Smiths Group plc (SMIN) Earnings Call Transcript & Summary

All right. Good afternoon, everyone, and thanks for coming out. I'm Paul Keel, I have the honor of leading Smiths Group. Joining me up here on the stage are some faces that are hopefully familiar to you if you've had a chance to review the videos. John Shipsey, our CFO; Julian Fagge, who leads our Interconnect business; Mr. Roland Carter, President of Smiths Detection; Amy Simpson is our EVP of Energy Transition; Jean Vernet leads John Crane; and last but certainly not least, Pat McCaffrey as the President of Flex-Tek. Just a quick preamble from me, and then we'll open it up for all of your questions. I'm going to cover 3 things quickly. First, I'll give you a quick summary of the agenda for this afternoon. Secondly, I'll offer a sketch of the technology expo, especially for those of you who have not yet had a chance to browse, it seems like many of you I saw have already had a chance to poke around a bit. And then third, I'll hit some of the high points from the capital markets presentations that we made available starting yesterday afternoon. Let me start with the running order for this event. We budgeted up to 90 minutes today for Q&A. And then we have another hour plus for reception afterwards. I'll give you another opportunity to interact with the scientists, the engineers and then the technologies. We have around 70 folks gathered here together in Kensington and another a couple of hundred or so who are online. Now having had the pleasure to meet many of you, I know you to be not a bashful bunch. But in the unlikely event that we don't get to your questions here in the next 90 minutes, chase any of us down in the reception afterwards or if that doesn't work, hopefully, you all know Jemma and you can just reach out to her directly. Second thing, I thought I'd just offer a couple of thoughts on the Technology Expo itself. What we tried to do is bring to life some of the many opportunities that you'll have seen in the videos. So the Expo features some of our more successful, already commercialized products that are in the market today as well as some of the more exciting platforms that are still in development. So for example, the most popular thing usually is the CTiX, the computed tomography scanner. If you guys haven't had a chance to test drive that, do it. You got to pretend to be a TSA agent for as long as you can tolerate it. And see exactly what the security agents see, and see whether you can spot the objects. We have a pretty interesting model of our FlashShield+ product, that's a multilayered tubing solution that you -- if you watch Pat McCaffrey's presentation, he talks about, has a number of interesting properties. Can dissipate energy better than some of the competitive solutions, and we have a model that brings that to life for you. In Interconnect, we have a vibration demo that shows the efficacy of some of our ruggedized connectors and the environments in which those are applied very important that it can stand both, mechanical as well as electrical disturbance. John Crane, we have digital feeds from our John Crane Sense connected seal as well as video feeds from our methane detection platform, and that's pretty interesting. I will unabashedly admit that there's a bit of a home team bias from me, but I still think even with that, you guys will find some of these technologies to be pretty interesting. Now for those of you online who couldn't join us today, we've also created sort of a digital twin of the Expo itself. We can't promise the exact same experience as getting behind the wizard or getting behind the curtains here and meeting the wizards, but it's still a pretty good representation of what these technologies are. I'd encourage you to give it a look. If you go to the landing page on our website, the Capital Markets landing page, you can get to the Virtual Expo. Which then brings me to the third item, the capital markets presentations. In addition to giving you a more detailed window into each of our industrial technology businesses, we tried to highlight 3 takeaways for all of you as you spend your time with us today. Three takeaways that underpin what we, all of us up on the stage, believe is a pretty substantial value creation opportunity right there for the taking. First thing I'd highlight is that as many of you who supported us over the years know, Smiths is an intrinsically strong company, grounded in 4 fundamental strengths: World-class engineering; leading positions in large, critical global markets; we have global capabilities that, in many cases, is just simply unmatched by our competition; and we have a unique and robust financial model that converts all of that, at the end of the day, into pretty strong cash flow. The financial output of that engine, as I say, is quite powerful. We get recurring revenues that come from our OEM model that generates aftermarket recurring revenues. We generally have high operating margins and good capital returns and then we convert that through a low asset intensity framework to generate the cash flows that I just mentioned. The third thing that I would highlight is probably the most important. The key to unlocking this value. The gap between our past performance and this significant potential. And we think what that comes down to is mostly execution. I've spent the last 6 months now intensively visiting our sites around the world. I've been in the labs with our scientists. I've been in the plants with our engineers. I have been out in the field with our customers. And I'm confident that this company is pointed in the right direction. A big part of us fulfilling this significant and realizable potential simply comes down to moving faster and executing better. As you heard me say in my presentation, it's as simple and as hard as this. And hopefully, you're seeing some early evidence of us pointed in that direction. Hopefully, you saw a piece of it in our good fiscal '21 results and further evidence of it in last week's Q1 trading update. We carry good momentum now into fiscal '22, and we're well positioned for accelerated growth in our core industrial technology businesses. Hopefully, you saw a little bit of that in the way we're executing the sale of Medical, now at a higher value and earlier-than-expected closing date. Yesterday, you probably saw 99.97% of our shareholders approved the transaction, a little better than 96% approved the return of capital. So we're going to start buying back shares beginning tomorrow morning. And hopefully, you're also seeing this in our more urgent execution of our ESG agenda. Now, just in the past 6 months, I spoke with many of you. You told me you wanted to see 3 things from Smith. You said you wanted to see a committed committee on our Board of Directors. You said you wanted to see ESG metrics tied directly to our long-term comp and you said that you wanted to see us name our first ever Chief Sustainability Officer, hopefully, reporting directly to me. We've done all 3 of those things in 6 months. Dame Ann, who leads our Board of Committee is here. You can track her down. Don't quiz her on engineering. She previously led the engineering department for Cambridge. She knows their stuff. And then our new CFO, John [indiscernible] also here. John, give a wave. So with all that now in place, our focus is squarely on execution. Execution and acceleration of learning, acceleration of growth and acceleration of value creation. So I think I'll leave it there for now and open it up for your questions. Emily and Carla have microphones that they'll bring across and then sanitize between uses. Of course, we're a small group here, and we'll be able to hear your question in the room, but because we have a great many people online, it would be helpful if you waited for the microphone and also if you'd be kind enough just to state your name and affiliation before the question, that will help the folks who are following remotely. I'll last comment, Andy Collingridge, our Director of Communications in the back. Andy, give a wave, is managing the online queries that come in, and he'll read those out to us as they come in. Okay. With that, who would like to kick us off? Here we go. First hand up. Good.

