The Investment Column: Kate Swann's on song for now, but WH Smith faces a difficult future

In 12 months, WH Smith has gone from being a stationary business into a stationery business. Under the instruction of Kate Swann, the retailer is back in the black after kitchen-sinking last year's results.

The secret has, literally, been stationery. Pink pencil cases, notebooks and ring binders all tastefully adorned with the Playboy bunny have been hopping out of the stores. So while like-for-like sales across its 800-odd high street stores fell 3 per cent during the past six months, underlying sales of fashion stationery have soared by double digits.

And yet the past year has been about so much more than just flogging this month's must-have exercise book to schoolkids. In the 18 months since this column last looked at WH Smith, the retailer has seen a takeover bid come and go, watched Richard Handover hand the chairmanship over to Robert Walker, cut loose its publishing arm, sack its finance director, hand £207m back to its shareholders and shovel £120m in to plug its pension deficit.

But you won't catch Ms Swann relaxing with a good book to take a well-earned breather. No, yesterday she was as eager as ever to prove her doubters wrong, pointing out she was just six months into her three-year turnaround plan.

Costs are down, gross margins are up. Selling more high-margin greetings cards and A4 files and fewer chart CDs helped to swell the group's gross margin by 240 basis points, a trend Ms Swann reckons can continue. A 31 per cent swing in the high street chain's profit to £55m drove the transformation in the group's fortunes. Meanwhile, cutting one-third of the company's head office staff pronto means it is ahead of target to slice £30m from its operating costs by the end of 2007. Once again, its travel stores shone, with a 4 per cent rise in underlying sales. The next focus will be books. More books in more stores; who knows, possibly one day even separate WH Smith book stores.

But the fear is that once the easy margin wins run out, once Ms Swann has tarted up each of the group's core ranges and once the likes of Tesco have grabbed an even bigger chuck of the average weekly shopping bill, then WH Smith will not look nearly so attractive. A tightening consumer environment is hardly the ideal backdrop to a recovery programme.

The shares, which are still lower than they were when we advised avoiding them, bounced yesterday on relief that there was no profit warning. That puts them on a price/earnings ratio of 12 times. Sell.