A great yield from Smiths

Smiths News was formed in 2006 when it split from high-street retailer WH Smith, since when it has delivered consistent and stable cash profits. Five-year average free cash flow before some exceptional costs has been £23m, comfortably more than the average dividend cost of £12m. Not just that, but free cash flow has been on the rise, shifting from £20m to £23m between 2009-10 and 2010-11, and broker Liberum Capital reckons it will climb to £33m by 2013-14. So on a cash basis the dividend looks decently covered, and Smiths prospects look sufficiently bright for that to remain the case.

For example, a good proportion of its revenues are underpinned by long-term contracts - it has five-year contracts to distribute titles produced by The Times and The Telegraph stables of newspapers that are not due for renewal until 2014. And the collapse of the News of the World, while a disruption, prompted readers to substitute a tabloid Sunday rather than given up their weekly dose of scandal. Also to combat falling circulation volumes, publishers have increased cover prices, which provides Smiths with a further floor to revenues. So its market is tough, but not unbearable.

Smiths' balance sheet is sounds enough, too. It has a so-called Altman Z score (a barometer of financial health) of 10, where anything above 2.9 is considered safe. Its quick ratio (of current assets to current liabilities) is just 0.5 times, but that shouldn't be a problem because Smiths - much like a food retailer - is a business that turns over its inventories very quickly. True, its net debt did increase from £45m to £63m in the latest financial year, but much of the rise was to fund the acquisition of rival Dawsons, whose distribution of academic books should be fairly resilient.

There are other defensive attributes to Smiths. It is the UK market leader in news wholesaling, controlling around 55 per cent of the market (the other member in the duopoly, Menzies, has the balance). Further, the costs and skills required to start a distribution operation are prohibitively high; Smiths recently spent £40m implementing a new logistics system in order to improve delivery efficiency.

Smiths' most recent set of results were strong. While sales of both newspapers and magazines were down in the full-year to 31 August 2011 by 5 per cent, profits rose 14 per cent to £32m, as the operating profit margin in the news distribution business improved to 2.5 per cent from 1.9 per cent. This was largely achieved by cost cutting. In 2010-11 alone Smiths' management hacked out £22m, most of which materialised when the company won Dawson's news distribution contracts. Now management reckons that £30m of costs can be taken from the combined businesses. Admittedly cost cutting can't continue forever, but City analysts estimate that future revenue declines of 4 per cent a year require annual cost savings of £5m to balance them and, given Smiths' track record, that could be achievable.

Yet the shares, at 78p, are unloved and oversold - trading on a PE ratio of just four times City forecasts of underlying earnings. And then there is that dividend yield.