Strategy
Smiths is committed to creating long-term value for shareholders by building and sustaining strong businesses in growth sectors.

The Company's objective is to create value from organic growth and from reinvestment of self-generated cash-flow. Adjustments are made to the business mix through both acquisitions and disposals to enhance value for shareholders.

Changes in Group composition
During the period Smiths acquired four businesses for a total of £52m. These became part of the Specialty Engineering and Detection divisions. Smiths sold three businesses during the year for a total of £22m. Further details of these changes are given in the relevant divisional paragraphs below and in notes 28 and 29 to the accounts.

Included in these disposals is the sale of Smiths interests in Heimann Biometric Systems GmbH to Cross Match Technologies Inc. in exchange for 43% of the issued share capital in that company.

Performance
The key Smiths performance indicators are sales, profits and cash generation which are closely monitored throughout the year and measured against pre-set targets.

In this review, you will see references to 'headline profit' as well as to the various statutory measures of profit. This is because the Company believes that headline profit provides valuable additional information on underlying trends, and it is used by management to measure and monitor performance. Normal restructuring costs are charged against headline profit, while the following items are excluded:

• exceptional items (including impairments);
• amortisation of intangible assets acquired in a business combination;
• profit or loss on disposal of businesses; and
• other financing gains and losses.

The table below shows overall performance on a headline basis.

	2006 £m	2005 £m	Increase
Sales	3,523	3,005	17%
Headline:
– operating profit	520	416	25%
– pre-tax profit	492	404	22%
– earnings per share	64.8p	52.8p	23%

Sales
Sales were £3,523m, an increase of 17% over the £3,005m achieved in 2005.

The translation of sales of overseas business units at this year's average exchange rates increased sales by 2%.

Excluding the effect of both acquisitions and currency translation, sales grew by 9%. All four divisions contributed to the growth. Medical showed the strongest growth, assisted by the full-year contribution from Medex. Further detail of each division's growth is shown in the divisional paragraphs.

Profit
Headline operating profit increased from £416m to £520m, an increase of 25%.

Excluding the effect of both acquisitions and currency translation, headline operating profit grew by 11%, with all four divisions contributing to the growth.

The operating profit on a statutory basis, after taking account of exceptional items (including impairment), amortisation of intangible assets acquired in a business combination, profit or loss on disposal of businesses and financing losses, amounted to £161m. This compares with £382m in 2005.

The translation of the headline operating profit of overseas business units at this year's average exchange rates increased profits by 3%.

Headline pre-tax profit was £492m, a 22% increase over the £404m achieved in 2005.

Profit before tax on a statutory basis was £132m compared with £366m in 2005.

Cash generation
Smiths places considerable emphasis on cash generation, with the objective of providing resources for the growth of the business both organically and by acquisition. In 2006 the Company achieved significant organic growth in addition to acquisitive growth.

Smiths measures operating cash-flow as a ratio to headline operating profit, with a target of at least 75% depending on the level of investment in capitalised development costs. For this purpose, operating cash-flow is measured before the cash impact of exceptional items and special pension payments and after expenditure on property, equipment, software and development costs.

The operating cash-flow on this basis was £420m, representing 81% of headline operating profit; greater than the £259m reported in 2005, representing 62%. The increase reflects the timing of payments on major defence programmes, as well as organic business growth and improvements in managing working capital. On a statutory basis, net cash inflow from operations was £389m (2005: £319m).

Cash expenditure on exceptional items was £17m, compared with £10m in 2005.

During the current year the Company made a special £61m contribution to facilitate UK pension scheme mergers involving under-funded schemes.

Free cash-flow (after interest and tax but before acquisitions and dividends) was £170m, compared with £147m in 2005. The higher free cash-flow reflects the improved operating cash-flow referred to above, offset by higher tax and interest payments than in 2005. It is also stated after the special pension contribution of £61m.

Dividends paid in the year amounted to £167m, compared with £154m in 2005.

Acquisitions and disposals resulted in a net expenditure of £46m, compared with £410m in 2005.

Earnings per share
Headline earnings per share increased from 52.8p to 64.8p, an increase of 23%.

Earnings per share on a statutory basis were 4.3p, compared with 48.3p in 2005.

Interest and other financing costs
Interest payable on debt, less interest on cash deposits, was £54m, compared with £23m in 2005. The £31m increase is principally due to the cost of financing acquisitions, mainly last year's acquisition of Medex, which resulted in higher net debt during the year. Rising US interest rates also contributed to the increase. The net interest costs were 9.6 times covered by headline operating profits.

The Group accounts for pensions using IAS 19, under which the overall retirement benefit cost is analysed into two elements, one of which is treated as a financing item. This financing item was income of £28m in 2006, compared with £11m in 2005, reflecting the strengthening of the funding position of the pension schemes. Under IAS 19 the administration costs of funded pension schemes are to be treated as a component of pensions financing.

Exceptional and other items excluded from headline profits
Exceptional operating items were £340m, compared with £28m in 2005. These comprised:

• £325m in respect of the write down of TI Automotive preference shares. Recognising continued deterioration in the automotive component market, particularly in the US, an impairment review of the preference share investment in TI Automotive has been undertaken, as required by IAS 39. The preference shares have not yet borne any dividends, and it is considered unlikely that dividends will be paid in the foreseeable future. Similarly, there is no current prospect of the preference shares being redeemed. The Board has also considered whether cash-flows could accrue from the investment in TI Automotive were the enterprise to be sold; such a sale is not currently considered sufficiently probable to take into account any cash-flows which could accrue in such an event. As a result, the Board has decided to write down the carrying value of the investment in the TI Automotive preference shares from £325m to nil value in the accounts. There is no cash impact from this decision;
  
  
• £19m for integration costs associated with the Medex acquisition, including provisions for the closure of manufacturing facilities (2005: £10m). Further costs of about £20m are expected for the completion of the Medex integration;
  
  
• profit on disposal of businesses of £16m (2005: £9m); and
  
  
• settlement of a product liability class action of £12m.

The amortisation of intangible assets acquired in business combinations amounted to £17m (2005: £6m). The amortisation relates principally to technology and customer relationships.

Financing costs amounted to £3m (2005: £4m). These represent the results of derivatives and other financing instruments which are not hedge accounted under IFRS. Of this sum, £2.8m (2005: nil) was charged to operating profit.

Net debt
Net debt at year end was £923m, compared with £931m at July 2005.

Research and development
Investment in research and development (R&D) drives future performance and is a measure of the Company's commitment to the future organic growth of the business.

Smiths invested a total of £352m in R&D, equivalent to 10% of sales. Of that total, £159m was funded by customers. The comparative figures for 2005 were £295m and £152m. Under IFRS, certain of these development costs are capitalised. The gross capitalisation is shown as an intangible asset. Where customers contribute to the costs of development, the contribution is included as deferred income and disclosed within trade and other payables.

R&D is discussed further in the divisional paragraphs below.