Smiths Industries – large conglomerate discount

I have put in about 12% of the portfolio into Smith’s Industries at 932  This is a FTSE100 listed Engineer involved in oil and gas, medical, detection and interconnect related businesses amongst others…

It has a market cap of £3.7bn with 818m of debt the pension deficit is circa 108m .  In 2013 Smiths got a £3.1bn offer for the medical division, in 2012 an offer of £2.45bn was made.  Both were turned down.  The medical division is earning more now and multiples are higher across most medical device producers.  

I am not entirely convinced these multiples are right – but in a broadly stagnant economy growth stocks are very highly valued and very well priced – so who am I to argue.

Medical is a good business to be in – apparently they sell the kit then get a nice annuity supplies / maintenance business….

This gets you to the bulk of the market cap – you (almost) get the rest of the company for free.  This is a good bit of the investment case – why overcomplicate ?

The company trades at a PE of 11 and an EV/EBITDA of about 7.7x.  It isnt particularly expensive by any measure.  Coupled with a hot M&A market and lots of cash about I recon there could easily be another offer.  Historically management have not wanted to sell – but they may be forced.  ValueAct (activist investor) held a stake but sold to work on Rolls-Royce.  Others will surely follow at this price, management will be forced to act there has recently been a change of management – making a deal more likely.

I believe much of the low valuation of Smiths is due to the oil and gas division (John Crane) being unfairly sold down due to the perception that they will suffer due to plummeting of oil and gas capex.  I doubt this….

Much of Crane’s work is maintentenance capex, seals which need to be replaced at certain intervals.  I guess these could be switched to those of another manufacturer but they seem to be relatively low cost/ high impact and it wouldnt be worth the risk if it shuts a firms oil refinery down.  In a transcript here – they say opex is 63% of revenues.  Not all is oil and gas some is chemical processing / general industrial, oil and gas is 38% of revenues – its likely to be much more stable than the market expects…

The business is showing no serious decline in earnings – revenue and earnings fell a modest 2% in 2015.

There is an asbestos liability of unknown size – I am confident that these claims wont have too much of an impact – there is a provision for $236m, 242,000/318,000 have been dismissed with 133 upheld at a cost of $153m.  This has been stable over time – but if enough of these are upheld the company will be sunk.  I dont think the risk of this is material.  Production of asbestos ceased in 1985 – so the youngest workers with it  are now 50+. Mesothelioma only happens after 40/50 years and would be hard to prove.  In addition these are (broadly) poor, unwell, ill educated people taking on a large corporation, which will fight.  It isn’t right but its the way the system works….

Other divisions are of less interest –

Detection is 16% of group Revenue / 10% EBIT before costs. This is security – airport x-ray scanners and the like.  Again if one applies multiples of comparable companies to this.  Leidos (a competitor) is trading at  30x earnings.  Again lots of scope for M&A / potential value to emerge.

Smiths interconnect do microwave signalling / connection components – 15% revenue, 9% EBIT. Again competitors are trading at a much higher multiple – Amphenol – a competitor is on a 22x PE.  These competitors however, seem to be growing much faster rate.

Flex tec has doubled EBIT since 2011 so it is something of an exception – still

Basically this is rated much too lowly.  I am not entirely convinced they are performing to their full potential – to me it makes sense to break the group up to achieve higher growth.  It must be difficult to manage.  I like the idea of a diverse group but in practice it appears that it has been unable to achieve growth so is valued at a low multiple.

I also believe the entire group is being tarnished by an association with oil and gas capex – a bad business to be in right now.

Dividend is  4.3% – so you get paid a bit to wait…

Happy to buy more at lower prices but will think again below £5 or if earnings fall significantly.  Part of the attraction of a conglomerate such as this is that this will be much less likely.