Rolls Royce Smiths Group shares recoup after activist invests

Is there a pattern emerging from news that activist ValueAct revealed sizeable stakes in two UK blue-chips within the space of a few days?

ValueAct scoops up Supercentenarians

It emerged on Friday that the San Francisco-based investment company had become the largest single investor in Rolls-Royce Holdings, with a stake of a little over 5%.

The news gave the shares of the world’s second-largest manufacturer of aircraft engines a fresh tailwind, extending the stock’s rally from July’s 2015 lows to 18% in five days.

Then on Tuesday, the Financial Times reported that the fund, which characterises its investment style as “active” and “constructive” had also accumulated a stake in 169-year old British engineering conglomerate Smiths Group.

The latter’s shares powered their way to the top of the FTSE 100 index early on and remained there for most of the session.

Whilst ValueAct, led by CEO and Chief Investment Officer Jeffrey W. Ubben was obliged to disclose its Rolls-Royce stake due to its size, there was no such requirement to do so in the case of Smiths.

And whilst the investor does not appear to have made any direct public comment about its latest investments, ValueAct at least appears to have provided extensive guidance to the media about the fact that it acquired these holdings, and about its potential next steps.

This raises the question of what ValueAct’s ultimate intention might be.

We know that both Smiths and Rolls are venerable British engineering names, each with a history of steady earnings and total return growth that has made them staples for investment institutions.

But they’ve both also fallen on more challenging times of late, with RR posting a run of profit warnings and Smiths announcing £30m in charges in 2014 related to low-margin contracts.

Both groups subsequently embarked on far-reaching strategic reviews and likely repositioning in their specific markets.

In Rolls’ case, this was led by a freshly installed CEO with an impressive track record.

The new broom was Warren East, formerly of ARM Holdings, who arrived at the 109-year old engineer having overseen a 50%-plus total return by the FTSE 100-listed chip licensor between 2009 and 2014.

Smiths will welcome its own new CEO in September, after the incumbent, Philip Bowman announced his retirement in December.

Rolls-Royce, at least, has struck a constructive tone about its new investor.

“We welcome any investor who recognises the long-term value of our business. We look forward to engaging with ValueAct, just as we do with all investors”, RR said last week.

Assets for sale

This sounded like a nod to ValueAct’s more conciliatory and consensus-seeking style than the high-pressure, confrontational one many US activist funds are known for.

ValueAct has opted to engage with management teams away from the public eye, urging them to refocus by means of disposals, if required.

A recent high-profile example was Microsoft.

ValueAct might have an eye to what may be regarded as ‘low-hanging’ fruit at Rolls Royce and Smiths Group.

Rolls has notably been pressured by large investors during the last year to sell its low-margin marine engine and power systems businesses.

RR indicated it would probably meet with the activist investor shortly.

As for Smiths, it has been attempting to dispose of its own ‘albatross’ for years.

It said in September it was not seeking to divest any of its “businesses as part of our restructuring”, but it had already attempted to sell its medical device unit twice.

That business makes syringes and catheters and was up until recently the company’s second-biggest revenue contributor.

Smiths’ John Crane unit, a maker of industrial seals, has also been cited as potentially up for sale.

Intrinsically undervalued 

ValueAct may be living up to its name in that Smiths’ intrinsic value would require its stock to rise about 17% above its Monday closing price to match the company’s implied worth, according to consensus data compiled by Thomson Reuters.

Similarly, Rolls’ valuation is bang in line with its peers in terms of estimated Earnings Before Interest, Taxation Depreciation and Amortisation (EBITDA).

Forecast EBITDA clocks in at 8.3 times full-year 2015—implying some medium-term undervaluation by the market.

At the very least, the US activist group has forced a sceptical market to take a second look at two ostensibly underpinned British stalwarts.

This has propelled RR’s shares off lows and enabled them to recoup the loss that coincided with the company’s latest guidance downgrade, early in July.

Ironically, now that RR has resolved the gap between its close on Friday 3rd July and Monday 6th July, it looks as if the shares need to consolidate.

Ideally, the stock should ease no lower than its Tuesday intraday low around 817p, which roughly coincides with a 261% Fibonacci extension drawn off the stock’s failed attempt to bounce in July.

Should that level give way, the stock would need to stay above 793p, Monday’s low, to confirm the new uptrend has legs.

Please click image to enlarge

Smiths Group’s stock chart looks just as constructive as Rolls’.

On Tuesday, the price broke above a downtrend that has been in place since January 2014.

Tuesday’s euphoric surge of more than 7% moderated by the close of trading, but the gain of 4%-plus to 1205p was still a big shot above Monday’s 1149p high.

Should Smiths’ potential consolidation fall no lower than the nearest point of the falling trend, around 1183p, further near-term gains would be likely.

Please click image to enlarge