Smiths Group shares join over optimistic defence sector reset

Smiths Group stock piggy-backed on a welcome rally of aerospace, defence and engineering shares, but the smart money was more likely stalking, not chasing.

Days after one of the worst terrorist atrocities in The West in modern times, investors were probably weighing prospects for Smiths’ Detection business.

It’s the world’s largest maker of sensors for discovery of explosives, weapons, chemicals, drugs and more.

Pension deficit benefit

The view that global intensification of anti-terrorism measures would increase demand for Smiths’ security products helped the stock rally as much as 11%.

But news of Smiths’ internal housekeeping was also a factor.

Smiths said in an otherwise lacklustre first-quarter report, that a change in pension funding would bolster free cash flow by £36m each year.

That will improve coverage of dividends, among other things.

Smiths’ free cash flow ebbed by almost 10% last full-year, down to about sector average, even though Smiths pays higher dividends than peers (4.4% yield vs. 3.9% sector average).

“Finalisation of triennial valuation of Smiths Industries Pension Scheme at 31 March 2015” resulted in a deficit that was £250m lower than the last three-year valuation in 2012, it said.

It was something of a relief for shareholders.

They’ve probably the watched the outlook for pay-outs at rivals like Rolls Royce darken with some alarm.

However, there was also more than usual cause for caution, despite Tuesday’s relief rally in Smiths.

Its John Crane unit, which services the beleaguered energy sector, remains at more than moderate risk of further downgrades for the full-year.

John Crane has latterly accounted for 31% of Smiths Group revenues compared to 16% from Detection.

After dividends, the cash flow boost would likely be remedial for John Crane, rather than a net advantage.

Return on capital employed at the unit declined 90 basis points to 25.8% in fiscal 2015, whilst revenue slipped 4% to £905m.

In Detection, sales fell 9% to £467m.

Light relief in heavy industry

That ought to temper optimism over demand for Smiths’ defence and security products.

More widely, anticipated uplift in demand for arms and defence equipment lifted the pan-European STOXX Europe Aerospace Index more than 3% on Tuesday.

On Monday, French President Francois Hollande pledged more spending on security in response to Friday’s attacks.

But there was room to question how distributed any sectoral benefits would be.

Especially for the hybrid defence/engineering mid-caps that form the bulk of the UK sector.

The FTSE 350 Industrial Engineering Index traded more than 3% higher at its best on Tuesday.

That was slightly better than the FTSE 350 Aerospace & Defence Index, which managed 2.7%.

Bargain hunting may account for at least some of Tuesday’s gains.

These sectors have lost between 17%-20% year-to-date. (FTSE All Share is down <3%>

A&D industry pressure from falling defence spending has played havoc.

Rolls-Royce’s fourth profit warning in about a year last week was a lowlight.

The oil price freeze since 2014 hasn’t helped the highly diversified group keep an even keel.

We see no material prospect of improvement in oil demand in the medium term—US prices have been trapped below $50/bbl. since late July.

Neither is European defence spending likely to ramp-up at a war-time pace in the near term.

That should leave the A&D and oil engineering sectors with a helpful tailwind from last week, but not a great deal more.

Small change

Smiths Group’s biggest investors signalled a more measured view too on Tuesday.

They seemed largely absent from dealing, or perhaps made great efforts to remain undetected.

Confirmed trades in Smiths stock were almost all in blocks of less than 600, according to ‘light’ and ‘dark’ order book data from Thomson Reuters.

One opening ‘uncrossing’ trade of 62,000 was reported.

Overhead winds

Smith shares had a chance to recoup losses made between mid-October on Tuesday.

Though a close about halfway between mid-September to mid-November’s decline (1021p) seemed likelier.

Tuesday’s jump did cross the 21-day exponential daily moving average (white, perforated line).

But a bunch of resistances (including that 50% marker) and sturdier 100 and 200-DMAs were strewn overhead.

A 38.2% extension of the fall during August had already stopped one attempted comeback, in October.

The stock also faced the challenge of closing for the day above a sharply descending trend.

It’s been breached around 1003p, just cents away from the price as this article went live.

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