SMITHS 2003 RESULTS DEMONSTRATED AGAIN THE BENEFITS OF FOCUS ON GROWTH AREAS ACROSS ITS BUSINESS GROUPS, OFFSETTING THE EFFECT OF SLUGGISH ECONOMIC GROWTH CONDITIONS IN MANY PARTS OF THE WORLD. FURTHER PROGRESS WAS MADE IN ENHANCING THE BUSINESS PORTFOLIO WITH THE HEIMANN ACQUISITION, INTEGRATED INTO OUR DETECTION BUSINESS, AND DISPOSAL OF LOWER MARGIN NON-CORE OPERATIONS. OPERATING CASH-FLOW PERFORMANCE REMAINED STRONG. DEBT FELL TO £715M AT THE YEAR-END AND WILL REDUCE FURTHER TO BELOW £250M WITH THE PROCEEDS FROM THE POLYMER DISPOSAL.

ACCOUNTING POLICIES
As disclosed in the interim announcement, Smiths has adopted voluntarily the full accounting requirements of FRS17 – Retirement Benefits in its 2003 accounts and comparative figures for 2002 have been restated accordingly.

With the exception of FRS17, there have been no changes in the group's accounting policies during the year.

PROFIT AND LOSS ACCOUNT FORMAT
'Discontinued activities', comprising principally the Polymer business, are shown in a separate column in the profit and loss account in order to illustrate more clearly the ongoing activities. Interest is allocated to discontinued businesses on the basis of net proceeds receivable. As a result, the profit before tax in the 'Ordinary activities' column is stated on a comparable basis between 2003 and 2002.

'Goodwill amortisation' and 'exceptional items' are also shown in separate columns in the profit and loss account and are discussed below.

PROFIT AND LOSS
Continuing activities (before exceptionals and goodwill).

Sales of £2.6bn were slightly over the prior year. Within this total, however, activity levels varied significantly, with growth in the Detection and Medical businesses offset principally by lower civil Aerospace volumes.

Benefiting from continuing cost reduction actions, operating profit from continuing businesses at £372m was ahead of last year by 2% and operating margins were unchanged at 14%.

Company funded research and development costs of £130m were £13m higher than the previous year, principally in Aerospace and Detection. Customer funded development costs also rose by £25m to £121m.

Total interest on net debt reduced to £38m (2002 £58m) as a result of reduced borrowings, and lower interest rates. Interest was 11 times covered by operating profit before goodwill amortisation and exceptional items (2002 7 times).

Other finance costs – retirement benefits, representing the financing cost of pensions and retiree healthcare benefits under FRS17, were a net charge of £2m (2002 net credit £26m) as a result of the decline in the funding position of the principal schemes.

Overall, pre-tax profit before exceptional charges and amortisation of goodwill, was down 4% as a result of adverse exchange translation and the increased cost of retirement benefits, but underlying growth was positive, as shown in the table below. Underlying growth is a combination of operational improvements and lower interest costs, partially reduced by higher research and development and restructuring costs.

Earnings per share fell 3%, less than the decline in pre-tax profit due to a 1% point reduction in the tax rate to 27%.

The dividend is almost twice covered by earnings (including discontinued activities).

CASH-FLOW
We believe that profit performance must be underpinned by strong and reliable cash generation. We monitor cash performance through the conversion rate of operating profit into cash for our operations (which we have consistently measured as being after investment in capital expenditure) and by the overall generation of free cash-flow at group level. We maintained our focus in this area in 2003, achieving a 90% conversion of operating profit to cash, and free cash-flow of £270m.

DISCONTINUED BUSINESSES
Consistent with the strategy of disposing of non-core businesses to reinvest in higher growth opportunity businesses, proceeds of over £630m were raised from disposals announced during 2003, of which £137m was in respect of disposals completed during the year.

The principal completed disposals were Lodge (November 2002) and the Air Movement and Cable Management businesses (December 2002). These disposals gave rise to net exceptional gains of £14.5m.

The sale of Polymer for £495m was announced in July, with completion expected by the end of September. Polymer's results have been included in the 'Discontinued' column in the profit and loss account but the business assets and liabilities are included in the group's year-end balance sheet, as the transaction was not completed by the year-end.

An exceptional charge of £137m has been recorded to write down the Polymer goodwill to its realisable value.

