Description

Smiths Group (SMIN.L – 1110p)

Founded in 1851, Smiths Group is a UK industrial conglomerate that consists of three high-quality, unrelated, and historically mismanaged businesses.  Philip Bowman, a new, best-in-class CEO, was recently brought in to restructure the company and ultimately break up the parts (likely in 2-3 years).  The 3 businesses, Detection, Medical and Specialty Engineering, generate a combined return on capital of 25% and organically grow earnings at 17%, 18% and 14%, respectively.  The SOTP valuation is 1850-1900p which suggests that the current price reflects a ~70% discount to intrinsic value.  In an uncertain macro environment, Smiths Group offers defensive business characteristics that provide an attractive return with limited risk.

Investment Merits

·         New best-in-class CEO: Philip Bowman’s track record speaks to his relentless focus on shareholder value creation.  In his prior roles at Allied Domecq and Scottish Power, he successfully restructured and sold the businesses.  Now at Smiths Group, Bowman is highly incentivized – he will earn $4mm if he achieves his aggressive performance targets.  Better yet, he has a change of control payout of $6mm (divisional break-up constitutes a change of control) which provides further conviction in his intentions.

·         Significant scope for margin improvement: Under Smiths former leadership, a substantial amount of useless G&A costs were allocated to each of the three divisions resulting in artificially depressed margins.  Bowman will not only to remove the unproductive cost structure, but also to reclassify division margins to reflect division level profitability which will, in turn, unmask the potential value of each division to potential buyers.   Additionally, Bowman identified numerous opportunities to rationalize SKUs, improve working capital and increase prices.  When Bowman outlines his strategic plan in September, he will identify at least 500bps of margin improvement (through strategic turnaround and ultimate G&A removal).

·         Market leading defensive businesses with strong growth: Smiths businesses are all market leaders in their respective niches.  Detection and Medical both benefit from secular demand trends that are independent of the macroeconomic backdrop.  The industry for detection products is growing at 11% a year and Smiths has been growing double that pace.  If the EU/USA standardize airport security measures, Detection stands to benefit enormously as 450 new airports would have the capacity to purchase its technology leading baggage screening products. Engineering serves oil and gas markets, but its products are largely replacement in nature (70%) and do not depend on new capital projects.

·         Attractive valuation with clear market dislocation: The 15%+ growth and 30%+ ROIC of Smiths suggests the company should command at least an 18x multiple on an absolute basis and more likely 25%+ higher than that when factoring in the imminent breakup. Conservative expectations of the restructuring imply Smiths is currently trading at 10.5x post-turnaround earnings  (turnaround margins on 2008 sales) which suggests a 70% discount to intrinsic value.  The valuation dislocation exists for three reasons: 1) misperception of true profitability; former management allocated group G&A to each division – Bowman will reallocate costs and properly communicate profitability in September (SOTP models will immediately increase in value), 2) poor sell-side coverage due to small size (UBS offers the only decent assessment), and 3) Smiths is a show me story – Bowman has not yet communicated his strategic plan and has spent limited time with investors; once he outlines a strategy and begins to consistently execute, the market will gain conviction in both the margin and the break up, and rerate the stock accordingly.

Investment Risks

·         Execution risk at Medical: Philip Bowman admitted that Medical “was a bigger mess than I had expected”.  While this means more potential for upside, it also suggests a higher level of execution risk for the turnaround at that one division.

·         Market conditions not ideal for a break up: Unlike other conglomerates, Smiths will not depend on a private equity bid for its assets – each of its three divisions would fit nicely with a number of strategic buyers with well-capitalized balance sheets. At the same time, private equity buyers can often bid up assets in an auction and ultimately cause these strategic buyers to pay more. If current market conditions prevail in two years, Bowman could struggle to get top dollar for the assets in the break-up.

Catalyst