Smiths News (LSE: SNWS) is a penny stock that has popped 35% this year. The company says it’s the UK’s largest wholesale distributor of newspapers and magazines, with a 55% market share. If you’ve ever wondered how your favourite newspaper or magazine is always at your local store, Smiths News is the reason.
But things haven’t worked out so well in recent times. The shares topped at around 250p in 2014, trod water for the next three years, and crashed in 2018. The pandemic wasn’t kind to the stock either, and in 2020 the share price bottomed at 11.5p. That’s a 95% plunge!
But things have picked up recently, and the shares have rebounded to 40p. I think there might still be some value here.
A successful turnaround
Smiths News released its full-year results last week that showed earnings grew by 11.3%. Free cash flow also rose by a highly impressive 120%, and dividends are being restored after they were halted last year due to the pandemic. Even better was that management said the overall performance was ahead of expectations.
Another good thing about the business is its high return on capital – the metric used to gauge how efficient a business is at generating profits with both debt and equity capital. It has been consistently in double-digits. I take this as a sign that the business is a quality operator.
But there’s a turnaround story playing out here. In April last year, Smiths News decided to sell Tuffnells (the green van-owning parcel delivery company) after a strategic review. Now the company is able to focus on its main distribution business, and it has brought down its cost base.
There has also been a reshuffle of the management team at Smiths News, with a new chairman and CEO coming on board.
Debt is the issue
What about the stock’s valuation? Well, the shares trade on an incredibly cheap price-to-earnings (P/E) ratio of just four. But there’s a reason for such a low P/E that I have to remember
In the results last week, net bank debt (the worst kind) was £53.2m. The company’s market value is only just under £100m, so this is significant.
However, Smiths News was able to refinance this debt at the end of 2020 with a syndicate of banks, giving breathing room for now. If trading deteriorates though, and cash generation dries up, this will be a huge problem.
When companies have high debt, I like to use a debt-adjusted P/E to take into account the extra risk of buying shares in such a business. For Smiths News, this is still an incredibly cheap 6.5.
The bottom line
With a new strategic direction, fresh leadership and more efficient operations, shares of Smiths News might only just be starting a charge back to 250p. That would be a return for my portfolio of 525% based on a share price of 40p! But my concern is the large debt load. If the cash generation stays high, and we avoid another lockdown, I might just buy this penny stock for my portfolio.
Dan Appleby has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.