Growth Likely To Slow in 2024 for Smiths Group Industries After Bumper 2023

Regional Director

Alex Morozov

Smiths Group is a collection of industry-leading niche businesses, each producing admirable margins and returns; however, growth across the group is inconsistent, with different divisions enjoying periods of strong demand but at disparate times. Research and development spending as a portion of sales has increased by 50 basis points over the past few years. However, to accelerate group-level revenue growth, several innovation winners—not a single one—are likely necessary, given the breadth of products across the businesses. The innovation cycle for each business is also likely several years, and the fruits of the recent ramp-up in spending have yet to be seen. That said, a few of these product categories, particularly in security and safety, have emerging technology potential that could lead to new market opportunities. Management sees a potential GBP 200 million-GBP 250 million in gross new revenue opportunities in the medium term. The net number will probably be lower after taking into account cannibalization of existing products by new product rollouts. 

Smiths Detection is the division with the potential to propel the group, as it offers security screening equipment with a potential addressable market beyond its current focus. The division specializes in screening equipment for airports and ports, mainly supplying to governments. The United States is an important medium-term end market for this equipment, and it is likely to go through a multiyear upgrade program, swapping out X-ray equipment for computed tomography scanners. Smiths has a record of supplying equipment to the Transportation Security Administration and has recently secured a sizable CT order from the agency.

Of the other divisions, John Crane is the most important cash flow driver, with a high portion of recurring revenue and an entrenched competitive position as the number-one supplier globally of mechanical seals. It faces a challenge over the coming years of managing likely declining revenue from its oil and gas customers with new products and end-market growth. Its deep expertise in improving seal performance suggests it should be able to offer compelling value to new end markets.

Business Strategy & Outlook

John Crane is the largest global manufacturer of mechanical seals, with 80% of products generating revenue over an average 25-year period and a brand that benefits from association with the invention of the mechanical seal. On that basis, we think it has strong intangible assets through its brand and technical expertise and benefits from high switching costs for its customers. We view this as a wide-moat business. 

George Cook invented the mechanical seal in 1907 and then founded a company called Cook Seal, which is now part of John Crane. Leveraging this early start, John Crane is now the leading global provider of mechanical seals with 30% market share. Its closest competitors are EagleBurgmann and Flowserve, with 20% market share each. John Crane has the largest service footprint among its competition with 230 sites. A wide service presence is critical to quick turnaround times on seal repairs. 

Mechanical seals are essential in providing heating, hot water, oil production, transportation, and refining. The most prevalent application of a John Crane mechanical seal is in a centrifugal pump, which is used to move/pump fluids through various processes. The job of the seal is to keep fluids or gases from leaking. For example, in a pump it is critical that a corrosive chemical that is pumped remain separate from the motor. Seals are essential to the functioning of centrifugal pumps, given that 69% of pump failures are caused by malfunctioning seals.

A typical mechanical seal in a centrifugal pump has two main components known as faces, one stationary and one rotating. The seal against fluid leakage is created in two ways: First, the two faces are placed within millionths of an inch of each other; second, a minuscule amount of liquid is allowed to come between the two seals. This strengthens the seal’s barrier and serves as a lubricant as well as a cooling agent for the seal. Because the liquid could be anything from water to a dangerous chemical, choosing the different metals for the seal faces and understanding how they will interact with fluid running through the pump is critical to proper functioning of the seal. The choice of materials will also depend on the temperature range and pressure conditions under which the pump is operating. In addition to material choices, the design of the seal will depend on the process in which it is being used. Summing all of these choices together, this means that 75% of John Crane seals are custom-built. This increases design and manufacturing complexity.

Mechanical seals last an average of 25 years and need maintenance about every three years. A seal failure can be expensive, for example, causing downtime in a refinery. The high level of customization and risk from a seal failure due to faulty repair drives most of John Crane’s customers to use the firm to maintain the seal. This creates a strong recurring revenue stream, with 80%-plus of John Crane’s installed base of mechanical seals maintained by the company itself, guaranteeing a stream of revenue for the 25-year life of the seal. Most of the revenue and profit potential of a mechanical seal is in the aftermarket. The original seal can cost up to $50,000, but significant repairs can cost as much as $40,000 and usually take place every three years. From this, we estimate that 75%-80% of the lifetime revenue of the seal comes from the aftermarket. This means that from a Smiths Group-level perspective, John Crane’s lock on the maintenance of its own seals is a key contributor to long-term economic profit. 

Nearly 80% of John Crane’s revenue comes from mechanical seals. The energy sector is one of the most important end customers for John Crane and Smiths Group as a whole. Oil production, transportation, and refining require numerous pumps at different stages, and the sector generates 70% and 16% of revenue at John Crane and Smiths Group, respectively. The seals are usually first sold to OEM pump manufacturers such as General Electric, Weir, and Flowserve. After the seals are installed, the end user, such as BP or ExxonMobil, becomes the customer through the ongoing maintenance of the seal. Mechanical seals are made up of several components, any one of which could need to be replaced due to wear and tear or faulty use. Nearly 60% of John Crane’s reported revenue comes from these aftermarket services.

