WH Smith is a leading retailer of books, magazines, newspapers, and periodicals in the UK. The Company generates approximately 55% of its trading profit from its Travel division (mostly airports and rail stations, but also motorways, hospitals, office buildings, etc.) and the remaining 45% from its High Street stores. I estimate that the category split is approximately 30% books, 35% stationery, and 35% news and impulse.

This is an opportunity to short a bricks and mortar retailer of structurally declining categories at peak margins and its all-time high share price into what I believe will be a series of earnings misses. I think the short is particularly timely given second half comping issues and the new internally promoted CEO takes over this summer, perhaps setting the table for an expectations reset.

While the analyst community agrees that the categories face structural pressure, they view the headwinds in the High Street business as surmountable through cost cuts and they see the Travel business as a crown jewel which can grow revenue low to mid single digit and EBIT mid to high single digit leading to modest revenue growth and 4-5% EBIT growth for the Group.

I think we are at an inflection point where LFL declines are accelerating and gross margin gains are decelerating which will lead to gross profit declines. Additionally, the store base has been stripped of operating costs so I expect operating deleverage over and above the gross profit declines. In FY08/15 I believe WH Smith will earn closer to £0.53 compared to consensus expectations of £0.82. Applying a structurally challenged retailer multiple of 7x, my price target is £3.70 for a return of more than 50% pre dividends (dividend yield is about 4%).

Top-Line

Consensus expects LFL declines to moderate and for WH Smith to return to growth over the next couple years. I think LFL declines will continue to accelerate as we have seen over the last couple years. In the last two years and the first half of this fiscal year, LFLs are running at down 5% compared to historical declines of 2-4%. This deterioration came despite a couple major tailwinds to this business, namely the Royal Wedding and the Summer Olympics which drove airport travel/tourism and souvenir/impulse sales. WH Smith will be comping against these events in the second half of this fiscal year.

We are seeing this deterioration across categories and I expect these categories to get tougher going forward. Books (c.30% of sales) have gone from 2-4% declines over the last few years to 6-7% declines in the last 18 months. It is important to note that this has been driven primarily by general declines in reading and supermarket/internet competition and only slightly by digital adoption. The UK is two years behind the US in terms of e-book penetration. E-books penetration is 6-7% in the UK (up from 1.5% in 2010) compared to the US at 24% (up from 7% in 2010). I believe this is basically the tipping point where e-book penetration goes from a low single digit to a high single or double digit drag on physical sales. News & impulse (c.35% of sales which I estimate is split 50/50 news/impulse) has gone from 1-2% declines to 3-4% declines and faces the same tablet/e-reader headwinds as books. Stationery (c.35% of sales) has gone from 1% growth to 1-2% declines. Importantly, this deterioration has occurred despite the two major LFL tailwinds of a bankruptcy of a major competitor and re-allocation of store space to stationery. Going forward I believe this category will continue to be under pressure from tablet/smartphone penetration and innovation in areas like e-cards.

To elaborate a bit on the tablet front, while I unfortunately do not have access to UK tablet shipment data from the likes of Gartner/IDC, anecdotally tablets are really gaining traction driven by lower priced tablets (Google Nexus 7, Samsung Galaxy, and a number of Chinese tablets which were priced at £100 or less). In its January Christmas trading update, Dixons indicated “tablet sales were phenomenal,” helping drive a +8% LFL in UK & Ireland. Dixons sold “well over 1 million tablets” in its fiscal third quarter.  Home Retail Group’s year end trading statement and conference call in March highlighted “strong double digit growth” in tablets as a key driver of its 5% LFL in the Argos business. John Lewis has also been calling out very strong tablet sales.

As one might expect, WH Smith says things like 75% of its book sales are non-fiction and kids books which are less subject to e-book adoption. I think that is a static view of the world and there should certainly be incremental pressure.  Very simply, my view is that continued tablet adoption does not bode well for WH Smith’s categories.

Gross Profit

I believe we are at the inflection point where gross margin gains can no longer offset LFL declines, a belief that has become reality over the last couple years.

