Shares digital

Smiths Group (SMIN) – 940p, stop loss 752p

SHARES SUMMARY

An unloved stock that is not expensive and has the potential to surprise, either through improved financial performance or radical surgery on its portfolio of assets.

Business:

Advanced technology and engineering group.

Vital stats:

Market VITAL STATS:

Market Value: £3.6 billion

Historic PE: 18

Prospective PE 2008: 13

Prospective PE 2009: 11.5

Sector PE (next 12 months): 14.2

1-month relative strength: -0.6%

1-year relative strength: 0.2%

Yield 2008: 3.8%

NMS: 12,500

Spread: 0.11%

A change in senior management often heralds a major shake-up at a firm and, according to a Shares survey (25 Oct’07), sparks outperformance from its shares. The arrival of Philip Bowman at Smiths Group last December was always going to generate interest, as in his previous two posts he sold Allied Domecq to Pernod Ricard in 2005 and Scottish Power to Iberdrola in 2006. Smiths' shares ran up in anticipation of the departure of Keith Butler-Wheelhouse, after his 11 years at the helm, but have sagged from £10.66 to 934p since Bowman got his feet under the desk. If the interims published in mid-March are any guide, however, patient investors should treat this as a buying opportunity.

Smiths' conglomerate status is an instant turn-off for many, and it is more than two decades since the market warmed to the buccaneering activities of firms such as Hanson and Tomkins. Yet each of its three key operational units – medical, specialist engineering and detection – are either late cycle or even relatively immune to economic uncertainty.

Detection is a beneficiary of the war on terror and rising government security spending, as it provides technology capable of screening airport passenger baggage and shipping cargo for intruders or unwelcome substances. Specialist engineering includes rotary seals expert Crane, which is riding the oil equipment boom. Medical provides patient safety, medication delivery and patient monitoring products.

The problem is, medical has failed to perform with any consistency since 2005's acquisition of Medex. Internal supply problems again dogged the interim results at the unit, so it was encouraging that Bowman chose to focus last month on operational matters rather than the group-wide break-up the market has been baying for.

Research and development spending is to be boosted at medical and also detection, internal manufacturing and financial systems are to be overhauled and bolt-on acquisitions will be made. These plans will be funded by a freeze in the dividend payment and a desire to rebuild dividend cover to around 2.5 times, from last year's skinny-looking 1.4 times.

Such moves should generate long-term earnings gains, and most analysts increased their earnings forecasts after the interims, despite another flat showing from medical. Upgrades should provide support for the stock, as any study of the market makes it clear that firms with rising earnings forecasts tend to easily outperform those with falling ones.

Bowman's record suggests he would not be frightened of major surgery but the timing is not propitious. Current credit market conditions mean finding a financial buyer for possible disposal candidates, such as Crane, Flex-Tek or even medical, would be difficult.

A break-up would be a powerful catalyst for share price performance but, if the new chief executive can simply deliver more consistent financial performance, he should win over the sceptics.

Ten of 15 brokers following Smiths rate the stock as a hold or a sell, according to Digital Look. This is a good start and a prospective PE of barely 13 for calendar 2008 also suggests little potential upside has been baked into estimates.

by: Russ Mould