Share tip of the week: a simple business for the income investor

By Paul Hill Nov 27, 2009

Paul Hill

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Two of Warren Buffett's best-known investment rules are: "only buy companies you understand" and ensure that they have "a wide economic moat" (in other words, make sure it's hard for rivals to duplicate their success).

Both of these rules apply to Smiths News. Although it has a simple business model, it is surprisingly hard to copy, as arch-rival Dawson News discovered when it was forced into administration in August.

Smiths News was formed from the de-merger of WH Smith in September 2006. It is Britain's top newspaper-and-magazine wholesaler, with a 55% market share, ahead of John Menzies, which controls pretty much the rest.

Smiths handles around 80 million journals each week, serving 30,000 retail outlets, ranging from small newsagents to supermarkets and garage forecourts. It operates out of 66 depots, employing around 5,600 staff.

Smiths News (LSE: NWS), rated a BUY by Altium Capital

As most items are sold on a "sale or return" basis, Smiths also deals with the collection of about 15 million unsold items each week. This is an extremely complex operation that creates substantial barriers to entry.

In respect of the broader industry, newspaper volumes have been falling since the 1980s, due to changing consumer habits and the growth of other media channels, such as TV and the internet. So far, this slow decline has been more than offset by cover-price rises, but this trend has itself been offset lately by some cut-throat discounting from the tabloids and other publishers.

Around 70% of Smith's turnover is derived directly from the retail price, with the rest largely dependent on volume. Customers typically enter into long-term supply deals (around five years), providing Smiths with excellent earnings visibility.

So how is the business performing? Analysts expect 2010 sales and underlying earnings per share (EPS) of £1.8bn and 13.6p respectively. That puts the shares on an undemanding p/e ratio of 7.7. A 6.8p dividend is also expected, giving a 6.5% yield. Net debt stood at a comfortable £50m in August, on top of a pension deficit of the same amount.

There are also opportunities to leverage Smiths' excellent distribution network in other areas, such as by accelerating its growth in the books area, along with providing online order fulfillment. With the internet becoming ever more crucial, retailers need rapid, reliable delivery of their goods. Smiths is well placed to benefit, particularly in light of the recent Royal Mail strikes.

What do we need to watch out for? Smiths' biggest challenge is integrating the £459m of annual contracts it picked up from Dawson News this year and realising the targeted £6m a year of cost cuts.

But as the top player in a duopoly market with a first-class logistics capability, Smiths looks a sensible choice for the income investor. England's qualification for the 2010 World Cup may also provide a boost, especially given the popularity of its high-margin sticker albums during such tournaments. Altium has a 155p price target.

Recommendation: Long-term BUY at 105p

• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments

Published in Tips & advice | More articles by Paul Hill

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