WH Smith: Travelling in the right direction

The business

Travel is managed as a completely separate business from the high-street operations. It sells food, drink, confectionery, books, magazines, newspapers, gadgets and souvenirs in locations such as airports, railway stations, motorway service stations and hospitals.

These locations have highly captive customers and concentrated levels of footfall. Customers are often time-constrained, buy on impulse and want a quick and convenient shopping experience.

The operating characteristics are very different to traditional high-street stores. The stores are much smaller and the cost of the selling space is very expensive. The running costs are also higher. The business is seasonal, with its sales peaking during the summer holiday months. It does not have a huge dependence on Christmas for its annual profits, unlike the high-street business.

The travel business operates concessions granted by the landlords of the location. These concessions tend to be five-10 years in length and have turnover-based rents with a minimum rent payable.

WH Smith had 581 stores in the UK at the end of August 2018; 149 were at airports,127 in railway stations and 131 in hospitals. Around 125 are located in motorway service areas and are franchised stores, with the remainder in workplaces and bus stations.

A total of 286 stores are located in airports outside the UK; 77 in Europe, 104 in the Middle East and 105 in the Asia-Pacific region. These stores are operated under a variety of different business models. Just over half of them are franchised, 40 per cent are directly operated by the company, with the remainder run under joint-venture arrangements. At the end of November 2018, the company added a further 114 airport stores in the US when it bought In-Motion.

Business performance

Since WH Smith demerged its news distribution business in 2006, the travel business has been able to grow its profits in every year since. The size of the business has increased from 309 stores in 2007 to 867 in 2018. With the In-Motion acquisition it will probably have more than 1,000 stores by August 2019.

WH Smith Travel financial performance

Source: Company reports

There is a strong correlation between trends in passenger numbers in airports and railway stations and the growth in revenues and profits. This gives the business a reasonable amount of sensitivity to the ups and downs of the economy. It does have some recession risk to its profits.

As you can see, the business had five consecutive years of negative like-for-like sales between 2009 and 2013 as a weak economic backdrop saw fewer people travel from airports and railway stations after the last recession. During the past few years, underlying sales growth has been very reasonable.

However, it would be wrong to assume that this business is all about traveller numbers and hospital visits. There is a lot of skill required to get the best out of the small stores, as well as winning new concessions and retaining existing ones.

One of the keys to success is managing the small amount of space at its disposal in a smart way. It’s all about getting the right products in the right space at the right time. A huge amount of time is spent on product category and space management to get the best bang for the buck from customers. For example, there has been a big focus on technology products, such as earphones, battery packs, mobile device chargers and gadgets.

The numbers suggest that WH Smith has been very good at managing its stores and has employed the same excellent category management skills it has used in its high-street business. Since 2008, excellent buying and changes in sales mix have brought a cumulative 1,320 basis points of gross margin improvements to the business.

Source: Company reports

Over the same period, operating margins have increased from 10 per cent to more than 15 per cent. Not many retailers have margins as high as this. Are they too good to last?

Last week, I wrote about how high margins can be a sign of an unsustainable business model based on companies gouging their customers with high prices. I think it’s certainly true that you are not going to get a cheap sandwich in a WH Smith airport concession and have some sympathy with the view that some prices are verging on a rip-off due to the lack of competition.

What is clear is that WH Smith is earning much higher profit margins than other travel retailers. This may be due to differences in sales mix, locations or might just be that they are inferior retailers. Dufry AG, the world’s biggest airport retailer, which sells a lot of duty-free perfume and alcohol, and Hudson in the US have margins of 4-5 per cent. UK-listed SSP is focused on food and drink and has margins of just under 8 per cent.

Over the past four years, the company has given more detail on the sales and profits of its international travel business. With a bit of simple number crunching, it is now possible to look at the financial performance of both businesses separately.

What we can see is how the UK business is very profitable, with margins of over 17 per cent in 2018. The outlook for this business remains reasonable and will be helped by the continued growth of hospital locations – which have been very successful and will become the second biggest location type after airports in 2019.

International sales and profits

Source: Company report

The international business – before In-Motion is considered – is not making a big contribution in terms of overall trading profits and operating margins. Its profit margins are half those of the UK business. Is this level of profitability more representative of WH Smith’s growth in profits going forward?

Predicting margins is not easy to call. It may well be that the cost of concessions and running costs at airports overseas do not lend themselves to as high margins as those offered by airports, railway stations and hospitals in the UK.

In-Motion has been bought with an Ebitda (earnings before interest, tax, deprecation and amortisation) margin of 13.9 per cent, which even after depreciation and amortisation expenses are deducted should enhance the profit margins of the international business.

WH Smith travel ROCE and cash conversion

Source: Company reports/my calculations

The profit margins of this business are a key attraction. As far as I can see, there is nothing to suggest – such as large amounts of supplier income – that they are not genuine. It’s not beyond imagination that a business with captive customers can charge higher prices and make higher profit margins. The key risk to investors is that they will be competed or perhaps regulated away.

Another attraction is that cash generation looks pretty good as well. You can use numbers in the notes on segmental performance in a company’s annual report to get a feel for the cash-generative characteristics of a subsidiary by calculating Ebitda (by adding segmental depreciation and amortisation expenses to operating profit) and subtracting capex.