Great. Thank you. This is Will Turner from Goldman Sachs. Thanks for hosting this event. My first question is on your organic growth. In the presentation you did yesterday, you broke it down into 3 parts, really. And one of the parts was expanding into new adjacencies. Can you elaborate in more detail on what exactly you're changing to be able to kind of enable that extra growth into new adjacencies?

Yes. Thanks for the question, Will. So to set the table, we announced medium-term financial targets yesterday. The one that got a lot of attention was a more specific articulation of our growth aspirations. So 4% to 6% organic local currency growth. Previously, we had a more general description outperforming our chosen markets. In the presentation, then, we lay out how we're going to do that, something that we call the growth pyramid, has 4 levels to it. The first level to it is one that a number of companies that participate in these markets are enjoying. There's a good tailwind across most of our portfolio, but we need to execute against that to capture those opportunities. The second layer of the pyramid is specific to our new product development engine. You probably saw no shortage of opportunities that we're working on. You can see the physical sort of manifestation of those today. But again, it comes down to execution. We've got to move those through the pipeline quickly, and we need to commercialize them aggressively. So now you get to the piece that Will mentioned, which is specific adjacencies. We decided to show 8 in our presentations, those that we felt were appropriate to share publicly. And then we went in each of the division presentations and talk through what is that opportunity and how are we turning it from an idea into actual financial results. And then on the top of the pyramid is supplementing that organic list of opportunities with bolt-on M&A. Now, you can do your own math on how we go from the current 3% growth that we had going into the pandemic to the 4% to 6%, but the sum of the new product pipeline we show anywhere from GBP 200 million to GBP 250 million of opportunity at the gross level before erosion. The adjacency will ask about another GBP 200 million to GBP 250 million of opportunity. And we're confident that we can get into that 4% to 6% range and stay there. So thanks for the questions.

Just I'm sticking on it and just delving a little bit deeper, is this kind of a push to go into new adjacencies? And if we just use like John Crane, for example, going into like non-oil and gas markets -- this has been something that John Crane has been kind of strategically trying to do for a while. So is there anything -- is it just a top-down pressure on to the divisions and then the people below? Or is there going to be changes in the remuneration for people going into new markets? Is anything like more specific on those things?

So 2 parts to your question. Let me take the first part, and then I'll ask Jean to speak specifically about John Crane. No, it's very much bottoms up. The -- at the group level, what we try to do is create a culture where people feel an obligation to surface ideas. We then try to prioritize and quantify these opportunities and then allocate capital against those that we think are going to generate the highest return. Those are the 8 that we show in the presentation. One of those 8 is the environmental opportunity across John Crane. It has a couple of different components to it, but I'll let Jean talk about that.

Yes. Thank you, Paul. In terms -- first of all, in terms of non-gas vertical, non-oil and gas vertical represent about 40% of our revenue today. We will continue to expand that, but -- and we have different ways to do this, through technological innovation and novel manufacturing process that significantly lower the cost of producing those products, which make us more competitive in non-oil and gas. But I don't consider that as an adjacency, I consider that as the core. To build up on Paul's point, where we differentiate in the market is 2 ways. We build product, we provide products that are better than any other product at fixing leaks and spills. That's one core competency. The second core competency is we're providing the aftermarket reliability service that are really, our claim to fame in the market. We are second to none. That's why we have such a large presence in the aftermarket and the end users. Building on that, there are opportunities in decarbonation. Decarbonation, if you take, for example, the case of methane. Methane represent -- has an impact of 30% to global warming. 30%, right? It's huge. 20% of methane comes from the oil and gas. And within that, about 10% to 15% comes from leaky compressors. We know that part. We have zero emission leaks seal that come to the market this year. But what we observed is that if we follow the traditional industry process, it's going to take us 500 years to update -- to upgrade those thousands of all compressors. With the ESG movement, we see another angle. We see those companies, those oil and gas companies having to report very, very soon, quarterly their carbon footprint. And building on the Smith capabilities of measurement, we have observed with our client that methane is hard to model. You have to measure it to know where it comes from. It's nonparametric, it's very skewed. And this is an example of adjacency that leaning on the digital core competency and the algorithmical competency of detection, we have internally, but also in partnership with small boutique technology start-ups that are sponsored by the industry, by the OGCI Group, developing an array of measurement technologies, measurement, medium to build those methane maps for our customers. We use from the satellite, to the avionics, to the drones, to the fixed IoT, depending on the circumstances, all types of measurement technology and our adjacency is to be part of that initial measurement step. To integrate that data, provide these data maps to our customers and convince them, you don't have to upgrade all your fleet of compressors, you have those few bad actors that represent 80% of your leaks. Let's do it before the next quarter or before the activist sends the satellite and denounce you to the world, right? So by this diagnostic upfront steps, we are accelerating measures to remediate methane very effectively, right? This, for me, is an adjacency, which Amy is leading, but it's really built on the combination of we have the solution to fix the leaks, the core competency of seals, and we have the Smith -- the Smiths Detection expertise in having built this measurement service upfront. And then it's going to be a quarterly reporting cycle, right? So it's going to be a repeat business as the big leaks get fixed, we'll go to the smaller leaks and the tiny leaks where we start converging with Roland because the tiny leaks are going to come from the cities, from the urban, millions of tiny leaks, right? But right now, we are concentrating on the big leaks, which are upstream wells, pipelines, compressors, we'll move on to the downstream. This is a perfect example of adjacencies we're talking about. I could go, if you could -- go on and on because we have the whole asset management part as well. But that one for me is what we call adjacency.

So big opportunity. He's only a little bit passionate about that particular one. But I think we have another question across the way here.

Mark Davies Jones from Stifel. Could I ask Roland about Detection's role in this picture of accelerating growth because that seems to be the most challenged piece, given the weighting of the aviation sector in there and the fact that it's being delayed in terms of its impact because of the cycle you've been going through. So given the weighting of aviation in the mix, how can you offset that? Can you actually get proper growth out of that business over the next 2 or 3 years, even if that headwind is still working there?