RESTRUCTURING
There were no exceptional restructuring charges in 2003 (2002 £43.7m) as the cost of major restructuring programmes, principally in Aerospace in response to lower civil build rates, and in Medical to relocate manufacturing to lower-cost locations, were recognised in previous years' accounts. The related actions were completed during 2003 and the annual cost base has now been reduced by over £100m over the last three years, at a total cost of £160m. Non-exceptional restructuring costs of £11m (2002 £3m) were charged to operating profit.

GOODWILL
Goodwill on all acquisitions since 1998 is capitalised and amortised over a maximum 20-year period. The carrying value of acquisitions is formally reviewed at the first full year-end following acquisition and is also reviewed when circumstances require it.

The annual goodwill amortisation for 2003 was £44m (2002 £39m). Except for the Polymer goodwill write-down there were no impairment charges made in 2003 (2002 £12m).

ACQUISITIONS
The most significant acquisition during the year was the Heimann business for £236m. In the first eight months of ownership, Heimann performed ahead of initial expectations and contributed £123m and £25m to sales and operating profit respectively, significantly ahead of its financing cost.

TI AUTOMOTIVE INVESTMENT
Smiths continues to hold, at cost, £325m of preference shares in TI Automotive, which was demerged in July 2001. No preference dividend has been received or accrued in 2003.

TI Automotive continues to trade satisfactorily and is in compliance with its banking covenants. Present and forecast levels of profitability are sufficient to support the carrying value of Smiths' investment.

GEOGRAPHIC SPREAD AND EXCHANGE RATES
The geographic analysis of ongoing operations, which was broadly unchanged from 2002, is shown below:

The key exchange rates affecting the group are the US$ and Euro. The table below shows the average and year-end rates for these currencies:

The effect of the decline in the average value of the US$ outweighed the stronger Euro and the net translation effect was to reduce sales and operating profit by £120m and £20m respectively. A movement of 1 cent in the US$ exchange rate affects profits by £1.5m. Net exchange exposure on export transactions was not material.

COST OF CAPITAL AND RETURN ON INVESTMENT
The company uses its weighted average cost of capital as one measure to appraise both internally-generated investment opportunities and acquisitions. During 2003, the company's weighted average cost of capital for the year remained at 8% with the increased cost of equity offset by reductions in the cost of borrowings.

The after-tax return on average shareholder investment, including goodwill, was 12% (14% excluding the investment in TI Automotive), compared with 11% last year and continues to exceed the weighted average cost of capital.

TAXATION
The tax charge for the year represented an effective rate of 27% on profit of ongoing businesses before taxation, goodwill amortisation and exceptional items (2002 28%). This is a reduction of 3.6 percentage points since 2000, due principally to the benefits of the merger.

In accordance with FRS19 – Deferred Taxation, the balance sheet includes all deferred tax liabilities.

RETIREMENT BENEFITS
The company has adopted the full accounting requirements of FRS17 to calculate its pension expense in 2003. FRS17 is a more prescriptive accounting treatment than SSAP24, and we consider that the greater transparency and consistency offered are significant benefits.

Under FRS17, the group's accounts reflect the net surplus/deficit in retirement benefit plans, taking assets at their market values at 31 July and evaluating liabilities by discounting at year-end AA corporate bond interest rates.

The funded pension plans, measured on this basis, started the year with a pre-tax deficit of £85m. The overall return on assets in the year was 7%. However, the AA corporate bond rate reduced during the year (from 6.0% to 5.5% in the United Kingdom), increasing the calculated value of liabilities by about £200m. The table below gives an analysis of the company's year-end liabilities calculated under FRS17.

The profit and loss account bears the cost of providing retirement benefits in two places. The actuarially calculated cost of the current year's benefits earned is charged against operating profit (the 'service cost') – in 2003 this was £48m (2002 £50m). The interest section of the profit and loss account is charged with the interest on retirement liabilities and credited with the expected return on pension scheme assets – in 2003 this was a net charge of £2m (2002 net credit £26m).

Pension funding (company cash contribution) decisions are based on the advice of independent actuaries, which takes account of the long-term nature of the liabilities. For funding purposes, the most recent actuarial valuations of the principal schemes were performed as at March and April 2003 in the United Kingdom, and July 2002 in the United States. Contributions to the funded plans were increased to £46m in 2003 (2002 £14m), similar to the service cost. Contributions are expected to increase further in 2004, depending upon investment performance. The FRS17 deficit will be reduced by the additional cash contributions, plus the extent to which investment performance exceeds the discount rate.