Smiths Detection's primary customers are government transportation and defense departments for use in airports, ports, government buildings, and security-sensitive venues. We think the company has a wide moat based on its position as one of a handful of large-scale equipment detection companies that are approved suppliers to certain security-sensitive government organizations, particularly in the U.S. Detection works closely with its customers to develop technology and software that can detect chemicals, weapons, narcotics, or radioactive materials, depending on its customer’s demands. This means that it has access to classified information on specific threats. The company constantly updates its technology based on changing threat levels and uses its knowledge from working with the governments, as well as its own large image library, to improve its threat detection equipment. The specific knowledge and Smiths' image library are not accessible to its competitors. 

Detection technologies are continuously evolving in terms of hardware and software to accommodate new threats. Smiths has a large and growing image library that helps it to more effectively identify objects that could be used to make an explosive device or weapon. It also has proprietary software that uses algorithms to analyze the images and chemicals detected by its machines. It regularly updates this software, which it then passes on to existing customers for a fee. This is part of its aftermarket revenue, which constitutes about 35% of division revenue. Smiths works closely with the Transportation Security Administration to adapt its products to new threats. The longer Smiths works with the TSA, the higher the switching costs for the agency, as Smiths accumulates knowledge and expertise that is confidential to outsiders and becomes a trusted partner. 

The detection business has a few different drivers for its equipment orders. Smiths and its competitors tend to get repeat contracts from customers, and on average, Smiths Detection's equipment has a life of five to seven years. Receiving contracts from the TSA gives Smiths cachet worldwide, securing its place as a major global provider of airport security systems. Regulations on required technical capabilities are updated every few years, creating a recurring replacement cycle.

Detection offers about 60 products in its airport segment, but these can be reduced to a smaller number of machine types: body scanners, servers to connect hardware in a screening area (for example, collecting data from all the images from the various X-ray machines), modular conveyor belt systems, hold-baggage X-rays, and handheld devices. Each of these product types are extended into different lines of specialization and levels of technical sophistication. For example, some equipment can be calibrated to focus on explosive device detection or just for testing bottled liquids. Some of the equipment is large, designed to handle large volume in a short amount of time, or small and handheld. 

Smiths has a separate division just for its contracts with the U.S. Department of Defense and Homeland Security agencies. This division also has a separate board that meets regularly with the U.S. government’s Defense Counterintelligence and Security Agency (part of the U.S. Department of Defense). The U.K. Ministry of Defence is also a known customer. About 75% of detection revenue comes from the U.S. and Europe. 

Combined with its $710 million acquisition of Morpho, Smiths Detection has about one third of the global detection market (GBP 1 billion out of GBP 3.3 billion). On a pro forma basis, we think Detection would become the leading provider in screening systems for air transport with about 46% market share, followed by L3Harris (16%) and Rapiscan (8%). 

Smiths Interconnect (13% of group revenue) manufactures equipment used for power, signal, and microwave use that can operate in high-pressure situations. This division has little aftermarket revenue but has a blue-chip customer base that relies on the quality and technological innovation of its products. We view Interconnect as a narrow-moat business built on strong intangible assets, brand and technology. Customers include Apple, AT&T, and NASA. For example, its connectors were used in the landing gear for the Mars Rover. For commercial airlines, the company provides equipment to enable Wi-Fi for passengers by capturing satellite signals from an antenna placed on the tail of the aircraft. The division spends around 6%-7% of revenue on R&D, with a small portion funded by defense customer programs. 

Despite the barriers to entry, highly specialized nature of its equipment and required regulatory approvals, we do not think Interconnect deserves a wide moat, as most of the revenue is based on discrete projects with little aftermarket.

Flex-Tek (26% of group revenue) is a specialist in hoses and has a strong record. About 25% of its revenue comes from providing hydraulic hoses for major aerospace programs lasting 15-20 years. The rest of the revenue is a mix of high-margin niche areas such as tubing used in medical applications. A small portion of its hoses are used for connecting gas lines into homes and other buildings. We consider this division to have a narrow moat based on the specialist nature of its products, many of which have to meet strict safety and regulatory standards. It has strong intangible assets from its technical expertise and brand.

Narrow

Economic Moat

Smiths Group PLC

Smiths Group Plc engages in the development, manufacture, and sale of control systems and instruments for industrial applications. It operates through the following business segments: John Crane, Smiths Detection, Smiths Interconnect, and Flex-Tek. The John Crane segment produces mechanical seals, engineered bearings, power transmission couplings, seal support, and filtration systems. The Smiths Detection segment manufactures sensors that detect explosives, narcotics, weapons, chemical agents, biohazards, and contraband. The Smiths Interconnect segment offers electronic and radio frequency components and sub-systems. The Flex-Trek segment includes components that heat and move fluids and gases, flexible hosing and rigid tubing. The company was founded by Samuel Smith in 1851 and is headquartered in London, the United Kingdom.

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