Well, thank you very much for the question. Aviation is always going to be part -- a major part of Smiths Detection. It's the core. And in the medium term, it is a very attractive market in itself, and it is, in the medium term, has very powerful megatrends driving it forward, and we are in a very much of an advantageous position within that market. That said, there are other aspects that are changing around that which give us not dissimilar to what we heard from Jean. Quite close adjacencies that we can step into, whereas the core passenger shifting whole baggage shifting part of the business has those challenges. There are the close adjacencies of air cargo that you see coming through, not -- it doesn't completely offset the passenger side of the business. But also, you see the mail screening parts coming through, and you've seen us build very strong technologies about air cargo, and you see those products coming through now. And we have very tight relationships with the big 3 in that area. We're already in building closer with the other people who we all are very familiar with moving air cargo and packages as well. So we see a lot of opportunity there to take what is our core technology and bring it into those relatively fast-growing markets where we not only have the right to play, but also have the right to win through that technology and those relationships. So as those market changes, we are very alive to that and moving across that. Other areas of the business, you can see where those technologies can be moved across in the urban security area. So you see that growth in several ways. One, almost a replication as those hardened targets of aviation are harder, and therefore, more difficult for a terrorist or malefactor to go up against. And therefore, we're seeing that spread into the metro market, the rail station market as well. So there's a lot of opportunity within those areas. So close adjacencies. And then you would have seen our large high energy which is the air cargo. So we hear a lot about cargo these days. There's a lot of cargo flowing around. There's a lot of choke points within that. So there is a substantial amount of growth that we see. And I'll talk about the order book in a moment, but there's so much amount growth you see there in sales as well coming through across that. And so those are the close adjacencies, and we are seeing positive in all of that from the order book including the aviation, the pure-play aviation sector. And then we have the other adjacencies where the technologies are coming through, which are very exciting where we have the capabilities, but not necessarily quite such an active route to market, which we are developing, such as the agricultural parts the food safety part, which the current situation that we're in has made people a lot more sensitive to. And then you have those bits that sit in the middle layer, for example, mail room safety, which is a very active part where we're beginning to turn from a niche player into a market leader as well. So there is a -- just in the same way that core technologies works with Jean, there is a whole broad range. And I think if you asked what's the difference between Smith now, it's about the prioritization and getting that focus on the priorities and being quite clinical about making sure that of all these great opportunities that we have, we really do focus down on making sure that we really are staying close to what we're good at, which is making those best generation next-in-class products for that broad range of products. Additionally, we sit around, there are still opportunities about geographic expansion, which we're pushing ahead. We are a global entity, but we're not dry -- we haven't driven all the geographical expansion that we could drive and we're active there. But definitely, you're right, there are adjacencies we can step into, and we're very excited about those.

It's Andrew Douglas from Jefferies. I have 3 questions, please. You talked about culture and impairments. Could you talk a little bit about what you found as you've been wondering around the group with regards to that. I would have hoped that the businesses are empowered or the people are empowered. So can you just talk to how that's going to change, what it's going to drive, how you're going to follow it, just to make sure it is actually changing and how much of an influence kind of genuinely we have? Second question is on the portfolio. Yes, the first quarter trading update is kind of classic Smiths, 3 businesses going very well, 1 not. How do you smooth that out over the cycle? Are the growth avenues that you're focusing on across the 4 divisions likely to then smooth that out every yearly. You're not going to grow every year about 4% to 6%, but... And then John on the margin target of range. Can you just give us an idea of how we kind of model that? Because you're already almost 18, if you take the annualized run rate second half. It looks like we'll get nice growth, hopefully, in the future, but no margin improvement. I'm trying to figure out is, is 18 to 20 the number now, stay there for a couple of years, then go 20 to 25? Or is this now the more we grow the bottom line, the more we invest in the top line?

All right. We got culture, portfolio and margins. Okay. I'll take the first 2, you take the last one. You take the hard one. Culture. So -- Many aspects, the culture. But at the end of the day, culture is moving from intention into practice. And think of the element of culture in any of your lives. There's ritual, there's replication, there is group commitment to those. And that's what we're trying to build at Smiths. There's no shortage of intention for us to improve our performance. But when you look back across the recent years, we haven't performed in line with our full potential. So it's what can we do to start to first, have people believe that we can perform at a higher level. Secondly, expect that we're going to perform at that higher level. And then when you do that enough, it becomes culture. It's you expect -- you accept nothing less than performing at that higher level. And that's really the difference between the consistent executors, companies just like ours in similar markets, that you know, that are valued at very high multiples, they consistently execute in line with their capabilities. And I think that is this -- the fuzzy word that people like to call culture. With respect to portfolio. So we're now on the cusp of the most significant portfolio action that Smiths has undertaken in more than a decade. And it will have a meaningfully beneficial impact on the company in a number of respects. So first, quite clearly, the 4 technology industrial businesses are much better strategically aligned than our Medical products business. So this is an opportunity, strategically, for us to reallocate our attention, our people, our resources, our capital, to a much more strategically aligned industrial technology core. The second thing it does for us is just mathematics. It definitively improves the financial makeup of the group. So over the last 5 years, the compounded annual growth rate of the industrial technology businesses has outpaced our Medical business by 400 basis points. The compounded annual growth rate of earnings in these 4 businesses has outpaced Medical by 1,100 basis points. At the group level, that's 110 basis points of growth just from separating Medical, very substantial opportunity in that regard. The third piece of it, of course, is the proceeds. So it's a $2.7 billion headline value. You'll have to make your own judgments about what you believe the equity stake and the buyers worth and the probability of hitting the earnout. The walk around number I use is about $3 billion. We'll return $1 billion of it to all of you beginning tomorrow morning through a buyback. We'll use a portion of it to further stabilize our balance sheet, taking our debt-to-EBITDA ratio below 1 and giving us flexibility then to respond when opportunities come. And then we'll still have $1 billion in additional proceeds, either to further invest in core opportunities to take advantage of M&A as we see it or to make -- if there's surplus beyond our needs to return more to shareholders. So we think we're in a very good position from a portfolio perspective, margins.

