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Morningstar | Smiths Group Announces Welcome Separation of Medical Division; Shares Attractively Valued

Smiths Group's announcement of the separation of its medical division solves one of the three issues that have been weighing on the stock: the uncertain long-term strategic direction for the medical division, recent declines in the medical division's revenue, and the detection division's loss of market share with port customers. Details are still murky, but we take the medical division's separation news as a welcome solution to the strategic question, as it was the division with the greatest long-term challenges to market expansion. The mechanism and the timing of the separation are not yet known, and management expects to give an update with the first-half results in March. We believe the other two issues are temporary and continue to see the shares as attractively valued relative to our GBX 1,810 and $23.20 fair value estimates the local and ADR, respectively. We retain our narrow-moat rating.

The medical division contributes just shy of 30% of group revenue, but another roughly 50% comes from the John Crane and detection businesses, both of which have potential for expansion into new markets with less risk of pricing pressures than medical, namely because of the stronger switching costs associated with long-life mechanical seals (John Crane) and software driven security equipment (Detection) as well as high retention rates on aftermarket services for both. Assuming a full separation of Medical, these two divisions would deliver the bulk of group profits at about 85%.

Weakness in medical division's revenue from the recertification process in Europe should continue in the first half of the year with a recovery in the second. Based on the high-level first-quarter trading update, we believe the division revenue declined by low-single digits in the first quarter. The recertification process should be completed soon, enabling a return to growth in the second half because of easier comparables and products coming back to the market.

In detection, the long-term potential of security equipment comes from growing demand for airport security screening equipment, with many U.S. airports in need of upgraded and new equipment for baggage screening--the detection division's bread and butter--as well as new end markets like urban security--for example, public venues. Smiths Group works with governments on airport security equipment, giving it an easier entry into other government entities, such as police and public transportation departments.

For more details on our views on the Smiths Group divisions, please see our report: "Smiths Group: The Niche Collector."