This gives a proxy for pre-tax free cash flow and can be compared with operating profits. As we can see, cash conversion (Ebitda less capex as a percentage of operating profit) is decent, although there was a big increase in capex in 2018 – presumably to do with the expansion of the international business.

Analysis point: Is ROCE as high as it seems?

WH Smith’s annual report gives a figure for the return on capital employed (ROCE) of the travel business by taking into account the capitalised value of the rents on the concession stores. This is useful as it gives the investor a feel for what type of return the business would be making if it owned the stores itself.

Renting stores understates the capital invested of retailers and gives a higher ROCE as the assets are not on its balance sheet. From 2019 onwards they will be, so the adjustments won’t have to be done going forward. That said, ROCE based on capitalised operating leases (or rents) needs to be treated with caution.

On this measure, WH Smith’s travel business is very profitable and has all the hallmarks of an outstanding business with a ROCE of 31 per cent in 2018. However, remember this is a concession business and the remaining length of rental agreements on some concessions could be very short.

Why does this matter?

Well, WH Smith calculates the capitalised value of its operating leases based on the remaining length of its outstanding obligations. A concession with a short amount of its term remaining could have a very low capitalised value of its store but still be making a lot of profit.

It’s also important to note that the lease calculation is based on the value of minimum rents rather than the likely higher turnover-based rents. In its accounts, WH Smith says that the remaining length of its leases – high street and travel – is just 4.5 years.

This could mean that capital invested is understated and that the ROCE could be very high, but in reality its true value is lower. If the concession is then renewed for another 10 years then the value of capitalised leases – and capital employed – would increase significantly and ROCE would fall. ROCE as reported by WH Smith is not just determined by its trading profits, but by how long its lease agreements have left to run. It has the possibility to mislead investors.

Let’s say a concession store in an airport owned by the landlord has a value of £100,000. It is rented out for £7,500 per year made up of interest of £5,000 and depreciation of £2,500. At an interest rate of 5 per cent, the present value of the lease obligations over 10 years would be £57,900 and lower than the value of the store. A five-year agreement would have a value of just £32,500 and one year just £7,100.

Value of capitalised leases

Source My calculations

I am strongly in favour of investors taking into account the value of leases when looking at retailers. However, it is important to note that with a short lease agreement that is about to run out – as with a concession – there is scope to be misled on the size of the ROCE being earned. If investors are going to assume that the profits from a concession have a high renewal rate and are long-term in nature then perhaps the assets being used to generate them – and the value of them – need to be considered as well.

Where’s the growth going to come from?

There’s a lot to like about the profitability of WH Smith’s travel business, but can it keep on growing? I think there are good grounds for thinking that it can if its margins are sustainable.

There are plans to add 20 new stores in the UK in 2019, with a further 15 in 2020 and 2021. From an international perspective, WH Smith has a very small slice of the airport concession market and can be expected to increase this, and seems in a good position to do so.

The company has a proven track record as a successful airport concession retailer, which should serve it well in persuading airport owners to grant it more concessions and give them a growing source of turnover-based rents. Its recent track record in winning a considerable number of airport concessions suggests that it is probably doing this very well.

The In-Motion acquisition looks to be a very good deal done at a high but not excessive price. It gives WH Smith a presence in the world’s biggest airport market and should provide a good platform for it to win more concessions. In-Motion’s specialist position as a technology retailer should also bring in a richer margin mix.

That said, WH Smith continues to face a number of challenges with its travel business. A slowdown in the economy leading to a reduction in travel is a real threat. EasyJet’s announcement this week that summer bookings were somewhat weaker than expected will mean fewer people visiting WH Smith’s airport concessions in the UK and Europe.

The ability to retain concessions at attractive prices will not be easy. That said, the company has been very good at doing this. Will a landlord take the risk of replacing a successful WH Smith concession with an unproven retailer?

Another risk to consider is changing consumer habits. Increased digitisation of news media and books may lead to fewer purchases of physical versions of them in WH Smith stores.

How much is WH Smith travel worth?

Travel looks as though it is a good business. It’s very profitable, cash-generative and looks as though it can still grow. This is a business that investors might be prepared to pay a lot of money for. But how much?

I am going to try to work out what the stock market might be valuing travel at. I’ve taken consensus operating profit and net borrowings forecasts for 2019 and then assumed that unallocated costs stay the same as last year at £16m.

I then allocate £6m to the high-street business and the rest to travel. This gives a profit estimate for travel of £117.2m, or £107.2m after allocating central costs, which looks conservative.

Source: SharePad/my estimates

Putting the high-street business on a low EV/Ebit multiple of 8.5 times gives an implied value for travel of just over £2bn at a share price of 2,116p. This equates to a forecast EV/Ebit multiple of 18.7 times compared with SSP (SSPG) which currently trades on 17 times. On a debt-adjusted price/earnings (PE) basis, this equates to 23.5 times for travel.

Source: My calculations

This high valuation may be justified, but after WH Smith’s shares have increased by 25 per cent so far this year, now doesn’t look like a great entry point.