Chief Executive's review
Since we announced our results in September, global markets have been in unprecedented turmoil. While the Group’s performance has not been immune from the repercussions, many parts of the business continue to show resilience in markets that are underpinned by long-term secular growth trends. John Crane delivered strong organic growth and continues to benefit from a robust aftermarket in sales and servicing which represents around two thirds of revenue. Demand for healthcare expands as populations age and become more prosperous. While tighter hospital capital budgets curtailed Smith Medical’s hardware revenues, most of its sales derive from single-use consumable items for which sales have proven to be more robust. Smiths Detection is driven by a risk environment that demands increased security and protection. As previously announced, its order flow was lower in the first half – particularly in the ports and borders segment – as a result of large contract wins last year. Smiths Interconnect’s largest end market is serving several long-term military programmes which have seen continued growth. However, investment by telecom wireless infrastructure providers has slowed. Although Flex-Tek is exposed to more cyclical markets such as US housing and domestic appliances, it has benefited from sales of high-performance products to the aerospace market. It has also made good progress in preserving margins through cost management and tactical pricing.
There continue to be significant opportunities to improve performance progressively over a three-year period and through this generate value for shareholders. In the first six months of the year, we have made good progress towards these objectives:
- Restructuring initiatives announced last year are well under way with savings to date of £8m following the opening of a much reduced corporate HQ and good progress made in John Crane, Flex-Tek and Smiths Medical;
- We are strengthening the product portfolio and extending our geographic presence through two acquisitions, subject to regulatory approvals;
- Improvement of our business systems to support better data-driven decision-making is on track with ERP programmes progressing well in Smiths Detection, John Crane and Smiths Medical;
- A product portfolio review is underway in Smiths Medical to examine the opportunities of enhancing its profitability. An early conclusion is the decision in March 2009 to discontinue the diabetes business;
- We have also increased significantly our investment in R&D to drive future growth through new product initiatives; and
- Our plans are supported by a strong balance sheet and in February 2009 we raised additional long-term debt capital from the issue of US$175m of Senior Notes.
Last year we launched a major restructuring programme across the Group and during this period we have made further progress. Reorganisation of the corporate HQ is now complete and, as a result, we have delivered savings of £3m compared with last year. Details of the restructuring programmes are given in the divisional reviews but to date we have delivered savings of £8m and have spent £13m, with £8m in the period. Together, the programmes are expected to produce annual cost savings of £47m when completed in three years time. The total cost of delivering these programmes will be £48m which is being treated as an exceptional item.
There are valuable opportunities to build Smiths through bolt-on acquisitions which can bring complementary technologies, support geographic expansion or leverage existing infrastructure. In the first half, Smiths Medical acquired Zhejiang Zheda Medical Instrument Co. Ltd (“ZDMI”). A manufacturer of syringe pumps and enteral feeding devices primarily for the fast-growing Chinese healthcare market. Smiths Interconnect agreed, subject to regulatory approvals, the purchase of Shenzhen Dowin Lightning Technologies (“Dowin”), a manufacturer of power and signal protection devices operating mainly in the wireless telecoms market.
Significant scope also exists to improve our information systems to enhance data-flow and speed up decision-making. For example, ERP systems are currently being deployed in Detection, John Crane and Medical. At a Group level, a new information platform is being introduced which will help capture operational data from the divisions. This creates opportunities to leverage the scale of the Group through group-wide procurement of travel, IT, logistics and other services.
During the period, we began a profitability review of the Smiths Medical portfolio – looking across customers and the portfolio of stock keeping units (SKUs). The analysis has already highlighted significant opportunities in pricing, minimum order quantities, customer management and complexity reduction. An early decision from this review is to exit the diabetes business. A considerable amount of intellectual property in the diabetes segment makes the development of next-generation products very costly and risky in terms of the potential for future patent disputes. As our only directly consumer-facing business, it shares few synergies with the rest of Smiths Medical’s enterprises and requires a dedicated support infrastructure. We have concluded that our modest share, in an environment with two large and well-resourced competitors, will lead to a declining and increasingly less profitable business.
We are also driving higher levels of revenue growth organically through an increase in research and development (R&D) investment focused more tightly on growth areas that can deliver the most attractive returns. R&D investment for the Group increased by 11%, at constant currency, to £49m. In Detection, we launched an advanced people-screener which uses patented millimetre-wave technology to reveal a far wider range of threat items than currently possible with traditional non-ionising technologies. We are also beginning trials of a biological diagnostics tool that enable vets to carry out a rapid diagnosis of animal diseases in the field. In Medical, we have extended the launch of CADD-Solis to new markets.