Thanks, Paul. So yes, you're right. We are proud of our margins. Our financial framework is built around them. We -- you're also right that in the second half of last year, we generated almost the 18% that is the threshold for our target 18% to 20%. So our financial framework depends on high margins, great operating leverage and then strong cash conversion. So we want all of that to continue. But what we also see is that margins of themselves are not our goal. We want to deliver sustainable, growing, very strong free cash flow. And to do that, the extra ingredient we need to add is top line growth. So top line growth, we were growing 3% pre-COVID, maybe modest, but 3%. We want to take that from 3% to our target range of 4% to 6%. If we do that, I have to say that I think the rest of the 4 metrics for me are a given, they will flow naturally. But when we generate that free cash flow, our focus then, as you see from the financial framework is on 3 things, and 2 of those are about turning that handle faster and driving top line growth and that virtuous circle to be even better. So organic reinvestment with complementary disciplined M&A. So we are on the threshold of 18% to 20%. Our second half is weighted in terms of volume. So it favors the second half. But with the restructuring coming through, those benefits, but more importantly, with top line growth coming through, I am not worried about our 18% to 20%. Please don't worry about that because we're going to focus then on sustainable maximized strong free cash flow.

And Andy, remember the 2 years leading up to the pandemic, we did generate good margin expansion, 70 basis points and 50, 1st year coming out of it, last year, 150 basis points. So there's reason to believe we know how to expand margins. Thanks for the question. Jonathan, I think, is up next here.

It's John from Barclays. I just have 2 questions, please. Firstly, just obviously, you focused quite heavily on execution. Do you feel that you need to change management -- incentivize agent to make them more accountable for that execution to make sure that they deliver? Do we need to see some change there?

Sure. You have to have your compensation line up to your strategy. I would say the broad strokes of our compensation is correct. You'll have seen this year, we did make some tweaks to our compensation plan. In particular, as I mentioned, we added ESG metrics now to the long-term comp. There's a little bit more work we need to do on that. [ Jean] and I have a project going to kind of do a bottoms-up diagnostic. We have all of that lined up. So a little bit more work to do on comp. At the end of the day, yes, comp is important, but I don't think that is primarily what drives these folks. I think what drives these folks is doing better tomorrow than we did today and better than yesterday. As we start to get our momentum going, building on the fiscal '21 results, the good trading update in Q1, you start to get a momentum and winning is contagious. And that's what we're looking for.

And the second question was just in terms of the portfolio. If we look at certain businesses such as John Crane, obviously, you've exited areas that you don't want to be in. If we look at the 4 divisions now, are there areas within those 4 divisions that you see as noncore? And also going forward, if certain areas don't deliver, would you be happy essentially to exit those?

So we're in dynamic markets. And one thing that is certain is that if we sit still, 5 years from now, our portfolio will not line up with our markets. So we'll be constantly looking to move out of dilutive or weak or nonstrategic positions. At the same time, we start to penetrate those adjacencies that we talked about. That said, again, we're about to complete the biggest portfolio action in more than a decade, we -- 3 years in the making to get to this point, and now we want to focus on the core businesses we have and the growth opportunity in front of us. And that's what's going to be the lion's share of our energy. To your third question, if an opportunity comes in, somebody expresses a strong interest in one of our businesses. I think we've demonstrated that we're pretty rational owners of these assets. And as much as I love all of you, we work for the shareholders. So we'll give it a look.

[Carl Harris] from Alliance Bernstein. I just want to pick up on this issue of culture again. I thought, by the way, that your materials for the CMD were just brilliant, just really, really clear and compelling and the story they tell for the group. I was talking to one of your engineers as I came in and I asked them how well they understand the group. And they said they didn't really understand it a year ago, but they felt more connectedness to it now because they have it but I thought that was interesting. As you look at the organization, when you go up and down the organization and you think about connectedness and the cadence of getting things done and how the culture works, what do you notice? And are you considering sort of changes in culture or systems or silos or how do you make this cultural shift?

So I've now worked in 3 different multisegment industrial technology businesses. I worked in GE back in the glory days, I worked in 3M when things were pretty good and now in Smiths, we're on the cusp of what I think is going to be a very good period. The vast mechanism I've seen to stitch an organization across to align strategy to execution to motivation are these continuous improvement systems. Of course, GE did invent Lean Six Sigma, but 3M got it from GE when Jim McNerney came across and then amplified it under George. And we're taking that playbook, which we know works. You see it across so many of our peer companies that perform at a high level, and they often have these continuous improvement systems in place. Now we have a head start on this. We put the Smiths Excellence System in place 3 years ago. And you heard me talk about it in my presentation, exactly the right strategy. But we probably didn't move aggressively enough with it in terms of deploying it as a vehicle for execution or for a vehicle for talent development. So those are 2 big pieces that we're putting in place. We created a role on our executive committee led by Tony Tielen to do exactly that. And you can catch Tony at the break, and he can tell you more about what we're doing. Thanks.

It's William Ashman from JPMorgan. I just had a follow-up on the margin question. So I'm just trying to understand the time line a little better. Is it the case that if you get back to sort of pre-COVID levels of sales, then you can reach the floor of the margin range?

Say the question again.

Sorry, if you get -- I don't know if you can hear me very well. If you can get back to sort of pre-COVID levels of sales, do you think you can achieve the lower margin range?

I'll give my view and then you can give them a more quantified view of it. Short answer is yes. We wouldn't have put out those targets just yesterday if I didn't feel comfortable at 18% to 20% was in range. Again, we were essentially there in the second half of last year. And there's great operating leverage in these businesses. A little bit of growth converts to a lot a bit of earnings. So if we can get the flywheel growing a little bit faster and hopefully, we gave you confidence, giving you a little more detail on what we're working on, I think margins are going to take care of themselves. But John?

I think that's absolutely the broad message is. We're comfortable on margins. We don't want to give you specific -- we can't give you specific guidance on timing and the relation to top line. But yes, we are confident that we can deliver those margins.

