Description

•        SUMMARY

o        I recommend a short position in WH Smith, which has the potential to deliver returns up to 47%. WH Smith is a UK convenience retailer facing intensified top-line pressure, margin compression, and declining FCF, yet has risen ~35% in the last year. Today the stock trades at 9.6x ’15 EV/EBITDA (~10% premium to the UK general retail universe), reflecting investor’s growing confidence in Management and their strategy of space optimization, cost cutting, and Travel division expansion. Furthermore, investors have become enamoured with the near-term outlook visibility and consistency of favourable earnings surprises - divorcing themselves from three operational realities. First, the high street business (~44% of operating profit) is threatened by crushing secular trends which are set to intensify over the next few years. Second, space optimization and cost-cutting initiatives, which since 2009 have grown gross margins 788 bps and slowed opex growth to 388 bps, can no longer serve as the principle engine of earnings growth given operational constraints and the devastating impact on brand equity. Third, the Travel business is reaching a saturation point in its domestic market and facing greater competition internationally. With a lofty valuation and significant operational challenges, WH Smith represents a short opportunity with highly attractive risk/return dynamics.

•        COMPANY DESCRIPTION

o        WH Smith is a convenience retailer which sells books, stationary items, magazines, newspapers, confectionery goods, and other impulse products across the UK (~95% of sales) and internationally (estimated ~5%). The Company operates two divisions: Travel (56% of EBIT), which tailors itself to traveling customers with 725 stores in airports, train stations, motorway stations, workplaces and hospitals, and High Street (44% of EBIT), which operates 604 stores across the UK high street. The Company has launched several growth initiatives including: (i.) international expansion of the Travel division; (ii.) creation of Card Market – a direct competitor to Card Factory; and, (iii.) Funky Pigeon – a personalized card retailer. None of these are material drivers of earnings yet, individually or collectively.

•        INVESTMENT THESIS

o        Weak High Street business model across several highly competitive end markets:

        Books: WH Smith faces three core competitive challenges in the UK book market. Firstly, the introduction of alternative methods of distribution and viewing (i.e. ebook readers, ipads, kindle, etc.) has encroached on the physical book market with an increasing share of the population switching to digital books. According to Nielsen Book research, ebooks accounted for one in four consumer book purchases in 2013, up from 20% in 2012, and many analyst see this rising to 40%. While WH Smith has partly mitigated this by shifting to titles less impacted by ebook purchases (e.g. children books), they remain highly exposed to growing digital content. Furthermore, their efforts to introduce a self-branded reader has been a failure (even more so than B&N in the US) with online retailers firmly controlling 95% of ebook sales (Bookseller’s association – MI Reports). Secondly, online competitors have gained an increasing share of the market, winning over consumers with competitive pricing, greater selection, and convenient browsing. As a result, WH Smith is forced to differentiate itself through convenient store locations to attract distressed book purchases, a market with increasing pressure from other UK bookstores. Brick and mortar competitors such as Waterstones have ramped store openings, boosted store refurbishments, added cafes, and increased local ownership, appealing to consumers’ desire for local stores with comfortable browsing environments (FT). WH Smith, meanwhile, has further isolated such customers with staff reductions, limited store improvements, and reduced selection. Traditional brick and mortar bookstores stores saw sales trough in 2014 while WH Smith delivered a LFL decline of 7% - in line with prior years. With greater e-book penetration, increased online ordering, and more competitive high street bookstores, WH Smith’s strength as a books retailer is exceptionally weak, and will translate into a continued fall in sales.

        Newspapers and Magazines: Similar to books, the newspaper and magazine industry is in the midst of a dramatic transformation, with the proliferation of free online content and new digital distribution channels posing a massive challenge to print media. Daily print circulation in the UK has fallen 2.6 million (22.5%) over the last five years with Sunday paper circulation falling almost 28% or more 3.3 million copies, according to the ABC. Furthermore, unlike book publishers and distributors which witnesses improving market conditions in 2014, newspapers continue to experience pressure. With a greater portion of the population shifting to online subscriptions, WH Smith’s value as a physical distributor of content is eroded and further reductions in like for like sales is to be expected.

