WH Smith’s rating is out of date

Within this coterie was newsagent WH Smith (SMWH), which after a predictably volatile 2020 was by the end of the year changing hands for £14.90 a share. Ten weeks later, despite widespread store closures and heavy losses, the stock was up more than a third at £20.64 as investor sentiment surged on the success of the UK’s inoculation programme and hopes of a rapid economic rebound with the lifting of restrictions.

What hasn’t budged throughout this period – and has barely changed since last summer, before vaccine breakthrough news started to arrive – is the consensus earnings forecast for the financial year to August 2022. According to FactSet, analysts expected 60.5p per share last August and expect 60.6p today (see chart).

The stock’s 70 per cent rally in the intervening period is due to investors looking further to the future for the eventual recovery to past glories ad beyond. Excluding extraordinary items, City analysts think 98.7p per share is achievable in the 2023 financial year, in line with shareholders’ profits in 2018. But we think markets have been enormously forgiving.

We’ll address why investors may now need to think twice in a minute, but first it’s worth outlining the reasons why WH Smith has such goodwill. In the five years prior to the pandemic, a well-executed push into travel locations meant groupwide revenues climbed despite steady declines in sales from a high-street business whose product focus on magazines, newspapers and books has long faced big challenges from the internet (see chart).

By expanding into more captive customer bases in airports, motorway services and train stations, Smiths could weather the strain on its traditional business while boosting its operating profit margin from 10 to 11.5 per cent in the five years to 2019. The hope was that further expansion into travel, stacked against a steadily-shrinking contribution from UK high streets, would allow the operating leverage in the business (sales per store growth lead to larger percentage profit increases) to motor. Excellent cash conversion and good use of share buybacks added further magic to the shares’ charmed decade.

Smart deals, bad timing

This pivot to travel pushed on in a big way at the end of 2018. The company completed the $198m (£140m) acquisition of US digital-accessories travel retailer InMotion, adding 114 stores across 43 US airports. A twofold strategic benefit was heralded: it would allow Smiths to work with InMotion’s landlords to export its store formats, while helping InMotion grow internationally. A year later, Smiths tapped investors for £155m to fund the $400m purchase of Marshalls Retail – another fast-growing North American travel retailer – just weeks before Covid-19 struck.

At its recent interim results day in April, the company suggested expansion had merely been delayed. Some 100 new stores – largely in resurgent and domestic-focused North American airports – are earmarked for opening across travel over the next three years. The business’s importance as a commercial partner for its travel landlords was again highlighted.

But more than a year after restrictions around international movement first bit, forecasts for a pick-up in travel remained woolly. This is perfectly understandable, and in the UK has been borne out by repeated government policy shifts around summer travel. But the point stands that it remains fiendishly hard to predict. Bain & Company has had a stab, and believes global airline revenues could be as low as $236bn this year, down from $666bn in 2019.

The consultancy’s baseline assumption for global air travel demand will still be 8 per cent below pre-pandemic levels by the end of 2023, versus a pre-crisis growth forecast of 17 per cent. At least North American intra-regional growth is expected to be better than Europe, which explains some of Smiths’ optimism.

With most of the £402m of goodwill on the balance sheet connected to the US acquisitions, investors will be hoping this sunny picture plays out. New variants, further dramatic spikes in inflation, big changes in business travel patterns and other as-yet-unseen consequences of the pandemic could all prove headaches.

High time for the high street?

What comes next for the high street, meanwhile, seems to be more managed decline. Analysts have pointed to the group’s ability to negotiate average rent reductions of about 45 per cent when leases expire as a positive. What’s more, some 430 leases due for renewal by 2024, including 150 where Smiths is “holding over and in negotiation with our landlord”. Such tactics have allowed management to promise £37m in annual cost savings by the end of the current financial year, although non-travel operating profit is only expected to ‘recover’ to £49m by next year. This compares with £60m in 2018, since when buying trends have considerably altered.

Even with the current success of personalised card and gift subsidiary Funky Pigeon, the fact is that customer footfall trends are unlikely to improve on pre-Covid levels. And while the capacity of teenagers and diarists to shell out for stationery should never be doubted, neither Smiths’ physical store offering nor its ecommerce profile provide much differentiation.

True, high-street sales made up less than half of the top line before lockdown, and rent deflation should bring benefits. But a general corporate policy to keep a store open so long as it generates cash throughout its lease life looks a case of making the best of a bad situation. Accordingly, this side of the business needs to be valued at perhaps half the cost implied by the group-wide earnings multiple in the full table below.

We also think the market needs to pay more attention to shareholder equity which at last count stood at just £177m. Net debt at the end of the first half stood at £328m before accounting for lease liabilities of £509m. Broker RBC believes net debt before leases will get to £354m by the end of WH Smith's financial year before starting to fall as trading recovers.

Banks have appeared understanding, though, with the company able to secure and extra £100m of facilities and minimum liquidity covenant tests have been waived until next February. The balance sheet was also strengthened early in the pandemic with the sale of £166m of new shares in April 2020 at 1,050p apiece. But with activity yet to show signs of dramatic improvement across its divisions, the balance sheet is a worry, even though the group was able to constrain the first-half free cash outflow to £13m.

It is hard to value a business that has been hit so hard by a one-off event. Looking back to pre-Covid times, brokers had expected the group to produce about £1.7bn of revenue in its first full year of ownership of Marshalls. The group's current enterprise value (market cap plus pre-lease net debt) represents about 1.5 times that level of sales. That compares with a three year average valuation up to 2020 (pre-Covid) of 1.6 times based on enterprise value to next 12 month sales (EV/Sales(NTM)). 

There is huge amounts of uncertainty about how quickly sales will recover, but broker RBC does not have a £1.7bn figure penciled in until the 2026 financial year. On that basis, we think recovery excitment has gotten ahead of itself and the current valuation fails to take proper account of the risk WH Smith still faces. 

Smiths is a well-run business. But it may need a momentous couple of years of recovery trading to avert a correction in its share price. On balance, we think investors would be better off getting out now. 

Last IC View: Hold, 1,827p, 29 Apr 2021