Okay. And then I just had another question on the sort of opportunity within energy transition and how should we think about scaling this business and the opportunity versus existing sort of oil and gas sales in John Crane?

Maybe I take this one? Or you want to take it?

I can't imagine I would even get a sentence in, Jean. So you go ahead.

All right. So when we think about energy transition, what I first see is this incredible long-term growth ahead of us driven by population growth, 1% to 2% a year over the next 30 years, plus higher standard of living, which is 2% to 3% additional. Now the only way to be able to meet that demand is if that demand is offset by an incredible amount of efficiency offsetting that gross growth, which is estimated to be 2% to 3% a year to 2050, right? So you have 2 phenomenon: one, a huge increase in demand and another one, a huge need for sustained efficiencies not like we have never seen before. Both play in our core. The demand will be met by a variety of energy sources. There's a lot of scenarios out there. What we know is the trend is to decarbonate right? It's going to be a mix of solar generation, wind generation, nuclear, biofuel, geothermal, a series of things and a baseline of oil and gas. We are not really in the business of oil and gas exploration and production. It's a tiny part of our business. However, most of our energy businesses is in the transformation of energy, wherever the source is. Whether it's solar, whether it's wind, whether it's any type of energy sources, you need to transform that pure energy into something that you can store. Hydrogen is a great mechanism. Methanol is another great mechanism. And you need to convey that energy somewhere through some pipeline. And you need to crack it again to transfer it back to energy or to re-gasify it to build petrochemical products that are recyclable, right? So that's the business we are in, which is called flow control. Any of those energy sources, which are going to be interplaying with each other, much more than in a traditional system, which were more siloed. Any of those energy sources will need more compression, more pumping, more storage, more conveyance that all require our critical products. So I'm actually very, very excited by this transition. And on top of that, the core, the base of oil and gas will require incredible amount of more efficiency, which plays to our asset management core and need to be clean. That's the methane story we talked about. But it's also less leaks, it's also less usage of power, less usage of water and all our products play into this, right? So for us, it's -- I'd like to say it's as big an opportunity as after the second world war, big scaling of industry globally or the invention of the combustion engine. I mean, it's huge for us.

And then maybe just one final one for me. In your sort of conversations with shareholders, what would you say the largest misconception they have of the group so far?

I think it's a pretty knowledgeable shareholder group. I've spoken with more than half the registered 3 times now. And you guys know what you're doing. I think the big question for us is what's going to be different this time. So the strategy -- the main pieces of the strategy that George put in place when he became Chairman are largely the same. They are elements that I know well from 3M and from GE, these are proven management processes for creating value. So why is it going to be different this time around? And again, I think it comes down to the 3 points that we talked about in the materials. I can get a little bit more growth, and hopefully, we've given you confidence that we have more than enough opportunity. If we can execute better through continuous improvement in the next phase of the Smiths Excellence System and if we can better inspire and empower people to do what they do so well, the strategy is right. If we execute it, there is a lot of value to be created here.

It's Andre from Credit Suisse. And apologies if you've talked about it already, I was a few minutes late. But I'd like to just talk a bit more about the construct of your growth target and how that adds up, bottom up, by divisions or maybe how you build it from the market indications that you've given? Maybe you could start with that, please?

Yes. We covered a bit of it but let me go through it one more time because it's probably the fundamental question. So the 3 reporting periods prior to the pandemic, we reported roughly 3% organic growth, each of the 3, so the 18 months leading in. We guided to 3% for this year for fiscal '22 and our Q1 results, although we don't give detail by division, give us confidence that we're on pace to meet that expectation. So we think of 3% as the baseline from which to start. And there are -- we walk through the growth pyramid, which has 4 components to it, beginning with market recovery, and we gave you examples across most of our portfolio. Detection, I think we already had a question around, is a notable exception in the near term. But the rest of the portfolio, very strong demand, very strong order books. Comes down to whether we can execute to convert those orders into revenue. New product pipeline in the materials give a number of different examples of specific programs, some of which you can touch and feel here. When we add up the forecaster for the pipeline, it's GBP 200 million to GBP 250 million of gross opportunity. We're trying to figure out what the core erosion that will offset that, but there's a lot going on in the pipeline. The adjacencies, we had a couple of questions on, and we could go back to the methane opportunity if Jean would be willing. But there's others. Maybe we'll give Julian a chance to talk about SATCOM, that's opportunity of similar size and scope. And then I think we're building a credible track record around M&A. We've done 10 acquisitions, 11 divestitures in the last 5 years. And building a competency on that to amplify our core organic engine. So again, I come back to no shortage of opportunity. That has been true with Smiths for many, many years. The question is, can this group execute, have a clear strategy, clear priorities, which of these opportunities we're going after and then can we hit the ball. And that's what it comes down to.

If I could have 2 follow-ups, please. One is on divisions. Would you go as far as maybe commenting on where do you expect this division to be versus the midterm target you put out, who should be higher who, potentially lower, if at all? Or maybe is that something we could expect as official targets maybe further down the line? And second one, on M&A pipeline, again, could you give us a bit more detail on kind of how built out it is? Maybe in terms of number of companies tracked? Is there a number that you kind of go out and visit due diligence on, given that you have got, obviously, now ample balance sheet resources to work with?

No. I'll take the second one, and then maybe I'll let the division presidents talk about what sort of growth you feel in your businesses? Of course, we can't give you specific division growth forecast, but I think we can give you a feel for what we have underway. So M&A pipeline, very strong. Of course, the M&A markets right now are very robust. The question is one of value. So we've been disciplined purchasers in the past. We know what model works for us and we're going to remain disciplined. So we're not going to chase bunnies running across the trail at crazy multiples just because it's a feverish M&A market. That said, even in this context, we're still getting deals done at very healthy multiples. Pat referenced the acquisition we did with Royal Metal. Did we publicly share the multiple on that?

Well, we showed that on an GBP 80 million acquisition cost in the -- less than the first 6 months, we delivered GBP 10 million of operating profit.

Proprietary deal, we knew that sellers, it was ours for the taking and integrated quickly and went after it. So pipeline is good, value is a bit of a problem, got to stay disciplined. Julian, talk a little bit about growth and Interconnect and what you're seeing.