TREASURY
Smiths applies centralised treasury management over its financial risks through a strong control environment.

All debt origination, management and derivative transactions are controlled centrally. No speculative financial transactions are permitted and all funding is recognised on the balance sheet.

The objectives of the treasury function continue to be to:

•	deliver the liquidity requirements of the businesses cost-effectively;
•	manage the central funding demands providing a low cost of debt;
•	develop and maintain strong and stable banking relationships and services; and
•	provide the group reasonable protection from the effect of foreign currency volatility.

These objectives are controlled through a Treasury Policy approved by the Board, and a Treasury Compliance report is presented annually to the Audit Committee to confirm that treasury activities have operated in accordance with policy.

During the year, Smiths raised US$250m through an issue of 10-year unsecured Senior Notes at a coupon of 5.45%. The issue was over-subscribed, demonstrating the strong credit quality of the group. Credit ratings of A- and A3 from Standard & Poor's and Moody's respectively were maintained.

Committed undrawn credit lines totalled £540m at the year-end, provided chiefly by the group's £500m revolving credit facility. Recognising the imminent completion of the Polymer disposal, these facilities were reduced by £400m since the year-end, still leaving more than adequate liquidity for the group.

The remaining borrowings are well spread in terms of maturity and there are no immediate refinancing risks.

Borrowings are maintained largely in US dollars to match the group's asset profile and split equally between fixed and floating rates of interest. In a period of falling global interest rates, this has proved effective in allowing the group to benefit from low floating interest rates and the group's average borrowing rate in 2003 was below 5% before tax relief, with maturities averaging over five years.

LEGAL ISSUES
As previously reported, John Crane, Inc. ('John Crane'), a subsidiary of the company, is one of many co-defendants in numerous law suits pending in the United States in which plaintiffs are claiming damages arising from exposure to or use of products containing asbestos. The John Crane products generally referred to in these cases are ones in which the asbestos fibres were encapsulated in such a manner that, according to tests conducted on behalf of John Crane, the products were safe. John Crane ceased manufacturing products containing asbestos in 1985.

With the benefit of its 'safe product' defence and with access to insurance judged sufficient to meet all material costs of defending these claims for the foreseeable future, John Crane has resisted every case in which it has been named and intends to continue the robust defence of asbestos-related claims.

As a result of its defence policy, John Crane has been dismissed before trial from cases involving approximately 90,000 claims over the last 24 years. John Crane is currently a defendant in cases involving approximately 174,000 claims. Despite these large numbers of claims, John Crane has had final judgments against it, after appeals, in only 28 cases, amounting to awards of some US$17.8m over that 24-year period. These awards, the related interest and all material defence costs, have been met in full by insurance.

The company continues to hold the view that the litigation does not represent a material contingent liability. No provision relating to it has been made in these accounts.

FINANCIAL CONTROLS
While our decentralised organisation delegates day-to-day control to local management, we have comprehensive budgetary control systems in place, with regular reporting to the Board.

The company has a continuous, formalised business risk management process operated at each business unit.

The internal audit department reviews all key business units over a rolling three year cycle and its findings are reported to the Audit Committee. All acquisitions are reviewed within 12 months of acquisition, to verify compliance with the company's procedures.

Further information regarding the group's procedures to maintain strict internal controls over all aspects of risk, including financial risk, are set out in the Corporate Governance section of the directors' report.

INTERNATIONAL FINANCIAL REPORTING STANDARDS
Following a recent European Union regulation, all listed companies in the EU will be required in future to prepare their consolidated financial statements under international financial reporting standards 'IFRS'. This will apply to the Smiths Group plc accounts for the year ending 31 July 2006 (with 2005 comparatives). It is a complex task to assess the differences between current accounting policies and IFRS, not least since many of the IFRS are themselves in the course of revision. It is clear that a number of accounting policies and some presentational aspects of the financial statements will change. Work has commenced to ensure the group will be ready to meet the conversion deadline and to present clearly the effects of this transition.

ALAN THOMSON
FINANCIAL DIRECTOR