Financial review
Earnings per share
Basic headline earnings per share from continuing activities were 72.4p (2008: 74.5p), a decline of 3%. This reflects an increased headline operating profit offset by higher interest costs on the newly refinanced debt and a lower pensions financing gain as a result of the worsening funding position of the company's retirement benefit schemes.
On a statutory basis, the basic earnings per share from continuing activities were 70.8p (2008: 63.0p).
Exceptional and other items relating to continuing activities excluded from headline profits
These items had no net impact in the year compared with a charge of £61m in 2008. They comprised:
- Gains of £70m arising from the actions taken to reduce liabilities associated with the pensions and post-retirement healthcare benefits;
- £24m (2008: £4m) in respect of restructuring corporate and divisional headquarters. This is part of a programme which is expected to cost approximately £45m;
- £22m (2008: £54m) in connection with John Crane, Inc. asbestos litigation (see litigation paragraph in the Legal issues section.);
- Amortisation of intangible assets acquired in business combinations of £35m (2008: £19m). The amortisation relates principally to technology and customer relationships; and
- Profit on disposal of businesses and property of £15m (2008: £27m).
- Financing losses amounted to £4m (2008: £2m). These represent the results of derivatives and other financing instruments which are not hedge accounted under IFRS.
Exceptional items in 2008 included Medex integration costs of £9m.
Cash generation
Strong cash generation this year resulted in a free cash-flow of £256m (2008: £91m). Substantially improved headline operating cash of £435m (2008: £273m) represented 104% (2008: 72%) of headline operating profit. The improvement was a result of reduced investment in working capital, particularly inventories and debtors, and lower net capital expenditure.
On a statutory basis, net cash inflow from continuing operations was £332m (2008: £198m).
Net cash expenditure on exceptional items was £32m, compared to £26m in the previous year. The Group made special pension contributions of £34m (2008: £34m). Free cash-flow from continuing operations (after interest and tax but before acquisitions. dividends and net investment hedges) was £256m (2008: £91m).
Dividends paid in the year on ordinary shares amounted to £132m, compared with £131m in 2008.
Interest and other financing costs
Interest payable on debt, net of interest earned on cash deposits, was £52m compared with £41m in 2008. Interest costs were covered 8 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 credit was £5m in 2009 compared with a net financing credit of £42m in 2008.
Net debt
Net debt at 31 July 2009 was £885m, up from £771m in 2008. The increase in net debt was the result of exchange rate changes, which resulted in a cash outflow of £90m on net investment hedges and a £28m translation increase in currency-denominated net debt.
During the year a £90m cash outflow, which increased net debt, occurred on the rollover of short term derivative net investment hedges caused by weaker sterling. These derivative hedges swapped sterling bonds into primarily US dollar and euro liabilities to hedge the significant translation exposure on US dollar and euro assets. If the bonds had been denominated in US dollars and euro, the same increase in reported debt would have occurred - reported not as a cash outflow but as an adverse translation effect. The financing strategy launched during 2009 with the raising of $675m of long term dollar bonds will replace these derivative investment hedges and more effectively match long term currency assets and liabilities.
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 £105m in R&D on continuing operations, equivalent to 4% of sales. Of that total, £15m was funded by customers. The comparative figures for 2008 were £85m and £13m. 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 in 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 in the Accounting policies section.
Taxation
The headline tax charge of £89m for 2009 represented an effective rate of 24% on the headline profit before taxation - unchanged from last year. The Group continues to take advantage of global manufacturing, research and development and other tax incentives, the tax-efficient use of capital and tax compliance management. On a statutory basis, the tax charge on continuing activities was £95m (2008: £75m).
The fundamental principles of the Group's approach to taxation remain unchanged as approved by the Board. It seeks to mitigate the burden of taxation in a responsible manner to enhance its competitive position on a global basis while managing its relationships with tax authorities on the basis of full disclosure, co-operation and legal compliance. A semi-annual report is reviewed by the Audit Committee to monitor compliance with these principles and tax objectives.
Return on shareholders' funds
The after-tax headline return on shareholders' funds for continuing operations, including goodwill set-off against reserves, was 16.5% (2008: 16.7%).
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 2009 and evaluating liabilities at year-end AA corporate bond interest rates.
We have taken action to reduce the Company's liabilities in respect of retirement benefits. The principal US defined benefit pension plan was closed with effect from 30 April 2009, after which no further benefits have accrued. In addition, future benefits accruing under the US and UK post-retirement healthcare schemes were substantially reduced; for most members, the Company has capped its contributions at 50% of the 2009/10 premium.
Company contributions to the funded defined benefit pension plans totalled £53m (2008: £56m). Company contributions included special UK contributions of £13.1m in respect of special covenant payments (2008: £17m comprising £13m of special covenant payments and £4m arising from the sale of Smiths Aerospace). During the year, the trustees of the TI Pension Scheme invested a further £249m in annuities that are matched with specific liabilities of the fund.