Sure. Thank you, Paul. I mean, look, I've been with Interconnect just a couple of months now. And one thing I'm really clear about is there are such a number of opportunities for us to drive the growth. A couple of examples. So for a long time, we've had component sitting in the space and SATCOM subsegment. Ferrites, these types of products. About 3 years ago -- 2 to 3 years ago, we made the Reflex Photonics acquisition, we've brought fiber optic capability into the stable. And that was a very distinct choice because we knew and our engineers knew that fiber optics would bring us -- was where the growth was going to come, right? Because satellites need to communicate faster in order to fulfill the huge global demand that's there and that is coming. So we are now really nicely positioned in terms of components and technologies to ride the wave of, and indeed, drive that growth. The LEO satellite opportunity, over the next 5 years, is enormous. My analysis says that if you add up the number of programs, there are 47,000 LEO satellites that are planned to be sent into orbit. And we are in a leading position to participate there. So a really nice opportunity in space and SATCOM. I won't talk at length on semi test, but the semiconductor business clearly is in a -- from an underlying market standpoint, in a position of strength, and we are in a very nice position in the subsegment of test, and we have some leading capability and products there that big, big customers are calling us to deliver to them. So some really nice growth opportunities coming from within our business. Really excited by it. So thank you.

And Pat, you have the best growth track record at 11% CAGR over the last 5 years. But I would humbly submit even you can do better.

I've heard that message. Okay. And we can, and we are. I started in the presentation, we sit, I think, in the best position since I've been with the company to grow. You've got a recovering aerospace by 2025 to pre-COVID levels. Great opportunity, but in construction. On top of that, with the acquisition of Royal Metals, we'll be able to take metal products to customers. We've never carried that product in. And then geographically, we can spread that across the United States. We started a site in Houston this last month. And you got that -- and then you got a line set launch, the customers are waiting to get that's going to come out in the third quarter of this fiscal year. So we look -- I feel great, I feel great, and you expect it. So I feel great, and we're going to deliver it.

All right. Thank you, Pat. Other questions from the group? Yes, in the back?

It's Robert from Morgan Stanley. I'd just be curious around your R&D and CapEx spend. Are you changing that materially versus the last 5 to 10 years? This is obviously not the first time Smiths has made a push to try and accelerate the top line growth. I'd just be kind of curious on the ground. A, are you changing anything in terms of the way you funnel those programs, you're putting more money into that in the near term. Does that have any implications on your cash generation? And then, I guess, second to that, just kind of more broadly speaking. When you look at across your different divisions, ultimately, the problem has always been aligning your different businesses. There's particular years where they kind of line up and everything is going well. And then many years where they kind of -- it's not that they don't grow but they cannot cancel each other out. How do you kind of -- how do you get over that hurdle to get sustainable growth in the medium term from the business? Do you feel that the portfolio mix is where it needs to be as further to go from an end market shift? I noticed you changed the reporting structure in terms of your end market as well. Is that something you're going to sort of push it further? Is there sort of specific end market that you're trying to get to a certain threshold or boost more because you see stronger growth opportunities?

All right. So I heard 2 -- at least 2 questions in there. One, has our R&D spending as a percent of sales and CapEx as a percent of sales increased over time. I think you're better positioned for that than me.

Okay. Good. So you'll have hopefully seen from the presentation, we are going to increase our R&D spend as a percent of sales to 5%. We're going to -- so we're going to increase that investment. We're also going to really target the effectiveness of that across all of the divisions and making sure that we've got optimized processes, not just for efficiency, but also for effectiveness of that spend. Within that 5%, it's also important to realize a substantial part of that is often funded by our customers because, for example, Roland is the go-to person if you are a government or a private customer with very specialized high-performance needs in terms of security. So we also do get within that 5%, we do try and make sure that whether it's government grants or customer-funded R&D, we make the most of that. So I see that just 5%, we will commit to that going forward, and we will be able to accommodate that nonetheless within our 18% to 20% margins. On CapEx, we also -- so we have high margins, we also have low capital intensity. I don't see that changing going forward. We are -- in FY '21, our CapEx ratio of -- CapEx to sales was between 2.5% and 3%, and I see that staying below 3% going forward, so no change there.

With respect to the portfolio. So I like the portfolio we currently have. You want to strike the right balance between having a diverse enough portfolio that you can smooth out the cyclical factors that you described. You certainly don't want a portfolio that is all tightly in phase because that defeats the purpose of having that diversification so that when some of our businesses, like Interconnect and Flex-Tek are very, very strong right now. They help offset Detection, [Roland's] business, which is soft right now. That will change. We know with a high degree of confidence that security in our world is not going away. At some point, inevitably, the U.S. construction market is going to have to soften. At that time, we'll be about when Roland's business starts to come back. The flip side of that is you don't want so diverse a portfolio that there's no unifying logic to it. And I think we have that now with a group of industrial technology businesses, all with similar characteristics. We lead with engineering. We have more sophisticated solutions that allow us to serve these demanding customers. We have similar business models with the OEM component, large installed bases, and then recurring revenue from the aftermarket that comes from it. Because we have more highly engineered offerings, we tend to have higher margins and higher returns. That then funds the investments that you talked about in R&D and CapEx. So we won't sit still. We'll continue to tweak and hone the portfolio, but we think we're in a pretty good place. And right now, we just want to move ahead faster.

Maybe just as one follow-up. Is there any process around potentially divesting any part of the portfolio? You mentioned the 11% growth at a 20% margin business. Is that -- do you feel that's been sort of fully reflected in the Smiths share price? Or is there opportunity to sort of -- I guess the ultimate question we always get is breaking up the Smiths portfolio in some of the parts argument and do you ever really get fair value for the quality of the businesses you have? Are you comfortable that through this strategy, that can be realized?

