Chief Executive's review
Smiths Specialty Engineering and Detection divisions delivered strong sales and profit growth in the first half, offsetting a flat performance from Medical. In Medical, we have initiated a detailed performance improvement programme and its delivery is a key priority.
Since joining three months ago, I have begun a thorough review of operations and I find a business that has many strong positions in growing markets. There are significant opportunities to improve performance progressively over a two-year period. Smiths will focus on margin improvement, top line growth - especially in developing markets - and financial returns. There is also scope to grow the business through bolt-on acquisitions, such as Indufil and Fiberod. Going forward, I believe there are clear opportunities to grow Smiths and improve returns for shareholders.
Philip Bowman
Chief Executive
Chief Executive's review
Smiths Group has a strong set of technology-based businesses, well-positioned in growth markets and with the capacity to demonstrate resilience in an economic downturn. There are clear opportunities to improve performance progressively over a two year period. Our focus will be on enhancing margins in all the divisions through a combination of improved data, cost control and top line growth - especially in developing markets such as India and China. There are also opportunities to drive future growth through a targeted increase in R&D investment, and to focus it more tightly on high growth areas that can deliver attractive returns. We also recognise the need to invest capital in additional manufacturing capacity and that our working capital requirement is likely to grow as we exploit these growth opportunities. For example, John Crane has significant scope to build further manufacturing capacity and aftermarket service centres to meet the strong demand from the petrochemical industry. Detection is succeeding in winning new contracts but the increasing size, the different counterparties and the changing nature of those contracts has raised its working capital requirements, which is reflected in its first half performance. In order to improve data flow and speed up decision making, we are also investing in information systems, such as Enterprise Resource Planning (ERP) in a number of areas.
Looking across the Group, there are opportunities to leverage the Group's scale – particularly as the divisions have been run independently with little incentive to share best practice or back office services. The structure of the organisation will be reviewed to deliver efficiencies. The Board will also continue to consider the structure of the Group, with the objective of maximising shareholder value. In the current environment, the Board believes that there are valuable opportunities to build the business with bolt-on acquisitions – particularly in John Crane, Interconnect and Detection. Such acquisitions may bring complementary technologies, support geographic expansion into new markets or leverage existing infrastructure. We announced on 19 March 2008 agreements to acquire Indufil BV (Indufil) and Fiber Composite Company Inc. (Fiberod) which will both expand John Crane's offering. Indufil is a Dutch–based specialist in filters for the petrochemical and process industries. Fiberod is a Texas-based equipment manufacturer that will extend John Crane's upstream oilfield services offering. Completion of both acquisitions is subject to regulatory approvals.
The profile of Smiths Group offers significant opportunities for growth in resilient markets. Given the current conditions in financial markets and the scope for investment in organic growth and acquisitions, the Board has reviewed its dividend policy and intends to grow dividends consistent with increasing cover to around 2.5 times in the medium term. In pursuit of this policy, the Board has declared an unchanged interim dividend of 10.5p per share and intends to recommend a total dividend for the year of at least 34p per share. The interim dividend will be paid on 25 April to shareholders registered at the close of business on 28 March. The ex-dividend date is 26 March.
Smiths Group delivered a good first half performance with sales from continuing activities up 7% to £1,088m. On an underlying basis*, sales increased by 8% with the main contributors being Specialty Engineering and Detection; Medical was flat. Headline operating profit grew by 7%, or £10m, to £158m on both an underlying and a reported basis. Overall headline operating margin for the Group was maintained at 14.5%. Of the £10m reported increase in headline operating profit, £6m came from Specialty Engineering while Detection contributed £4m. The key drivers for the growth in headline operating profit were:
- Strong demand from the petrochemical industry for John Crane's products and services;
- Good progress at Interconnect with new contracts to support USA 4G wireless broadband and the next generation of Satellite Communications On The Move (SOTM) for the military; and
- Benefit of new contracts in Detection, particularly for checkpoint detection systems; the Joint Chemical Agent Detector (JCAD) with the US Department of Defense; and high energy x–ray screening systems.
*Underlying performance excludes the year–on–year impact of currency translation, acquisitions and disposals.
The net interest charge reduced from £30m to £20m reflecting the lower net debt position following the Aerospace sale and lower interest rates. There was a pensions financing gain of £21m (2007: £16m) relating to continuing activities, which reflected the funding position of the company's retirement benefit schemes at July 2007.
Headline pre–tax profit increased by 19% to £159m (2007: £134m). The company's tax rate on headline profit for the period was 25% (2007: 26%). Headline earnings per share were 30.8p (2007: 17.4p). The comparison in earnings per share is distorted by the share consolidation carried out in June last year; on a pro-forma basis, earnings per share grew by 20%.
Headline operating cash–flow from continuing operations totalled £99m, representing 63% of headline operating profit, and reflects investment in capital projects and increased working capital to support business growth. The working capital investment was particularly driven by the timing and nature of contracts in Detection and John Crane. Net debt has increased since July 2007 by £85m to £675m.
Statutory reporting
Statutory reporting takes account of all items excluded from headline performance. On a statutory basis, pre–tax profit from continuing operations was £165m (2007: £136m) and earnings per share were 34.3p (2007: 18.6p). The items excluded from headline performance comprise amortisation of acquired intangible assets of £7m (2007: £7m), profit on disposal of businesses of £27m (2007: £15m), acquisition integration costs of £2m (2007: £5m), financing losses of £3m (2007: £1m gain) and adjustments to the discounted provision for John Crane litigation of £8m (2007: nil). These adjustments to the provision arise from changes in US interest rates and the unwind of the discount and do not represent any change in the underlying assessment of the base provision before discount. The discontinued operations represent items in respect of the Aerospace division, sold in May 2007.
Outlook
Smiths Detection is expected to deliver continued growth, although the rate of increase is not likely to be as strong as in the first half. John Crane and Interconnect will continue to benefit from their strong market positions. Flex–Tek will be held back by the ongoing uncertainty in the US residential construction market. A detailed performance improvement programme for Medical is underway and its delivery is a key priority. The first six months provide a solid foundation for meeting expectations for the full year.