        Stationary: Stationary products have been critical to the success of WH Smith’s space optimization strategy in recent years; however, WH Smith is set to experience increased pressure as market growth slows and competition intensifies. In the greeting card market, WH Smith has benefited from two notable trends that are not set to continue. First, the overall market has been growing, with OC&C estimating that non-personalized single cards, a core WH Smith stationery product, had a CAGR of 1.5%, by value, from 2009 to 2012. That number is set to contract over the next few years as personalized cards expand and value-oriented products reach maturation. Second, general stationery retailers such as WH Smith benefited significantly in recent years from the disappearance of a key competitor, Clinton Cards, whose market share dropped from 15% in 2009 to 10% in 2012 before ultimately falling into administration. The drastic reduction of a core competitor is a one-time event. New competitors are emerging with strong value propositions and even better balance sheets. WH Smith’s direct specialty competitor, Paperchase has stabilized following their MBO in 2009, and begun to take share with premium customers (WH Smith’s core customer) who value the company’s innovative designs and high quality products. Even more dramatic is the emergence of value-oriented players such as B&M, Poundland, and Card Factory, which offer price-sensitive customers more value for money. Discount retailing is an emerging threat across all WH Smith’s stationary products, and will be more of an issue in the future as stores like Poundland and B&M muscle their way into new locations. WH Smith’s competitive position for stationary is weaker than figures suggest, and is unlikely to support store like for like figures in the future.

o        Peak margins with little opportunity for future margin expansion:

        Space Optimisation: WH Smith has impressed investors over the last ten years with EPS growth fuelled by consistent gross margin expansion. The core levers that have enabled this strategy are nearly exhausted. The Company has proved highly effective at store space optimization by mix-shifting their product offering to higher margin goods, such as cards, confectionary, and school items. Since 2009 this has resulted in COGS as a percentage of sales dropping 788 bps to 43.2%. Low hanging fruit was quickly captured under Kate Swan: the entertainment business was shuttered, newspapers were scaled down, and space quickly allocated to stationary as rivals suffered. Today these opportunities have been fully captured, and WH Smith will have to rely on specializing in growth sectors. The Company, however, has not taken the steps to make their most profitable segments viable in the long term. As highlighted earlier, WH Smith’s core markets have become significantly more competitive in recent years, yet WH Smith’s has not lowered prices to remain competitive (though it is possible they have been raising them), nor invested in stores to maintain customer loyalty. Other stores offer a significantly better customer experience, yet operate with lower margins. WH Smith gross margin of ~57% is substantially above Ryman (~19%), B&M (~34%), Poundland (~37%), and Card Factory (~30%).   Given the increasing price discrepancy between WH Smith and competitors in growth segments, as well as their rapidly decorating brand equity, it is highly unlikely that the Company can continue to boost their gross margins through space optimization.  

        Operating Expenses: While the Company has been successfully growing gross margin, they have struggled to reign in operating expenses as a percent of sales. Since 2009, distribution expenses (excluding one-time gains) have jumped from 37% of sales to 41% today, despite massive cost efficiency initiatives. WH Smith has been one of the most aggressive employers in the UK firing ~3,000 staff in five years, holding uncompromising part-time labor schemes, and placing a high work load on each individual employee. The unsurprising result of such initiatives (combined with general underinvestment in stores) has been significant brand destruction. WH Smith was recognized two years in a row as the worst retailer in the UK according to Which? magazine, ranked 1.2 out of 10 by 80 consumers on TrustPilot.com, and even given a 2.5/5 by employees on Glassdoor. Various site visits by the author have confirmed that most stores (Travel and High Street) have the bare minimum staff to stock isles and work the register. Current employees often complain of being overworked and not having time to balance stocking the isle and running the till (Student Room). According to Consumer Focus (a non-departmental public body), WH Smith branches have the longest wait times on the High Street. Such evidence suggests that WH Smith will find it difficult in the future to manage their staff costs as efficiently as was done historically. Furthermore, new IT initiatives that Management have highlighted, such as auto check-outs, will have limited impact on the P&L as WH Smith has already fired excess staff at tills. With staff costs around 15.6% of sales, the Company faces greater operating leverage than currently appreciated by the public markets.

