SMGZY - Smiths Group: Taking A Leap Of Faith

2023-03-29 05:46:12 ET

Summary

• Smiths Group has undergone changes, including the sale of the Medical business and the appointment of a new CEO.
• SMGZY's 1H23 results were solid, and the raised guidance reflects management's optimism about the state of the market.
• There is potential for expansion through innovation, emerging markets, and M&A activity, and the company has a strong balance sheet to support this growth.

Description

I have faith in the long-term viability of Smiths Group's ( SMGZY ) assets due to their dominant market positions, high and stable margins and returns, and substantial aftermarket earnings. However, there is no denying that these assets have generated slower organic growth - which is something to note. SMGZY has undergone more change in the past year than in the previous decade, what with the sale of the Medical business and the appointment of a new CEO . As a result of these adjustments, I anticipate higher productivity across the board. Even though I have my doubts about future growth, I am giving management the benefit of the doubt and assuming that the new financial targets are realistic. However, the new CEO could prove to be the impetus for change and expansion this time around. There is an element of faith involved, as there is with any thesis stems from major change, and I would recommend buying a small pilot position and size up when we see significant improvement over the course of a few more quarters.

1H23 results

SMGZY has produced a solid performance, with 1H23 Interims exceeding forecasts. Moreover, each division has seen successful outcomes as well. Management emphasized optimistic remarks about John Crane order books and noted the division's strong OCC growth and healthy margin improvement (>200bps) to 22%. Despite uncertainty in the US real estate market, Flex-Tek has also outperformed forecasts for sales. On the other hand, even though Detection performance was strong, the adverse effect of the OE mix shift on profits was felt. The raised guidance is something I really like, as management is now expecting at least 8% growth in OCC sales and modest margin improvement. This bump isn't huge, but it reflects management's optimism about the state of the market. I expect consensus to upgrade their estimates accordingly.

Growth outlook

With the new CEO in place, I anticipate a strategic shift that will fuel expansion. Specifically, I anticipate that SMGZY will continue to innovate new products and seize opportunities in emerging markets (higher growth tech regions with improved pricing). As for new markets, I think the venture into adjacent markets would be the natural move, for instance, security systems in the Detection division. Finally, I believe that management should not rule out M&A activity (I further discussed potential below), which, if done at the right valuation, should enhance the growth profile and opportunity. The volume is not the only factor in the growth equation. Management will likely implement an organic price increase as well. If anything, I think SMGZY should be able to increase price-over-cost margin as inflation slows. In sum, I believe there are a number of levers that can be pulled to drive results; the question now is whether or not management can actually deliver on these promises.

When it comes to margins, I believe SMGZY has a proven track record of execution success. Over and over, the company has exceeded expectations by producing mid- to high-teens EBIT margins, a ROCE in the mid-teens. Although the group has a strong and well-established presence in the market, thanks to its history of providing top-notch engineering solutions, I think there is room for improvement by instilling a culture of continuous enhancement. One obvious way would be to simplify the portfolio (which has been done) and moving toward decentralized operations should help the company find new ways to cut costs, leading to better execution and higher profit margins.

John Crane and Detection

John Crane's energy and industrial markets are the ones I see the most potential in over the next few years. With the energy transition trend as a long-term growth driver, I anticipate Energy entering its upcycle. However, I would like to draw attention to the fact that the transition from traditional assets to the new technologies may cause some minor near-term growth headwinds throughout the cycle. The narrative surrounding John Crane should begin shifting from its current focus on its core business - O&G - to its growth outlook. The Detection segment has a relatively low EBIT margin, but its strategic value lies in the R&D it contributes to the company as a whole. The company as a whole can benefit from this R&D capacity, leading to quicker innovation and, naturally, higher margins overall.

M&A

In my opinion, SMGZY has the potential to increase its profits through M&A. Currently, the company has a net debt of about 300 million, which is less than one times its EBTIDA. By leveraging this debt to two times its EBITDA, the company could have an additional 700 million in funding for conducting deals. If SMGZY were to acquire another business with similar multiples to United Flexible , where they paid a multiple of approximately 11 times EV/EBITDA, this could result in an increase of about 63 million in EBITDA (which is 11% of the FY23 EBITDA). It is unclear when the company will decide to pursue a deal, but this example demonstrates the potential benefits provided by the company's strong balance sheet.

Summary

While there are some concerns about the slower organic growth of SMGZY assets, I have faith in their long-term viability due to their dominant market positions, high and stable margins, and substantial aftermarket earnings. The recent adjustments made by the company, including the sale of the Medical business and the appointment of a new CEO, are expected to result in higher productivity and growth. The 1H23 results were solid, and the raised guidance reflects management's optimism about the state of the market. With the new CEO in place, I anticipate a strategic shift that will fuel expansion, including innovation of new products, opportunities in emerging markets, and potential M&A activity. Smiths Group's strong balance sheet provides potential benefits in pursuing deals. Overall, I believe there are multiple levers that can be pulled to drive results, and management's ability to deliver on these promises will be key in the company's future success.

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