I mean it's a fair question. And it's certainly one that is on people's minds right now because you saw GE that split into its 3 component parts. You saw the DowDuPont split into 3 component parts. You saw United Technologies split into 3 component parts. And there's reasons for that. Underperforming multi-segment players trade at a lower value, underperforming pure-play companies trade at a lower value. The common denominator between the 2 groups isn't structured, it's performance. So in our case, if we perform better, there will be no conglomerate discount dismiss just as there's no conglomerate discount to [Helmer] or Atlas Capco or Danaher or Honeywell. Multi-segment players who perform trade at premium. Andy's got another one here in the front. Sorry, sorry. Sorry. You got to wait.

It's Ed Maravanyika from Citi. This one, I guess, more for Roland at Detection. Could you please talk more about your biological detection products in terms of new product development. And I'm referring more specifically, I guess, to BioFlash, which I thought was conspicuous by its absence in the presentation yesterday.

Bio Detection, BioFlash, what do you got going?

Yes, absolutely. So we have a broad range of technologies that we use to serve our customers. And part of that technology is a chemical and part of it is biological and then we also have the radiological and the nuclear aspects, which we have in those areas. And often, those are produced and productionized as a bundle for our customers, they're looking for a broad range of products. So definitely behind that acquisition of that technology was to make sure that we have the full suite that could deliver to relatively traditional customers of ours. With BioFlash, it's running, actually at this very moment in this room. And it is and does have the capabilities of detecting COVID well below the concentrations that you need to have to be infected by. So we do have a very effective and very fast -- we can detect it within 3 minutes of the test being carried out. So we have a very competent and capable piece of equipment there. And at the moment, we are working with various customers -- important infrastructure customers to develop that product into something that can be truly commercialized and really brought to follow what we do, which is to make the world a safer place. So we are still developing that product. We have some lead customers who are utilizing that product to protect people and revenues in those cases. So we are using that for COVID detection. We use it for the more traditional uses for it, which are -- for example, I mentioned the adjacencies of mail rooms. There's a lot of those in a lot of vulnerable mail rooms around the world where we look for different aspects such as ricin or anthrax as well, again, to protect people, to protect property and to protect revenues. So it is very much the focus of our broad sweep of technologies to allow us to serve the customers going forward.

Right here in the front, Carl.

Thank you. It's pretty much the Smiths Excellence System. On Slide 22, you talked about the 3 years of laying the groundwork. How comfortable are you with this system? It looks like you've introduced lean to only 40% of your plants globally, which is an extraordinary number. Do you still need to do a lot of work on the Smiths Excellence System? Or is it fit for purpose as we stand today? It's just more about execution?

The system itself is well known. The tool set around lean management systems or Six Sigma or Agile scrum is another one we use for accelerating development. Those are well known and applied in a number of different businesses. And I would think -- I would say the toolkit that we have and the training that we've done into portal is quite good. I would say where we have an opportunity is using that system now as an operating tool, as an execution tool. It's currently a reference tool. If employees have an interest in learning more about Lean, we sponsor them to go to Oxford and get a green belt or a black belt. So we need to change the mindset from reference to action. That's the big move. It's not trivial. It's a different way of thinking. But if you're successful, it has a big impact. I've lived it twice. I saw it transform 2 companies.

Sorry, but Paul? Sorry to interrupt you.

Andy, yes. We've had a few questions in -- coming online. So I thought I'd get those into the conversation.

The first one from Rodman Moorhead from Tocqueville. Why are you guiding to operating cash conversion rate and not free cash flow conversion rate?

I'll give you my view and then turn it over to John. We track both. Both are important and, of course, the 2 are closely connected. In fact, a little linear Algebra gets you from operating cash flow to free cash flow. So we think both are important.

Yes. Yes, absolutely. And thank you for the question, Rodman. Good to hear from you. Thank you for joining remotely. So you're absolutely right. We have 5 priority metrics that we've picked out. And they operate individually, but they also operate together. And we have focused on operating cash flow because our primary target is to increase the rate of top line organic growth. And that organic growth needs to convert through profit to operating cash. So that's the reason, and you'll have seen from the history -- hopefully, from the presentation that we have generated 108% cumulatively over the last 5 years as a group, and every single business has generated over 100%. They've all contributed to that strong operating cash conversion. So that's good. But I don't want you to think that we are exclusively focused on operating cash. We do really care about what happens between operating cash flow and free cash flow. And it's very deliberately on the diagram that shows the Smiths financial framework, the center of it is free cash flow. That's what we are about because we want to generate as much of that as possible in order to reinvest in organic acceleration, in complementary M&A and also in returns from shareholders. Maybe just some -- a couple of points of evidence for -- to, if you like, justify that focus that we also have on free cash flow. Well, partly, we have an EPS target within our 5 priorities as well. And that EPS target, clearly, that carries a lot of items that come below operating profit, particularly tax and we're focused on cash tax, interest, et cetera. So those 5 metrics work together. But also, historically, you look at what happened in FY '21. We actually generated earnings of about GBP 370-odd million just over. Our free cash flow was over GBP 380 million. So I think that does show that we are focused on maximizing free cash flow as well as operating cash flow. And we have more to do. So it's not just the lines that come into earnings and EPS. But you know what we're doing, for example, on pensions. So we have 2 very strong, well-funded U.K. schemes that historically, we've been contributing GBP 24 million a year to. Earlier this year, well, last year, we were able to hold contribution -- pause contributions to the TI scheme. And earlier this fiscal year, we also did the same for the SIPS scheme. And that's because they're so well-funded but that's GBP 24 million of our free cash flow machine that is now available for those 3 uses that we're focused on. So Rodman, I can absolutely assure you, we are very focused on free cash flow.

That's great. Thank you John. And so the next question was from Mark Fielding of RBC. His question was previously the group had divisional margin targets, although generally, they were being achieved already. As noted, we are not far from the bottom of the group target range. Does that mean that most divisions are operating close to their potential already? Or is the margin opportunity greater in some areas than others?

Two thoughts on this. I think we touched on a bit of this already. We think there is margin expansion opportunity here. It's not our primary focus because of good operating leverage we get in these businesses. If you get the growth, you get the margin expansion. So we think there's more to come. That said, I'm personally more interested in growing earnings than I am growing margins. So if there are opportunities for us to go after very fast growth markets that might lead to a penalty in operating margins, I'm going to make that trade-off every time. I think we have enough leverage in our business for those margins to grow. Our primary focus is on accelerating the top line.