This is worrying for a company where other operating expenses are mostly fixed. WH Smith has large operating leases and occupancy costs (£250 million) for which there is little room for cost reduction. On the High Street, the Company signs standard institutional lease terms, subject to five year upwards-only rent reviews. The travel stores operate mainly through turnover-related leases, usually with minimum rent guarantees, and generally varying length from five to ten years. While Travel stores have variable rents based on turnover, cost savings can only be realized in an unattractive environment where the Company is also facing declining LFL figures. Furthermore, given the increasing competition in the international retail travel market discussed below, it is highly unlikely that landlords will allow WH Smith to maintain their large profit margin given their superior negotiating position.

o        Stagnating FCF:

        WH Smith faces declining FCF in the future as margins contract, capital efficiency degrades, and capex intensifies. WH Smith’s challenging end-markets, faulty business model, and levered operating model will significantly reduce the profitability of WH Smith going forward. In addition, the Company is likely to face a continued deterioration in their capital efficiency. Asset turnover has decreased from 2.7x to 2.5x in the last five years while inventory outstanding has jumped from 80.5 in 2009 to 104.7 today, given diminishing sales per store. The Company has widely used vendor financing to bridge this gap with current liabilities (not including ST borrowings) rising to 53% of total assets; however, this is not a sustainable solution. Finally, the Company’s declining LFL numbers ensure that Management will have to boost capex as they open stores and acquire companies in growth markets. The net result of these three powerful factors is a meaningful reduction in FCF, reducing the Company’s ability to maintain both their dividend policy and generous stock purchase plan. Interestingly, capital efficiency and capex drains have been present for the last five years: FCF (as measured as CFO ex pension contribution minus growth capital) has risen only 11% while earnings have risen 46%. In the last 12 months, two clues have emerged supporting accelerating FCF issues: (i.) WH Smith finally recorded £12 million of ST debt; and, (ii.) the announcement of capex increases for 2015 to the tune of £38 million.

o        Top line growth opportunities overvalued:

        International: As every bull will tell you, WH Smith has a tremendous opportunity to expand travel locations globally. Admittedly, the Travel business is on firmer footing than High Street with less of their sales exposed to product groups in secular decline. In addition, WH Smith’s Travel stores offer a strong value proposition to customers in airports and rail stations who are generally wealthier, have limited choice, and desire goods quickly. As one would expect, demand is much more inelastic allowing WH Smith to charge premium prices. LFLs across the business, however, are under pressure and Travel is near saturation in their core market. To maintain growth, WH Smith must go international.

It’s important to appreciate a simple point: international travel markets are not the same as the UK. Whereas WH Smith is the leading travel retailer in the UK, they are a distant competitor in every other region including Continual Europe, Asia, and North America. They rank 16th globally - behind stronger, more international companies such as DFS (€5.1B in sales), Dufry (€4.6B PF for Nuance Group acquisition), King Power, and Gebr Heinemann. Furthermore, most of these competitors have both duty-paid and duty-free store offerings. Their size and scale is critical because it reinforces their influence with key landlords who value strong, financially stable retailers with whom they share an operating history. While historically fragmented, the international travel market is in the midst of consolidation, evident in Dufry’s recent acquisition of Nuance, western players grabbing real estate in Asia and South America, and the expansion of SE Asian incumbents. WH Smith will likely have considerable difficulty positioning themselves in the best locations without achieving pyrrhic victories.  

Despite being part of the Travel division, WH Smith’s international operation is filled with stores that more closely represent their cousins on the High Street. Travel operates 15 mall locations, most of which have been established with franchisees with little to no public track record running a retail business. This is most notable in Dubai where five franchise malls locations (soon to be 7) are being operated in partnership with Aventus Global Trading, L.L.C., a company who acts solely as a franchisor for WH Smith. Given mall locations are generally larger, an estimated ~30% of new floor space in the international division is comprised of mall locations with materially different economics than the traditional Travel business. Franchise agreements help mask this with contracted franchising fees and interest, but ultimately their success is tied to challenging end markets. WH Smith has also opened numerous stores and kiosks in the metro stations of developing countries. In China they have opened 15 kiosks in a self-titled marketing ploy, but this seems suspect given the Travel division’s goal of targeting affluent travellers- not citizens reliant on public transportation. It suggests that WH Smith is having difficulty establishing themselves in their intended destination- key train stations and international airports.