We have a strong balance sheet and in February the Group successfully raised additional long term capital in the US private placement market through the issue of Senior Notes with a fixed 9 year maturity and fixed coupon of 7.37%. This flowed from a thorough review of the Group’s financing strategy with the objective of extending the maturity of its debt and reducing its dependency on the banking market. We will continue to look for further opportunities to improve our financing profile.
Last September, we set out ranges for sales growth and margins for each of the divisions based on what we believed the businesses could achieve over the medium term in a financial and commercial environment consistent with that of recent years. Since then there has been a serious discontinuity in the economy and in financial markets. While our businesses are comparatively well placed, it will be harder to operate within these ranges in the near term. However, we remain committed to improving performance and delivering shareholder value consistent with achieving these ranges as the financial markets stabilise and world economies return to growth.
Smiths Group has not been immune to the economic challenges but our half-year performance demonstrates a resilience that augurs well for the longer term in markets with inherently strong secular growth prospects. Smiths Detection will benefit from the global need for better security, although the scale and variability in the timing of order flow could affect short term results. John Crane’s leadership position, strong aftermarket business and restructuring initiatives are expected to sustain margin improvements. The medical needs of an ageing population support long term growth for Smiths Medical but the pressure on healthcare budgets and the decision to exit the diabetes business will squeeze sales and profit expectations in the near term. Several long term military programmes support over a third of Smiths Interconnect’s sales while the wireless telecoms and other industrial sectors are likely to be weaker. Flex-Tek will be held back by the recession in the US construction market but its restructuring initiatives are expected to preserve margins. Across the Group, our focus remains to deliver our cost saving initiatives, generate cash and deliver long-term value for shareholders. Absent further deterioration in world economies and assuming current exchange rates, we remain on track to deliver full year results in line with expectations.
Sales increased by £204m to £1,292m. Currency translation on overseas sales contributed £199m of this increase while the net impact of acquisitions and disposals increased sales by £40m. On an underlying basis, excluding the effects of currency translation and acquisitions and disposals, sales fell by £35m, or 3%. This £35m underlying decline in sales was driven by:
- John Crane (up £19m) as a result of ongoing projects, particularly from the oil and gas industry offset by;
- Smiths Detection (down £28m) reflecting the variable nature of the order flow, in particular with lower sales from the ports and borders market;
- Smiths Medical (down £11m) as a result of a slowdown in the healthcare market driven by lower hardware sales although disposables sales have held up better;
- Smiths Interconnect (down £2m) reflecting a slowdown in sales of components and subsystems to the wireless telecoms industry partially offset by continued growth in several military programmes; and
- Flex-Tek (down £13m) driven by the recession in US residential construction and domestic appliances, offset in part by growth in sales of fuel and hydraulic hoses to aerospace customers.
Headline operating profit rose £27m to £185m. Headline operating margin decreased by 20 basis points to 14.3% (2008: 14.5%). The increase in headline operating profit comprises £36m from favourable currency translation, £11m from the net impact of acquisitions and disposals made during the year, offset by a £20m, or 10%, decrease in underlying headline operating profit. The main drivers of this £20m underlying decline are:
- John Crane (up £8m) reflecting strong volume growth and price increases;
- Lower corporate centre costs (£4m benefit) offset by;
- Smiths Detection (down £19m) driven by lower volumes and adverse currency transaction;
- Smiths Medical (down £5m) reflecting lower hardware sales, increased ERP and R&D costs, and higher amortisation of capitalised R&D for newly launched products;
- Smiths Interconnect (down £6m) as a result of restructuring costs and adverse mix; and
- Flex-Tek (down £2m) reflecting lower volumes.
Operating profit on a statutory basis, after taking account of the items excluded from the headline figures was £160m (2008: £170m).
The net interest charge increased to £21m (2008: £20m). There was a pensions financing gain of £2m (2008: £21m) which reflected the worsening funding position of the company’s retirement benefit schemes.
Headline profit before tax increased by £8m to £167m. The Group’s tax rate on headline profit for the period was 24% (2008: 25%). Headline earnings per share increased 6% to 32.5p (2008: 30.8p).
Headline operating cash flow totalled £154m, representing 83% of headline operating profit. Net debt has increased since July 2008 by £204m to £975m primarily as a result of foreign exchange translation (£118m), maturing net investment hedges (£45m) and acquisitions (£40m).
In March 2008, the Board announced its intention to grow dividends consistent with increasing cover to around 2.5 times in the medium term. In line with previous guidance, the Board has declared an unchanged interim dividend of 10.5p per share. Looking ahead,our focus will remain on rebuilding dividend cover. This reflects the opportunities to invest in organic growth and acquisitions and the challenges in the financial markets which have affected the financing of corporates and defined benefit pension funds. The interim dividend will be paid on 24 April to shareholders registered at the close of business on 3 April. The ex-dividend date is 1 April.