Smiths News: Cash cow or investment dog?

In a recent article, I screened for stocks that are cheap on a free cash flow basis. Several companies stood out as worthy of a more detailed look. This week I am looking at one of them: Smiths News (LON:SNWS) . This Company was also one of Ed’s 2023 NAPS Portfolio stocks, so followers of that strategy will also be keen to understand the company further.

Summary

• Smiths News has a geographic duopoly in newspaper distribution to newsagents. They operate primarily in the South of the UK, with Menzies as the leading newspaper distributor in the North.
• This partial monopoly, together with long-term contracts, means the Company is able to pay out a hefty dividend, which is approaching a 9% yield at the current share price.
• However, physical newspaper distribution is a declining business. The Company's attempts to diversify have been mixed. The purchase of Tuffnell's parcel distribution business for £113m was ultimately a failure. It was divested in 2020 for a mere £15m in deferred consideration.
• New management has successfully focussed on the core business and small expansions such as the distribution of Carabao drinks to newsagents. However, these are unlikely to make up for the decline in the core business in the short term.
• This makes the business a "melting ice cube". As such, the best valuation is via a Discounted Cash Flow, not via a price-earnings ratio or similar metrics.
• A Discounted Cash Flow analysis shows that the company looks fully valued on its current revenue decline trajectory. However, the stock will still appeal to income investors who are willing to accept little to no capital gains over the long term in return for a 9% dividend yield. Or those who believe the revenue decline can be reversed.

Profile

Smiths News is a Main-Market listed distributor of mainly newspapers and magazines. It primarily operates in the South of England, where it effectively has a geographic monopoly. It started life as a demerger from WH Smiths in August 2006. In 2014 it rebranded itself as Connect Group, having purchased Tuffnells Parcels Express in late 2014 for more than £100m in an attempt to diversify away from its core declining business. However, the parcel delivery business, operating in a highly competitive industry, suffered several years of poor performance under the group's stewardship. Several good ideas, such as "Pass My Parcel", which allowed online shoppers to get parcels delivered to local newsagents, failed to generate sustainable profits and were canned. 

Jon Bunting joined as interim new CEO in late 2019, and his role was made permanent in the middle of 2020 after the appointment of a new Chairman. In 2020, Tuffnells was sold for a mere £15m in deferred consideration. In October 2020, they reverted back to the Smiths News name. A new CFO was appointed in 2021, marking a complete change in the executive board composition. Today the Company focuses on its core competencies of newspaper and magazine distribution to newsagents, airlines and airports, plus the distribution of corporate news publications. They recently signed a deal to distribute Carabao sports drinks to newsagents in an attempt to diversify away from their core declining business.

The Company has an exceptional StockRank of 99. The Value Rank is also 99th percentile, but strong recent trading means that the Momentum Rank is also strong at 95:

The Company is somewhat geared with debt making up around 25% of the capital structure:

However, net debt has been falling rapidly since 2020:

It is worth bearing in mind that this represents the year-end figures. The Company helpfully provides an average net debt figure for the full year, and this is significantly higher:

Business Model

Smiths News' business model is now very much focussed on delivering value to shareholders by managing their existing operations as effectively as possible.

Competitive Landscape

Smiths News only has one main competitor in newspaper and magazine distribution, the private equity-owned Menzies Distribution. However, News UK, publisher of The Times and The Sun, do their own distribution within Greater London. There are other newspaper and magazine distributors that focus on the corporate, hospitality and residential markets. However, Smiths News are the largest distributor to newsagents, and it generates significant economies of scale from this. As a declining industry, there are unlikely to be many new entrants undercutting them on price.

Strategy

The Company recognises that newspaper and magazine distribution is a declining business, saying:

The UK's newspaper and magazine market remains large and resilient, albeit challenged by a structural decline of sales volumes. To deliver sustainable returns, we must therefore find efficiencies to offset the reduced gross margin from our core sales on an annual basis.

In pursuing this task, we are aided by the scale of our operation, together with the relative predictability of our sales and costs. The security afforded by long-term contracts further supports long-term planning for the delivery of efficiencies that underpin our profit and cash flow.

So this is a business that is aiming to profitably manage a decline in sales rather than pursuing growth.

Competitive Advantage

The Company has a reasonable but not outstanding Quality Rank:

The F-score is high at 8 out of 9, mainly due to recent positive trends in business performance. However, the Company is flagged as at high risk of bankruptcy on their Altman Z-score due to negative tangible assets and negative working capital. Its operating margin is low, but that in itself should not indicate a lack of competitive advantage since, as a distributor, there is a large amount of pass-through revenue. In terms of return on capital figures, these are muddied by the negative book value. The Return on Assets shows an acceptable but not outstanding level:

Overall, it seems the Company does have a competitive advantage from its partial geographic monopoly—however, the decline in the products they distribute limits pricing power. Plus, larger newspaper groups can do their own distribution for the most accessible and most profitable areas, as News UK have started doing in Greater London.