Totally agree.

Okay. The next question was, can you outline the type of discussions you are having with customers who are looking to shift energy forms?

Amy, if we're going to give you a chance to talk a little bit about energy transition and what you're hearing from customers in terms of that.

Sure. So thank you for the question, wherever it came from. We've met with a variety of types and sizes of customers, at least in the 8 months since I've been on board. And we -- so we have people who are -- customers who are relatively further along on their journey. It's a mix. So some people already have a handle on some of their methane emissions challenges and they are looking for more monitoring type solutions and they -- or maybe further afield, internationally, they're still concerned about how to measure and monitor and make those maps that Jean mentioned. Others are really starting that journey. So they're really interested in what can we help them with here and now and finding the super emitters. So there's -- at the moment, the conversations are heavily focused on addressing that really near-term problem of how do we get rid of the methane problem. And obviously, in parallel, we're having discussions around removing carbon from the atmosphere, so it's around carbon capture and what can John Crane do to help them in that space. And we already do play on a big variety of carbon capture projects. We play in, I think 80% of capacity, if I'm not mistaken. We are already in a high number of hydrogen projects as well, particularly some of the largest blue hydrogen projects that are out there. So we do have a lot of ready, now technology and know-how. So we have a lot of discussions with customers on those angles. Any others that I should mention?

No, this is a great overview. I would say that end users or the operators are currently more focused on blue hydrogen, as you mentioned, capturing methane emission while the OEMs, which is our other customers or our other customers, as well as the EPC are also looking further along to the next horizon, which is developing the compressors and the pumps of tomorrow that will allow green hydrogen to function at scale. I mean we are talking different scale, right? So frontier products that sometimes twice the speed that we see today because hydrogen is obviously a much lighter compound with very, very abrasive and hostile action to the traditional material that they use in compressors and pumps. And then at much higher pressure rate as well. So that really is a technology discussion. We don't necessarily see immediate revenues from that because this is the next generation of product. But the elder in John Crane tell us that it's very similar to what we went through when the LNG started back in the '90s. And if we go back 20 years, 25 years, we actually invented with some of our key OEM partners, whether this was Siemens or at the time, GE Oil and Gas or Nuovo Pignone, we essentially invented what LNG became today in terms of the new LNG trends. It's very, very similar.

The only thing I would add to what Jean mentioned, and thank you complementing that, is in parallel to energy forms that they -- that we talk about, there is always the underlying discussion on efficiency. So that's something that -- it's a current that runs through every single customer interaction. Our engineers that are sitting in facilities around the world are obsessed with this topic with customers and how to get more with less energy basically in their systems. So that's something that's a constant. Thank you for the question.

Great. Thank you both. So we've had a few questions on the same subject. This is a good example to illustrate. Therefore, making it sort of the last question we've had online. I've seen some of your competitors that refer to supply chain issues. What are you seeing in your businesses?

I'll offer a couple of thoughts from the group perspective to set the table and then I'll ask Julian and Pat to share with what their feeling in the front line. So 3 thoughts from the group perspective. First, the macro climate, right now, is broadly favorable. Demand is strong, the world is opening up, so interaction with customers and with partners is much easier. But with that warming economy comes the tendon complexities that are inferred in this question. So yes, there are material supply constraints. There's inflationary pressures. There's a tight labor market in certain skill sets and geographies. Smith has some structural advantages in managing these, but we feel all 3 of those. Some of the structural advantages, first, again, is the broad portfolio. We're not dependent on any 1 raw material for a material contribution for revenues at the group level. Secondly, many of our solutions rely on a core technology, but then are customized for a very specific customer application. So we're localized in that regard. We like to source materials locally, assemble locally, deliver locally. So we're not exposed to these various transoceanic constraints that you hear about in the press. The third is, because we have more highly engineered solutions on average, we think we're in a better position either to pass on raw material increases in the way that we've negotiated the contracts or capture price for the value that we offer. So we have these pressures like anyone else. We think we're managing them well, but why don't we hear the specifics from Julian at that.

Sure. Happy to add some perspective. So from an Interconnect standpoint, yes, we are seeing some supply chain issues. What I'd add to Paul's comments is, first, we absolutely do have local supply for local facilities. So we have a different supply chain for our facilities in China versus our North American business, for example, served out of Tijuana. The second thing we're doing, frankly, is just hard work. So we're just managing very, very specifically the issues that we have. We're looking into our forecast, and we're very, very tightly managing the supply needs to serve that specific situation. And we're getting through it. I think the third thing I'd say is, we are working really closely with our customers. If we are going to miss a delivery slot, we communicate, we talk to them. And frankly, if you can manage your customers well through this, you actually come out on top. Particularly if you do that job better than your competition. So yes, we're struggling in certain areas, but it's very much in control.

Pat?

Yes, I'll pick up on what Julian said because -- we're having trouble, too. 2 parts. We're having supply issues, but we're also -- labor issue. Supply issues, what Julian touched, we're close to our customers. If you can stay real close to them, they're having other issues besides us. So they're working with us, whether it's deviations or other things, and we're able to pass it to and get them to products. We'll also be able to source others, might have to pay more, but as Paul says, we'll be able to pass that cost to and we've been very successful. Labor has been a challenge in all the construction market. And we've taken this opportunity first. We got incredible people. And if you sit down with them, you'll be amazed with the solutions they'll come up with to help you get to the situation. And we do a lot of that. We're also looking to automate and we are automating. And that's a big key because automation not only help us now. It's going to help us in the future, so we've kind of kicked that in. So we're able to get through these, but it is a lot of conversations with customers, our employees, but you'll be surprised they'll all step up and help you through them and they have with us. So it's been good.

Thanks, Pat. So that's it for questions online, Paul.

Any more in the room? Or are you guys out of bullets? All right. Why don't we leave it there? Again, we'll have plenty more time to catch us at the break. I thank you for all coming out again and your interest. I hope you heard from the group on the stage. We have a clear vision of where we're going. We think we have a simple, clear strategy in terms of our priorities. And we're confident in our ability to execute and convert that potential into value. So hopefully, some of that came through. Thanks, everyone.