WH Smith

In the past we have favoured WH Smith (SMWH) because we believed that the high street retailer had been oversold by the market following a period lacklustre performance. In addition, we had great confidence in the ability of new management. Whilst we remain upbeat about the long-term recovery story at the company, we believe that market conditions and recent price action dampen the prospects for further gains in the medium-term.

Thus far we have been impressed by management's approach to turning the company's fortunes around. The group has stopped chasing unprofitable sales and instead has focussed on cost control, product choice and improved availability. The strategy has enabled WH Smith to increase margins although sales have declined. However, we view this as the beginning of the journey for the retailer. Although we recognise the group's long-term potential, competitive pressures and softening market conditions make the ultimate outcome far from certain.

Figures released last week by the Office for National Statistics showed an unexpected increase in high street spending in April, however the annual rate of growth fell to its lowest level in two years. In addition, sales in the three months to April are at a two year low. We believe these figures indicate a significant downturn in consumer activity. Given our belief that interest rates have not topped out yet, the general outlook for the domestic retail sector is still bleaker in our opinion. As such, despite the turnaround being engineered at WH Smith, sales and earnings growth will inevitably be stunted or worse in our view.

In addition, in such a competitive retail environment characterised by slowing growth, WH Smith could find it increasingly difficult to remain on terms with the large supermarket chains and on-line retailers. Although Smith's News Distribution business would still provide solid cash flow, in our opinion this would not be sufficient to underpin meaningful growth in shareholder value.

Our confidence in the management team at WH Smith is undiminished. Nevertheless, based on our evaluation of market conditions we believe significant share price increases from current levels are sometime off in the future. Clearly a fresh takeover bid would provide additional support for the shares. However, following WH Smith's own experience, as well as those of Woolworths and even Marks and Spencer, we are somewhat jaded when the subject turns to retail takeover attempts.

Shares of WH Smith have slipped over the past four weeks having traded as low as 314p - their lowest level since January. We believe the stock's inability to stabilise during the past month has clouded the near-term picture even more. Given a worsening retail environment we believe that the shares have run their course in the near -term.

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