Aug 31 -
Summary analysis -- Smiths Group PLC ------------------------------ 31-Aug-2012
CREDIT RATING: BBB+/Stable/A-2 Country: United Kingdom
Primary SIC: Electronic
Mult. CUSIP6: 832101
Mult. CUSIP6: 83238P
Credit Rating History:
Local currency Foreign currency
15-Jan-2007 BBB+/A-2 BBB+/A-2
19-Apr-2000 A-/A-2 A-/A-2
The ratings on Smiths Group PLC (Smiths) reflect Standard & Poor’s Ratings Services’ assessment of the group’s business risk profile as “strong” and its financial risk profile as “intermediate.”
Smiths’ business risk profile is supported by good diversity and leading technology-based positions in specialty markets with solid long-term growth prospects. We consider that the group has low capital intensity, and low cyclicality in large parts of the business (especially in Smiths Medical [medical devices] division and the aftermarket business of the John Crane [mechanical sealing systems] division, which together represent about one-half of sales). As a result, the group enjoys good profitability and robust cash generation.
These positive elements are, in our view, partially offset by Smith’s exposure to a number of cyclical industrial markets; prospectively austere government budgets; and a geographic reliance on North American markets (about one-half of sales). The group is also exposed to technology and pricing competition in several industrial markets.
We consider that Smith’s “intermediate” financial risk profile is supported by consistent free cash flow generation. Nevertheless, potential risks stem from a volatile pensions deficit and the group’s appetite for material-sized acquisitions.
S&P base-case operating scenario
We recently revised upward our GDP growth forecast for the U.S. to 2.1% in 2012 from 2.0%, and revised downward our forecast for 2013 to 1.8% from 2.0% previously. At the same time, our forecast for GDP growth in the European Economic and Monetary Union (EMU or eurozone) is just 0.4% in 2013, following a 0.6% decline in 2012. We see the main short-term economic risks in weakening business sentiment throughout Europe, increased regulatory uncertainties in the U.S., and a possible rapid deceleration of growth in China. These risks are among the factors that we believe could slow demand in Smiths’ main markets. We therefore anticipate a difficult operating environment for Smiths in calendar 2012 and 2013.
Consequently, our base-case scenario assumes that Smiths’ sales will remain largely flat in the next 24 months. We believe that strong order intake at John Crane and improving market positions in the Flex-Tek (engineered components to heat and move fluids and gases) divisions should allow Smiths to offset the anticipated earnings decline in the Smiths Detection and Smiths Interconnect divisions in financial 2012 (ending July 31, 2012), compared with financial 2011. (Smiths Detection produces detection system equipment, while Smiths Interconnect makes electronic and radio frequency products.) We understand that visibility on military orders in both the Detection and Interconnect divisions is unlikely to improve because of the U.S. defense budgeting process being delayed by the presidential elections.
We believe that Smiths Medical will maintain a stable level of revenues in the short to medium term. Stronger revenue growth in this division is possible if economic recovery in the U.S. proves more robust than we currently anticipate, leading to an increase in procedure rates (covering medical procedures and operations).
Over the next two years, we forecast that Smiths should be able to maintain its current level of profitability, with an EBITDA margin of about 18%-19% on a fully adjusted basis. Furthermore, we believe there is room for a modest improvement in profitability as Smiths advances in its restructuring program and manages to align its cost base with the market environment, particularly in the Detection and Medical segments.
S&P base-case cash flow and capital-structure scenario
Our base-case scenario assumes that Smiths will be unable to deleverage significantly in the medium term due to a forecast increase in the group’s unfunded pension liabilities. Such an increase is likely to result from an unfavorable market effect on both the asset prices and the discount rates used in the liability calculation. In addition, we believe that the group will continue to pursue an acquisitive growth strategy in the medium term. At the same time, we believe that Smiths will be able to maintain its funds from operations (FFO)-to-debt ratio at about 30%-35% in financial 2013 and beyond. This follows the 31% posted in the 12 months to Jan. 28, 2012.
Our base-case assessment is that Smiths will continue to convert a relatively high share of its operating earnings into cash. This implies modestly negative outflows on working capital financing, and capital expenditures (capex) contained at about 70% of depreciation. We therefore estimate that the ratio of FOCF to debt will be about 25% in the near term.
The ‘A-2’ short-term rating reflects our view of Smiths’ “strong” liquidity position as defined by our criteria. We consider the group’s liquidity profile to be adequately supported by its ample available liquidity sources and its proactive treasury management.
Our base-case liquidity assessment reflects the following factors and assumptions:
-- The group’s sources of liquidity will exceed uses by at least 1.5x over the next three years. Sources include operating cash flow, surplus cash balances, and availability under the committed revolving credit facility (RCF). Uses are mainly capital spending and possible acquisitions of up to GBP100 million. The $69 million cash proceeds from the recently announced sale of Smiths’ minority stake in Cross Match Technologies should further support the group’s liquidity position;
-- Liquidity sources would continue to exceed uses if EBITDA declined by 30%;
-- Smiths appears to have good relationships with its lenders; and
-- We understand that the group was in compliance with the interest coverage financial covenant included in the RCF documentation as of Jan. 28, 2012, and had headroom of significantly more than 30%.
On Jan. 28, 2012, liquidity sources consisted of surplus cash and cash equivalents of about GBP91 million, excluding the GBP55 million that we consider tied to operations. In addition, Smiths has access to the $800 million RCF, maturing in 2015, which had more than $700 million undrawn capacity at the reported date.
There are no significant debt maturities until 2013, when $250 million of private placement notes are due; we understand that these notes can be covered by drawing on the RCF.
The group’s public debt instruments contain no rating triggers or onerous nonfinancial covenants. The RCF documentation does not contain a material adverse change clause, and is subject to a financial covenant. A mandatory prepayment clause in the event of a change of control is a feature of Smiths’ public debt instruments. This clause would become effective if the ratings on these rated public instruments were lowered to speculative grade on any such event occurring.
The stable outlook reflects our view that Smiths’ strong end-market diversification and cash flow generation capability should allow the group to weather the general economic weakness that we anticipate over the near term. We believe that Smiths’ moderate financial policy and “strong” liquidity will allow the group to achieve its strategic targets, including possible acquisitions of a moderate size, without material deterioration of its financial ratios from the levels commensurate with the rating.
We could consider taking a positive rating action if Smiths continued to increase its earnings steadily, and demonstrated the ability to generate an FFO-to-debt ratio consistently above 40%. Sustained improvement in profitability from the restructuring of the Detection and Medical businesses to an EBITDA margin of about 20% on a fully-adjusted basis could also support rating upside.
Although we consider a negative rating action in the near term as unlikely, barring very sizable debt-funded acquisitions, we could consider taking such action if we believed that Smiths would not be able to maintain FFO to debt of at least 30%. We believe the main risks here stem from debt-funded acquisitions and a significant increase in the pensions deficit should asset values and discount rates continue to decline.
Related Criteria And Research
All articles listed below are available on RatingsDirect on the Global Credit Portal, unless otherwise stated.
-- Key Credit Factors: Criteria For Rating The Global Capital Goods Industry, April 28, 2011
-- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009
-- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008