If large international airports and rail stations are the key to profit growth, how many did the Company penetrate in 2014? Just six: Bali Aiport (13m passengers p.a.); Adelaide International (7.6m); Langkaw International (2m); Hamad international (10m); Riyadh King Khalid International (18m); and Abu Dhabi (18m). Such targets are significantly below WH Smith’s existing airport relationships (Heathrow - 72m; Manchester - 21m; and, Copenhagen - 26m) or even their UK rail station relationships (Liverpool Street – 58m; St Pancras – 45m). To maintain strong growth in the Travel segment, WH Smith must significantly improve their penetration in growth markets. The success and profitability of the international division is also questionable given sales and earnings are not reported independently despite making up ~20% of Travel’s store count. This indicates that they have either not gained meaningful sales or they are failing to operate at a margin significantly below the core UK business.

Given significant competition, little international experience, and weaker international markets, it is unlikely that WH Smith future expansion will live up to current expectations.

•        VALUATION

o        Trading at 1330 pence (£1,522 billion EV; £1,544 market cap; 9.6x ‘15 EV/EBITDA; 15.7x ’15 P/E) as of January 28th, the stock has priced in consistent margin optimization, cost cutting, and growth plans, limiting the stock’s upside potential and raising the prospect of a material price decline. While predicting when the business will finally peak is difficult, the full valuation helps to limit risk in the near term (a factor not enjoyed by short-sellers a few years ago). Using a DCF methodology, I value the market cap at £847.4 million with an implied share price of 712.1 pence (47% discount). This assumes a 5% p.a. LFL decline in High Street sales, £16 million of additional cost savings over the next three years, 150k sq. ft. of new Travel retail space over the next five years, moderate space optimization, and flat LFL Travel sales. For the DCF, I use an 8% WACC and assume no growth at perpetuity. In my nightmare scenario (stabilization of High Street, very successful space optimization, 250k sq. ft. of new travel space), I value the Company at £1.7 billion or 1,420 pence (7% premium to yesterday’s closing). Using a more conservative sum-of-the-parts valuation, I derive a £1.2 billion market cap or 984p share price (26% discount), assuming a 5x multiple for the High Street division (mix between troubled Debenhams and Home Retail), an 8.8x multiple for Travel (in-line with UK General Retail), and 11.0x for an estimated international division (in-line with Dufry).  

•        RISKS TO THESIS

o        Potential sale or spin-off of Travel as part of wider industry consolidation could provide a meaningful uplift to the stock price:

        Mitigant: WH Smith does not currently hold an attractive real estate portfolio that would entice many large travel retailers. With a substantial portion of its sales in the UK and in second-tier international locations, larger players such as Dufry will not be interested.

        Mitigant: WH Smith is already widely valued by equity analysts using a sum-of-the-parts analysis with Travel holding a premium valuation to the broader sector. Furthermore, the attraction of a stand-alone high street division requiring significant capex for future growth will likely counteract any benefits created by Travel. In the event of a spin-off, it is unlikely that significant value will be created.  

           Mitigant: "The majority of Travel's airport and railway concession agreements contain change of control clauses, giving various rights to the grantor of the concession, such as termination of the contract, in the event of a successful takeover bid for the group." - WH Smith Annual Report (p.18)


o        Success of new business ventures:

        Mitigant: WH Smith’s executives are not specialists in new business ventures, and have had greater success in cutting costs and expanding proven retail designs. The challenge of successfully scaling a new venture (or presiding over a separate team to do so) does not play to WH Smith’s strengths. While their experience in high street real estate will likely enable them to grow Card Market, it is unlikely that it will be able to compete effectively with Card Factory, especially while maintaining current margins.

        Mitigant: Funky Pigeon has not gained considerable scale in recent years in the greeting card industry. While it is better represented looking at the personalized card sector, it remains a distant second to Moonpig and its growth has not accelerated significantly in recent years.

        

o        Stabilization in end markets:

        Mitigant: Even in the unlikely event that certain end markets stabilize, WH Smith’s business model is at jeopardy given cost cutting initiatives which have decimated brand equity and isolated customers. With uncompetitive prices and a poor shopping environment, the Company will continue to lose share to better positioned rivals as is already being seen within the book market. If they do intend to compete in the new market and boost capex, it will destroy Management’s successful thesis and shares will likely react negatively.

o        Success in international:

        Mitigant: Markets have already priced in moderate success in international markets and should not have a material impact on the overall future of the Company. If earning contribution is robust, however, this breaks down the short thesis and would be a time to cover.

Catalyst

o        Deteriorating earnings; disappointing international expansion & new ventures; reduced FCF; slowing dividend growth