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Announcement:

Moody's changes Smiths' rating outlook to stable from negative

09 Dec 2010

Approximately GBP1 billion of long-term rated debt affected

Frankfurt am Main, December 09, 2010 -- Moody's Investor's Service has today changed Smiths Group plc's rating outlook to stable from negative. The group's Baa2 issuer rating and its Baa2 senior unsecured rating are unchanged.

The Baa2 long-term ratings are a reflection of (i) Smiths' continuing focus on sectors with potential for above-GDP growth and EBITA margins in the high teens; (ii) the group's leading positions in niche manufacturing markets; and (iii) the low capital intensity and reinvestment needs of these businesses. However, the ratings also take into account (i) a degree of weakness in terms of debt leverage, which is a result of the group's acquisitive strategy and substantial pension obligations; (ii) potential lumpiness in the sales of the Detection business, as investments generally do not enhance revenues for infrastructure operators; and (iii) resulting current weak retained cash flow/debt coverage metrics.

"The change of Smiths' rating outlook to stable from negative reflects the strengthening of the company's debt capacity resulting from improved profitability and a strengthened generation of funds from operations and free cash flow," says Oliver Giani, Vice President at Moody's and lead analyst for Smiths. "This allowed the company to meet Moody's expectations for a stabilisation of the rating during FY2010 (31 July) -- however, any headroom in the rating category still needs to be built. Moody's notes that the agreement the company achieved with the trustees of its pension plans sets a reasonable timeframe to reduce the still substantial pension deficit without putting the core business and financial profile at risk," he added.

While Smiths' underlying sales remained broadly flat in FY 2010 as a result of the adverse economic environment, the company's EBITA-Margin improved to 18.1% (15.3% in FY2009) reflecting benefits from the major restructuring programme that the group implemented over the past two years. In addition, cash generation benefited from higher funds from operations, working capital releases as well as lower capital spending, resulting in an improvement in the group's free cash flow (FCF)/debt ratio to 16.3% from 9.2% the previous year. Moody's cautions that the group's cash generation remains relatively weak for the Baa2 rating category, as indicated by a retained cash flow (RCF)/net debt ratio of 20.1% in FY 2010, which nevertheless improved materially from 13.9% the year before. Going forward, Moody's expects this ratio to be further improved.

The strengthened profitability was a key driver for the reduction in leverage towards our expectations for the Baa2 rating category. For FY2010 we calculate a leverage of 2.5x Debt / EBITDA compared to 3.0x during FY 2009. Net debt reduced slightly to GBP1.3 billion (GBP1.38 billion at FYE 2009), not yet reflected in (gross) debt and leverage. Moody's notes that management follows an acquisitive strategy as reflected by the recent buy of Interconnect Devices, Inc. announced in March. Going forward Moody's expects Smiths to build some headroom in the rating category by further debt reduction.

The agreement between Smiths and the trustees of its major UK defined benefit plans is seen as a positive development, as it is intended to address the group's large pension deficit over a longer-term period until 2020, thereby mitigating the risk of significant increases in cash payouts in the short term. Part of the cash contributions to these plans are invested in UK gilts, which are held in an escrow account. This will allow the group to redeem the cash in the event that it is able to eliminate the pension deficit, which could result from higher discount rates, increased market value of the plan's assets or a combination of these factors. However, despite this agreement and additional measures taken by Smiths to address the pension deficit, Moody's is still concerned that the magnitude of the group's pension liabilities relative to its size remains substantial. Therefore, any variation in liabilities or assets can significantly impact the group's credit metrics, as evidenced in FY 2009.

The stable outlook reflects Moody's expectation that Smiths will be able to sustain current profitability levels, as indicated by EBITA margins well above 15%, which the group is expected to achieve on the back of (i) cost savings and efficiency improvements resulting from its recently extended restructuring programme; and (ii) a return to revenue growth. This should allow the group to further improve cash generation, supporting a reduction in debt levels and improved cash coverage ratios, as indicated by Debt to EBITDA between 2.3 and 2.8x, FCF/debt around 10% and RCF/net debt between 22 and 25% over the next 12 to 18 months.

For a rating upgrade to be considered, Smiths would need to adjust its financial policy, with moderate shareholder distributions and a commitment to further debt reductions, in order to achieve target leverage below 2.0x on a sustainable basis. At the same time, cash coverage, as measured by the RCF/net debt ratio, would need to be sustained in the high twenties.

Downward rating pressure would arise if (i) Smiths were unable to sustain its profitability metrics, as indicated by EBITA margins falling below 15%, or (ii) the group was unable to improve its cash generation, reflected by an RCF/net debt fails to improve from its current level. In addition, downward pressure on the rating would also result from rapidly increasing capex requirements as a result of, for instance, Smiths developing new detection systems or increasing capacity in its Medical division. Both such scenarios would permanently limit the group's FCF to below 5% of debt. Further, the rating assumes that the liabilities related to asbestos will continue to diminish over time. Also, accelerated shareholder strategies such as extraordinary dividends, additional portfolio restructuring reducing the scope of the company's activities without parallel debt reduction could be negative for the rating.

Outlook Actions:

..Issuer: Smiths Group plc

....Outlook, Changed To Stable From Negative

Moody's previous rating action on Smiths was implemented on 30 March 2009, when the company's rating outlook was changed to negative from stable.

The principal methodology used in rating Smiths was Moody's "Global Manufacturing Industry Rating Methodology", published in December 2007. Other methodologies and factors that may have been considered in the process of rating this issuer can also be found on Moody's website.

Smiths Group plc is an internationally diversified technology company with leading niche positions in its areas of specialisation. During fiscal year 2010 (FY 2010, ending 31 July), the group recorded sales of GBP2.8 billion, employed 23,550 people and operated under five divisions.

Frankfurt am Main
Oliver Giani
Vice President - Senior Analyst
Corporate Finance Group
Moody's Deutschland GmbH
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Paris
Eric de Bodard
MD - Corporate Finance
Corporate Finance Group
Moody's France SAS
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's Deutschland GmbH
An der Welle 5
Frankfurt am Main 60322
Germany
JOURNALISTS: 44 20 7772 5456
SUBSCRIBERS: 44 20 7772 5454

Moody's changes Smiths' rating outlook to stable from negative
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