

President

Smiths Detection is a world leading designer and manufacturer of sensors that detect and identify explosives, weapons, chemical agents, biohazards, narcotics and contraband.

Our technology helps customers in the global transportation, ports and borders, critical infrastructure, military and emergency responder markets. We have the most comprehensive range of detection technologies in the world, including trace detection, millimetre-wave, infra-red, biological detection and diagnostics.

Employees

2,300

Principal operating regions

Our eight manufacturing centres are concentrated in North America, Germany, and the UK. We sell to over 100 markets around the world either through a sales and marketing company or a third party distributor.

Customers

Our technology is deployed at nearly 80% of the world's commercial airports. Some 85% of sales are influenced by more than 100 governments and their agencies, including homeland security authorities, customs authorities, emergency responders and the military. These include the US Department of Defense, US Transportation Security Administration (TSA), UK Ministry of Defence, and airport operators such as BAA in the UK.

Contribution to 2008 Group sales^#

22%

Contribution to 2008 Group headline operating profit^#⁺

22%

Competitors

Data published by IMS Research* shows that, in the combined Transportation, Critical infrastructure and Ports & Borders sectors, Smiths Detection has a 29% market share, with GE Security (15.5%), L3 Security & Detection Systems (12.5%), Rapiscan Systems (8.5%) and Nuctech (8%) the main competitors. In the Military and Emergency responder markets (not included in this data), the main competitors are General Dynamics, Bruker, Environics and Canberra.

#Based on revised operating structure for 2008/09 (see Segment information)

+Percentage relates to headline operating profit before corporate costs

*The World Market for Explosives, Weapons & Contraband Detection Equipment 2007 Edition

Markets

Homeland security is a top priority in western countries, with 11% per annum market growth expected. The worldwide market for Smiths Detection products and services is estimated to be worth £3.5 billion.

Smiths Detection’s products serve the transportation, critical infrastructure, ports and borders, military and emergency responder markets. The Group also adapts technology developed for these markets for carefully selected industrial applications in life sciences, food quality and safety.

The transportation sector, which includes airports, is the largest representing 38% of total sales. The airport security market is expected to grow in response to:

projected growth in air traffic;
new security threats; and
customer pressure for faster throughput at checkpoints and an improved passenger experience.

The critical infrastructure market is diversified with varying growth rates in the different segments. Smiths Detection focuses on three key areas: mass transit, sports and events and government and military facilities. Smiths Detection has a growing involvement in helping protect a number of important metro systems in both the US and Europe.

The ports and borders market is a rapidly expanding sector driven by government objectives of enhancing security screening and protecting tax revenues. Customers require mobile and fixed units capable of detecting explosives, weapons, radioactive materials, narcotics and contraband.

The military market for UK and US technology is restricted by export controls, and these two governments form a large part of the market which is characterised by tendering opportunities for large individual contracts that typically run for several years. Smiths Detection intends to develop new business by expanding systems integration activity, offering improved functionality in protective shelters and introducing new technologies through government funded partnerships.

The emergency responder market is smaller than the others, with US sales accounting for more than 50% of global demand. This market is characterised by more localised purchasing decisions and steadier growth.

A possible future market is with biological detection and its application to veterinary diagnostics. Smiths Detection's expertise in producing rugged portable sensor equipment has enabled the development of a field-based device which can detect a range of animal infections such as foot-and-mouth and avian flu. It could also be developed for clinical applications.

The markets served by Smiths Detection are particularly influenced by specific events and the perception of the threat of terrorist activity or other security issues. This perception itself has been and is likely to remain variable.

Performance

	2008 £m	2007 £m	Reported growth	Underlying growth
Sales	509	438	16%	12%
Headline operating profit	86	79	9%	2%
Headline operating margin	16.8%	18.0%
Statutory operating profit	85	65

Reported sales grew by 16% and headline operating profit increased by 9%. Currency translation benefited sales by £17m and headline operating profit by £5m. On an underlying basis, excluding the impact of currency translation, sales grew by 12% and headline operating profit increased by 2%. The key drivers of growth were contract wins for airport checkpoint explosive detection systems, for cargo screening systems and for JCAD, the advanced chemical point detector. Headline operating margin declined from 18.0% to 16.8% reflecting the impact of currency transaction and the timing and mix of new contracts compared to last year. We also incurred additional costs associated with the scaling-up of our manufacturing to meet the strong customer demand for new products. The year-on-year impact of adverse currency transaction amounted to some £9m which, if excluded, would give an underlying operating profit margin of 18%.