Financials

Growth and Profitability

The revenue figures show the decline in physical media consumption, which dwarfs any ability to raise prices:

The EPS picture is more mixed, as the ability to take cost out has kept this essentially flat, despite declining revenue:

Balance Sheet

Usually, a current ratio of less than one would represent a weak balance sheet. However, this Company has operated with negative working capital for some time.

Another factor that sometimes signals financial distress is negative book value, which has been negative for some time here. Although the trends show recent improvement:

This means that there is no tangible asset backing to fall back on. If the Company faces a significant solvency issue, shareholders will get nothing. The Altman z-score suggests that we should be cautious about the Bankruptcy risk:

But when I drill down into the details, the same concerns over working capital and book value are the cause:

A declining business and negative working capital should give investors pause for thought since the working capital unwind will suck in cash. However, in this case, the working capital position is much better than in the recent past:

However, the Company currently generates significant operating cash flow from its long-term contracts and has little commitment in terms of capex. This means that net debt is likely to fall further in the short term, and the Company is unlikely to face financial troubles due to its high free cash flow.

Cashflow

For the last two years, Free Cash Flow per share has been significantly higher than EPS:

This is because the depreciation of assets has been higher than capex, and a number of non-cash charges, such as share-based payments, go through the income statement. A one-off payment of £8.1m to the company from a buyout of the pension fund flatter the recent figure, but even excluding this, the recent cash flow has been excellent.

Dividends/Buybacks

The Company currently pays almost a 9% dividend yield, which is very good even in current weak equity markets:

The level of the dividend payout is currently capped at £10m by the agreements the Company has in place with its lenders. However, if the net debt can be reduced further, the management believes their lenders would be amenable to increasing this cap. This would mean that the level of dividend yield could rise even further.

Ownership Structure

The shareholder structure is a balanced institutional one, as investors would expect from a company that has been listed for some time. Moreover, with a 35% free float, the shares will be liquid enough for most smaller investors to consider.

The downside is that directors don't have a lot of skin in the game. And the shares they do own are primarily through option exercise rather than on-market purchases:

CEO Jon Bunting and CFO Paul Baker have been selling shares to meet tax liabilities after exercising options. While it is normal for directors to do this, it would be nice to see them putting their own money into the shares in more than token amounts.

Valuation

As investors would expect from a stock with a 99 Value Rank, the Company is very cheaply rated on a number of metrics:

The exception is that this is not an asset play with negative book value, as previously described. However, there is an elephant in the room – the core business is in permanent decline. This makes using a number of these metrics inappropriate or difficult to use for valuation purposes. The most appropriate form for a "melting ice cube" is a Discounted Cash Flow analysis. In this form of valuation, an estimate of the free cash flow generated by the business in each future year is calculated. This is then discounted back to the present at a particular discount rate for each year and summed together. This is known as the Net Present Value (NPV) of future cashflows and should represent the real value of the business based on those assumptions.

These are my assumptions:

• Analysts' consensus has the decline in revenue at 4% for the next two years. In their latest results presentation, management confirm this as a reasonable assumption, so I use this assumption for the next two years. For longer-term decline rates I model there scenarios -2%, -4% and -6%.
• For Gross Margin, I assume this can be maintained at FY22's 6.9% going forward due to cost reductions in line with revenue reductions.
• Admin expenses, I assume they can take £5m in extra costs out over the next two years before these start rising again in line with 3% long-term inflation rates.
• For finance costs, I assume these reduce linearly with reduced average debt levels.
• For tax paid, I assume is at a 25% corporation tax rate going forward.
• For depreciation, Amortisation and Capex, I assume are at similar levels as FY22.
• The fully diluted share count is 252m shares. Accounting for share-based payments is a challenge since these are non-cash but will increase future dilution. The easiest way is to assume they are equivalent to being paid in cash.
• Net debt is £14.2m, so I add this to the EV. However, there is also negative working capital and provisions to consider. These should unwind over time. In this case, I assume this will happen linearly over the next 20 years. A similar effect would be achieved if I took the average net debt over the year rather than the year-end value and assumed a similar payment schedule.

The challenge with a discounted cash flow calculation is that it can be made to say almost anything by changing the growth (or, in this case, decline) assumptions and the discount rate. Therefore, looking at the NPV based on various assumptions is more useful. The two big levers here are the long-term revenue decline rate and the discount rate used. Here is what I get for the NPV based on different assumptions:

10% is roughly the long-term nominal broad stock market return, so I think it would be difficult to argue that a small cap stock in a declining market should be valued at a lower discount rate than this. This means that if the 4% revenue decline continues and my assumptions on gross margin and admin costs are correct, the Company is fully valued at the current share price of 48p.