The retirement benefit position was:
|
31 July |
31 January |
31 July |
|
|---|---|---|---|---|
Funded plans |
|
|
|
|
UK plans – funding status |
|
95% |
94% |
106% |
US plans – funding status |
|
72% |
64% |
89% |
Other plans – funding status |
|
75% |
77% |
81% |
|
|
|
|
|
|
|
31 July |
31 January |
31 July |
Surplus/(deficit) |
|
|
|
|
Funded plans |
|
(254) |
(330) |
102 |
Unfunded plans |
|
(85) |
(134) |
(113) |
Total surplus/(liability) |
|
(339) |
(464) |
(11) |
Full details of the retirement benefits are shown in note 10.
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.
|
2009 |
2008 |
|
Average rates: |
|
|
|
US dollar |
1.58 |
2.00 |
Dollar strengthened 21% |
Euro |
1.16 |
1.35 |
Euro strengthened 14% |
Year-end rates: |
|
|
|
US dollar |
1.67 |
1.98 |
Dollar strengthened 16% |
Euro |
1.17 |
1.27 |
Euro strengthened 8% |
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.
Intangible assets arising from business combinations ('acquired intangibles') are assessed at the time of acquisition in accordance with IFRS3 and are amortised over their expected useful life. This amortisation is excluded from the measure of headline profits.
Other intangible assets comprise development costs or software which are capitalised as intangible assets as required by IFRS. Amortisation charged on these accounts is deducted from headline profits.
The goodwill balance was tested for impairment in 2009 and 2008.
Treasury
The Board has approved a Treasury Risk Management policy which governs the activities of both group treasury and subsidiary companies and the financial risk profile to be maintained by the Group. A monthly report for the Executive Committee and a semi-annual report to the Audit Committee reports on compliance with the policy. The Board maintains a strong treasury control framework within which bank, financing and debt strategy, interest rate risk and currency translation exposure are reserved for group treasury while cash and currency transaction exposure management is devolved to subsidiary companies.
The Group uses financial instruments to raise financing for its global operations, to manage related interest rate and currency financial risk and to hedge transaction risk within subsidiary companies. The Group does not speculate in financial instruments. All financial instruments hedge existing business exposure and all are recognised on the balance sheet.
There are four components of the Treasury Risk policy and in each component a series of metrics measured monthly.
1. Credit quality
The Group's strategy is to maintain a solid investment grade rating to ensure access to the widest possible sources of financing and to minimise the resulting cost of debt capital. The credit ratings at the end of 2009 were maintained at BBB+ / Baa2 (both negative outlook) from Standard & Poor's and Moody's respectively, the same rating as 2008 except for the change in outlook from stable to negative. An essential element of an investment grade rating is robust cash-flow metrics. The Group's objective is to maintain an operating cash conversion of greater than 80% and to maintain net debt/headline EBITDA of less than two times. At 31 July 2009 these measures were 104% (2008: 72%) and 1.8 times (2008: 1.7 times) respectively.
2. Debt and interest rate management
The Group's debt funding requirements are managed centrally. At 31 July 2009 net debt was £885m (2008: £771m). In 2009 the Group raised $675m in new-long term US $ capital markets financing to further its debt strategy via $250m 6.05% senior notes due 2014, $175m 7.37% senior notes due 2018 and $250m 7.2% senior notes due 2019. These funds were used to repay £70m of EIB 2010 loan finance, repay short-term bank debt and finance on-going activity of the Group. The Group's objectives are to ensure that funding from the bank market is less than 30% of net debt, the average maturity profile of all debt is at least four years and between 50% and 80% of debt is at fixed rate of interest. At the 31 July 2009, these measures were 8% (2008: 42%); 5.4 years (2008: 4.0 years) and 79% (2008: 46%), respectively.
3. Liquidity management
A committed £660m revolving bank credit facility is available to the Group until July 2012 and is provided by a quality group of 11 global relationship banks. At the 31 July 2009, £623m of the facility was un-drawn (2008: £450m). The Group's objective is to ensure that at any time un-drawn committed facilities net of overdraft financing are greater than £200m. At 31 July 2009, this measure was £595m (2008: £378m) respectively.
The Group aims to minimise levels of surplus cash across the Group and, where cash resources exist, to ensure they are securely placed on deposits with highly rated counterparties at short-notice availability. Credit exposure to every bank is defined by the Treasury Risk policy by reference to long-term rating and compliance is measured monthly. At 31 July 2009, 83% of surplus cash was on deposit with the 11 global relationship banks and only £5m was on deposit with banks rated less than A+.
4. Currency management
The Group has adopted hedge accounting for the significant majority of transaction hedging positions, thereby mitigating the impact of market value changes in the income statement. Material sales or purchases in foreign currencies are hedged at their inception by appropriate financial instruments, principally forward foreign exchange contracts and swaps. The Group's objective is to reduce medium-term volatility to cash-flow, margins and earnings.
The Group is an international business with the majority of its net assets denominated in foreign currency. It protects its balance sheet and reserves from adverse foreign exchange movements by financing its currency assets in the same currency such that, where the value of net assets is over £20m equivalent, over 50% of those assets are matched with same currency liability. In total 52% (2008: 47%) of foreign currency assets were matched by currency liabilities.
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 statement.
Essential contracts
The divisional reviews describe our main customer and supplier relationships and the 'Risks and uncertainties' section outlines the risk management aspects of our contractual arrangements. Smiths Group has a wide range of suppliers and customers, and while the loss of, or disruption to, certain of these arrangements could temporarily affect the operations of an individual division, none is considered essential.