The year had a very strong start with underlying sales growth of 21% compared with 6% in the second half. This is a result of winning some particularly large contracts in the first half of the year and some delays to contracts at the year end. It demonstrates the increasingly volatile nature of the order flow of this government contracting business. In addition, the strong growth in Detection, coupled with the increasing size and changing payment terms of the new contracts, has raised its working capital requirements.

In transportation, we have benefited from the introduction of a new generation of airport checkpoint explosive detection systems. Unlike conventional X-ray systems, this equipment captures multiple views of carry-on bags in a single sweep. The system also includes powerful software that helps the system operator detect potential threats and it can easily be upgraded to meet future threats. Smiths Detection has won substantial contracts in the UK and US for this new equipment which is helping airports to speed up passenger security checks. To support future demand, a new 4,000 square metre high-tech production plant was completed in Wiesbaden, Germany, in July. Overall, Wiesbaden produced a record 5,000 X-ray scanning units during the year.

Our results also benefited from strong demand in the ports and borders segment for advanced, high-energy cargo screening solutions to inspect inbound and outbound shipping containers and trucks. Deliveries to the Russian authorities from the St Petersburg facility were completed in December, while a major order from US Customs and Border Protection is now being fulfilled.

In the military segment, the recently developed JCAD programme has begun to roll-out with further orders received from the US Department of Defense. Orders totalling $52.3m were received during the year. The JCAD is an advanced chemical point detector designed to help safeguard troops by automatically detecting, identifying and quantifying both chemical warfare agents and toxic industrial chemicals. We have begun to expand production in the US with an extension of our facility at Edgewood. Construction began in 2008 and is expected to be completed by January 2009.

The implementation of a new ERP system began during the second half following 18 months of planning and preparation. This single system will replace 14 legacy business software systems and provide a common information platform to support data-driven decision making. Nine sites in the military and emergency responder area went live with the new system in May 2008. The project is expected to conclude by the end of calendar year 2009. Investment to date has been £15m, with a total budget of £22m. We anticipate that once complete the project will generate efficiencies in working capital of £11m and annual cost savings of £8m.

Research and development

Smiths leadership in the sector is maintained by ongoing product innovation developed by in-house R&D, government-funded research and through partnerships and licences. Company-funded R&D increased by 10% to some £29m or 5.6% of sales (2007: 5.9% of sales). This includes £8m of capitalised projects. Smiths Detection actively seeks customer and government support for R&D which totalled £9m in the period (2007: £7m). Total R&D spend was £38m (2007: £33m) or 7% of sales.

Key R&D projects:

X-ray screening continues to be a focus for our investment. This has supported the development of a new generation of cargo screening which will be launched in the coming year. We have also continued to invest in the development of our airport checkpoint explosive detection systems particularly to address new threats.

We have continued to invest heavily in chemical and trace detection. In September 2008, we launched two new handheld detectors for the military and emergency responder markets. High-Performance Radioisotope Identifier (HPRID) is our first portable handheld radiation detector which can be used for highly enriched uranium, plutonium and other radioactive substances. We also launched the Multi-Mode Threat Detector (MMTD), a portable device that detects a range of explosives including the materials most commonly used in homemade bombs.

Smiths Detection is developing technology that detects weapons, explosives and other potentially dangerous items concealed under layers of clothing without physical contact. The new system is based on patented millimetre-wave technology and creates video images that reveal a far wider range of concealed weapons and hazards than is possible with traditional people screening technologies. With trials and testing underway, the system will offer a fast and efficient way of scanning people as they enter airport checkpoints, high profile buildings or other facilities that require protection.

Diagnostics has also been an area of focus with the development of a portable biological detection system that enables veterinarians to carry out on-site diagnosis of animal diseases such as foot-and-mouth and avian flu. The technology is now being developed for clinical applications such as the detection and identification of MRSA, sepsis or other medical conditions.

Outlook

Looking ahead, the sector is set for continued growth and Smiths Detection should benefit from its leadership position and the roll-out of new technologies. We are well-positioned for future growth although the increasing size of contracts coupled with the irregular timing of government contracting – particularly where there are elections – may cause variability in the pattern of contract wins and working capital requirements from period to period.

Our investment in R&D continues to drive advances in argo screening. The HCV series of high-energy screening equipment identifies both contraband and security hazards hidden in trucks and other freight. The HCV Passthru, recently sold in the US, features advanced high throughput technology which can scan 200 trucks per hour, enabling customers to implement 100% cargo screening processes. The new Datasets Management System(DMS) enables customs officers to analyse images and information taken at the container's departure point remotely, allowing them to clear the container before its arrival in the destination country.

Next division

Smiths Group divisions:
Smiths Detection, Smiths Medical, John Crane, Smiths Interconnect, Flex-Tek