This may seem strange for a company on a forecast P/E of 4.5 and a dividend yield of almost 9%. However, this is the impact of declining revenue on long-term valuations. For example, here is what the model gives for Free Cash Flow based on a continuous 4% revenue decline:

This is why investors should always do their own DCF valuations for this type of Company. To argue that the stock is undervalued with a margin of safety, investors have to see a path for the revenue decline to cease and for other revenue streams to take over from the declining core business. Although management have some ideas in this space, I have not seen enough progress in the area to be able to argue that this should be the central case.  However, this analysis shows that the valuation is highly sensitive to these factors, so investors who are able to make the case for a slower revenue decline in the future may value the business more highly.

Still, there is no sign that the dividend will be cut anytime soon, and with the reduced debt, the ability to pay out higher dividends will be possible. This will appeal to today's income investor, even if this high payout looks unsustainable over the long term. With a 4% revenue decline, my assumptions show the current dividend is payable from Free Cash Flow until 2032. At this point, investors will have largely received their money back in dividends. The reason that this doesn't necessarily represent a great investment is due to the time value of money and the ability to invest in higher-returning stocks in the meantime.

Risks

It is clear from the above that the most significant risk is that revenue declines more rapidly than expected. So far, publishers, such as Reach (LON:RCH) , have been using cover price increases to offset circulation decline. However, there is a risk that this becomes a vicious circle as higher prices accelerate the decline in circulation.

There have also been rumblings of discontent amongst Smiths News' newsagent customers. A 2.9% increase in prices in July last year (which, with current inflation, looks very reasonable) led to the following comments from Jason Birks, the national president of the Federation of Independent Retailers:

As the cost of living continues to bite and our bills go ever upward, we are dismayed. Also, there is no guarantee from Smiths News as to how, or even if, this new income from carriage charges will be reinvested into its business. If that were to be the case, at least members would see some service improvements. Currently, for too many of our members, the service levels they are receiving remain unsatisfactory.

It is also worth noting that the historical FY22 EPS figures are adjusted for an exceptional loss:

Adjusted items before tax of £3.2m (cost) relating to Continuing Operations were a £2.9m increase from the prior period (FY2021: £0.3m cost). The major contributing factors to the increased cost were the impairment of receivables (£4.4m increased costs) which was offset by £1m lower finance income. Impairment of receivables is a provision resulting from McColl's going into administration in May 2022.

Although this was a one-off, given that their customers operate in a low-margin declining industry, bad debt remains an ongoing risk.

The final risk is that other distributors, such as News UK's in-house distribution, cherry-pick the most profitable parts of the distribution chain, as they already do in Greater London. With the denser populated South East of England part of Smiths News historical territory, this may disproportionately affect them compared to Menzies Distribution.

Recent Trading

In the recent trading statement in January, the Company said:

The Board is pleased to report that overall trading in FY2023 to date is in line with market expectations. Revenues in the core business are ahead of historical trends, supported by cover price increases. Inflation continues to be managed in line with our business plan and sustainable efficiency savings and operational cost controls are all collectively on track. The Board remains confident in the Company's profit and cash generation.

These expectations have been raised during the year, so this represents a strong performance:

The Company also says:

Significant progress has been made to progress long-term publisher contract renewals, with 46% of newspaper and magazine revenues now secured through to 2029.

However, given their geographic monopoly in the South of England, it would be surprising if contracts with publishers were not renewed.

Sentiment

It isn't just recent trading performance that is strong. The medium-term share price performance has been positive too:

Leading to an exceptional momentum rank:

Given this momentum, holders may want to stick with the business despite concerns that it may be fully valued on a DCF basis.

Conclusion

Smiths News has been on an interesting journey. By making a bold move to diversify their declining business into parcel distribution, they undoubtedly destroyed shareholder value. In the last few years, a new management team has taken them back to their core competency of newspaper and magazine distribution, where they have a virtual duopoly. This strategy has paid dividends, literally, with a yield approaching 9% despite a share price that has been strong over the last year.

However, this remains a declining business, and their more modest diversifications, such as sports drink distribution, are unlikely to mitigate the decline in physical media retail. This means the Company is best valued on a discounted cash flow basis. Here the current revenue trajectory implies that the current share price may be fully valued. Given the obvious attractions, momentum and income investors may want to hang on to the shares. However, the value investor will likely want a greater margin of safety before investing, either in terms of discount to fair value or a clear sign that the current revenue decline trajectory can be halted or even reversed.