EUR 850.00 For Business Accounts Only

Morningstar | SMGZY Updated Star Rating from 18 Jul 2018

We would take advantage of the share price weakness in narrow-moat Smiths Group following the company's profit warning due to extra costs in its medical division (28% of revenue). The costs are related primarily to regulatory changes, but also to changes in distribution. In total, we believe the extra costs will be around GBP 25 million per year, with about GBP 15 million regulation-related, from fiscal 2018 to fiscal 2020. This lowers our EBIT in those years by 4%-5% per year; however, as the extra costs are temporary, and we use a long-term DCF to value the company, the costs are not significant enough to change our GBX 1,810 valuation. We would take advantage of the sell-off to pick up shares, as the remainder of the businesses (70% of revenue) are attractive niche businesses whose growth seems to be picking up, including (we believe) Smiths Detection in the second half of the year.

The incremental costs break down into two parts: 1) regulation-related, and 2) extra distribution costs and a product refresh. Last year the European Commission introduced new medical device approval regulation with higher standards. The companies that check for compliance with EU regulation, "notified bodies", also had to be approved to review devices for compliance with the new regulation. Due to the extra costs for the notified bodies from the new regulation, some of them have chosen to forgo the process, with the result that the number of bodies has shrunk dramatically. We count 25 companies today as part of The European Association for Medical Devices of Notified Bodies, down from around 80 in October 2017. One of the bodies that dropped out was used by Smiths Medical, forcing it to pull all of its medical device products from its shelves until they have been recertified under a new body. Smiths is in the process of doing this, with some products already recertified, and the rest to be phased in over the next 2.5 years at a cost of roughly GBP 15 million per year.

The remaining GBP 10 million in extra costs is related to a large distribution contract, as the company was unhappy with the contract and is thus in search of a new channel, as well as the refresh of some older products with new ones coming into the market.

From a strategic standpoint, Smiths Group has been trying to return the medical division to higher growth by embarking on a broader product portfolio refresh with a shorter gap between the introduction of new products, relative to the previous management team's schedule. It is also possibly looking into a joint venture with ICU Medical that could be related to distribution and cross-selling, but no details on those talks have been revealed.

The company as a whole has attractive long-term prospects due to the margin and return stability through the cycle, associated with the dominance it has in its markets. For more details, please see our recent report titled "Smiths Group: The Niche Collector".