Over the last 8 years, LFL declines have been about 4% p.a. Over that same period, gross margins are up around 1,500bp from 38% to 53% which, coupled with a modest store growth contribution, has led to gross profit growth of roughly 2% p.a.

Various analyst estimates suggest 40-50% of the gross margin improvement has been from category management or getting out of the low gross margin entertainment category and reallocating this space to high gross margin stationery. Another 25-30% has been from markdown/promotion management, aka pricing. The remainder is from better buying, Asian sourcing, shrinkage reduction, etc.

WH Smith’s gross margins are now at the top end of UK retail: (UK retail gross margin graphic is unfortunately not pasting, will try to post in comments)

While the Company is still achieving gross margin improvements, the improvements are now around the +150bp level rather than the +200-300bp level we have seen in the past. On a much higher gross margin base (53% in FY8/12 compared to 38% in FY8/04), this is problematic for the degree to which gross margin gains can offset LFL declines to generate gross profit growth. Total gross profit dollars have peaked and were flat for the last two years and I estimate that “gross profit LFL” actually declined 2% both years.

Operating Expenses

WH Smith has done a great job containing operating expenses. Over the last 8 years the company has taken out £119 million of costs on a starting cost base north of £500 million. Operating costs per square foot have been broadly flat in nominal terms.

I think cost cuts have gone so far that they are to the point of impacting the shopping experience. For example when doing field work, multiple contacts mentioned that the stores are now very dimly lit which makes them uninviting and can even make navigating the stores difficult. The contacts thought it was likely these costs would have to be added back. Of course there are many other examples such as the quantity and quality of employees has been slashed, store fittings and fixtures are tired, etc.

High Street vs Travel

Up to this point, I have not made a distinction between the High Street and the Travel stores. I concede that the Travel stores are better than the High Street stores in terms of having a captive audience and traffic tailwinds since they are levered to UK/Europe travel rather than trips to the UK high street.

However, Travel is still geared to the same structurally challenged categories as the High Street business. The result is that while Travel has outperformed the High Street LFL declines of 4-6% over the last several years, Travel has still seen 2-3% LFL declines. Notably, Travel LFLs have declined 3% over the last couple years while UK terminal passenger growth has grown low single digit.

In the field we have also heard commentary that competition to get concessions is increasing and the airport operators are also flexing their pricing power, which is putting upward pressure on fees. This could partially explain why rent has gone from 10% of sales in FY08/05 to 15% of sales in FY08/12 at the Group level. Additionally, we have heard that the airports are looking to re-allocate space away from the news & gift category to other retail segments.

Estimates

Over the next three years, I am modeling 5-6% LFL declines and +1-2% store contribution leading to sales of £1.1 billion in FY08/15. I assume gross margin expansion of +145bp in FY08/13, +100bp in FY08/14, and +90bp in FY08/15, which leads to a gross margin of 56.8% in FY08/15. Assuming operating expense inflation of 2%, cost savings of £17 million this year followed by £15 million in each of the next two years, £50 million of share repurchases, and a 17% tax rate, I get FY08/15 EPS of £0.53 compared to consensus of £0.82.

Bull case / Risks to Short

Bulls believe that management is very good and I do not disagree. Management has a great track record and has done exactly what you would want a management team to do with this kind of business. They have been aggressive on the cost base, they were happy to shrink revenues and did not waste resources trying to grow for the sake of growing, and they returned a ton of capital. Bulls also say that this management has never disappointed in terms of meeting or beating consensus expectations.

Bulls believe High Street profit can be preserved through cost cuts and Travel is a growth engine with call options on a bunch of geographies. They also believe that the UK economy has been poor so there should be a cyclical tailwind at some point (despite the fact that a cyclical rebound was not seen in WH Smith’s results the last couple cycles).

And lastly, bulls like that the stock is trading at a discount to the UK retail sector.

If the Company meets consensus expectations over the next couple years, this will not be a good short. I question how much multiple the stock will get because structural concerns should remain present, but you will almost certainly lose money being short.