The constant mantra at WHSmith has been “Sales down, gross margins up, costs down”, but is it time to split the business up?

The constant mantra at WHSmith has been “Sales down, gross margins up, costs down”, but is it time to split the business up?

It is often said in retailing that sales are vanity and profits are sanity and WHSmith has certainly pursued that approach relentlessly under the impressive stewardship of CEO Kate Swann. Those who worry about constantly falling LFL store sales would have been driven insane by the way in which WHSmith has deliberately sacrificed top-line sales to engineer growth at the bottom-line, via margin control.

The reaction to today’s Q3 trading update is case in point. The 14 weeks to June 8 saw LFL sales down 7% on the “High Street” and 4% down in “Travel”, with management pointing to the tough “50 Shades of Grey” comps with last year in the book business.

But there was, as usual, a big gross margin offset, with a 200bp increase in the High Street Division and a 160bp increase in the Travel Division (with the aggressive promotional trading stance easily paid for by sales mix benefits, buying benefits and supply chain work). WHSmith sold a lot of copies of “50 Shades of Grey” last year, but didn’t make much money out of them.

And, of course, there has been very tight cost control on all back-of-store activities. Plus ca change…So, there is no change today to the consensus forecast of £107m PBT for y/e August at WHSmith (versus £102m the year before).

But the stockmarket still frets about the fear that the cost control discipline at WHSmith is unsustainable (as it has been at Halfords, for example), unless LFL sales start to go up, even though it admires the dividend growth and cash generation of the group. And with the huge sales mix shift out of low margin Entertainment (into snacks and stationery etc) now complete, some also worry where the next gross margin increase is coming from.

There is, needless to say, no sign at all that WHSmith will respond to their critics and shift strategy and when the new CEO, Steve Clarke (the current MD of the High Street Division), takes over from Kate Swann next month he will soon start working on his presentation for the October final results and the plans for even more cost reduction programmes.

However, Steve Clarke will no doubt have to fit a few different types of meeting into his diary soon, to listen to all the hard-working investment bankers from the City anxious to secure the mandate to demerge the Travel Division.

Interestingly, the Italian group Autogrill announced plans last week to separate its core Food and Beverage business from its Travel Retail business (which includes World Duty Free) and many people have always thought that a demerger of the Travel Division would be the final solution at WHSmith.

It is not generally recognised that WHSmith is really two different businesses: the High Street Division of WH Smith (based in Swindon) is run completely separately from the Travel Division (based in London), with different Buying teams, reflecting the very different sales mix and operating model of the two operations.

The consumer sees the one WHSmith brand, whether it be a shop on the High Street or in an airport, railway station, motorway service station, hospital or workplace location. But, technically, a stockmarket separation of the High Street Division from the Travel Division would be easy to arrange.

A free-standing “WHSmith Travel Retail PLC” would be a highly attractive entity for investors, combining great defensive, recovery and growth characteristics with formidable free cash flow generation. It is being held back by the weak state of the UK domestic air passenger market, but it is still managing to grow profits nicely, thanks to its channel diversification, and it clearly now makes well over half the group’s total profits.

The WHSmith Travel business is expanding quickly into Overseas airports and as it does so it is competing increasingly against the big European and global players in the Travel Retail market (like Autogrill and the French player Dufry). “WHSmith Travel Retail PLC” could be an interesting M&A vehicle in its own right, both as a potential acquirer and as a takeover candidate itself.

But what of the outlook for “WHSmith High Street PLC”? Conventional wisdom has it that if you spin off the good bit of the group, nobody would want the bad bit and that shareholders would be no better off if the “High Street” was de-rated, undermining the re-rating from “Travel”.

Well, arguably, the implicit rating of the “High Street” part of WHSmith is so low anyway, despite its free cash flow generation, that nothing might be lost if it was demerged/or sold off. And maybe a private equity company (who wouldn’t have to keep reporting its LFL sales every few months) might be a good owner for WHSmith High Street.

The great irony here, of course, is that Kate Swann has pursued a classic “private equity” approach to running WHSmith in the High Street in recent years and highly successful it has been too, even if it has offended the retail purists. Will her chosen successor, Steve Clarke, be bold enough to sell/or separate off his own baby, WH Smith High Street, and let its sister, WHSmith Travel, swan off on its own?

About Nick Bubb

Nick Bubb has been a leading retailing analyst for over 30 years. He is a well-known commentator on UK retailing and is a founder member of the influential KPMG/Ipsos “Retail Think-Tank”.