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Cash clinic: is Marks & Spencer's dividend safe?

Even with poor clothing and homeware sales, M&S has been flashing the cash. But where’s the money coming from? This the first of our new series on understanding cash flow
July 29, 2016

Despite Marks and Spencer's (MKS) well-publicised struggles to revive its clothing sales over recent years, the high-street stalwart has been flashing the cash. M&S pushed through the first dividend increase in four years in the 12 months to April 2015. It then spent £150m on share buybacks in its 2016 financial year and increased the dividend a further 4 per cent to 18.7p. What’s more, it announced a 4.6p special dividend for the first half of this year – worth £75m in total – when it reported full-year results.

With the shares at 313p, the 18.7p historic dividend, coupled with the special payout, represents a 7.4 per cent yield. And it could get even better from here, as the dividend is forecast to rise again this year and the new chief executive, Steve Rowe, has promised to update shareholders on cash returns at the half-year stage as part of an ongoing commitment to return surplus cash.

But given that the company has been reporting falling statutory profits for the past three years and continues to experience serious trading difficulties at its clothing and homeware division, the big question is: where’s the money coming from and will it keep coming? For its part, M&S’s management says it expects the business’s future to be “strongly cash-generative” and has made this a key focus. We’ve wheeled M&S into our newly kitted-out cash clinic to assess how feasible this is.

 

 

THE SYMPTOMS

Profits down, free cash flow up

A key feature of M&S’s recent past is that profit and free cash flow have been, until 2016, moving in the opposite directions, as can be seen in chart 1 (above right).

Free cash flow is also now comfortably covering the amount being paid out to shareholders, including last year’s £150m buyback (see chart 2, bottom left).

These are good early signs from M&S’s cash clinic check-up. It’s also encouraging to see that net debt has been falling over recent years (see chart 3 below) and, at 1.6 times cash profits, net debt is comfortably within management’s target range of 1.5-2 times. Another balance sheet positive comes from the fact that the company’s pension position moved from a £290m deficit at its 2012 triennial review to a £204m surplus in 2015. Plans to close the defined-benefit pension scheme at a one-off cost of £100m-£150m should also create more balance sheet certainty.

 

Chart 1: Free cash flow vs profit after tax

Chart 2: Free cash flow and cash returns

 

Why has free cash been outstripping profit?

Some of the difference between M&S’s statutory profits and cash flow is explained by the fact that the past five years have seen a persistent stream of non-underlying items mar the profit-and-loss account (see chart 4 below). Such large and regular non-underlying adjustments make it harder to form a clear judgement on reported earnings, which arguably provides added reason to pay close attention to cash.

A significant amount of M&S’s past non-underlying items have consisted of write-downs to the value of assets and other non-cash charges. Such charges often do not depress cash flow in the year they’re reported because they reflect a reassessment of the commercial wisdom of spending in previous accounting periods. For example, from the bumper 2016 non-underlying charge of £201m, M&S only took a £63m knock to free cash flow.

 

Chart 3: Net debt chart

Chart 4: PAT versus adjusted PAT

 

Other sources of cash

Over recent years, the movement in two other big items in the accounts also help explain why free cash flow moved north while profit after tax went south; both of these items have a relationship to each other (see chart 5 below).

Starting in 2012, M&S significantly increased capital expenditure (capex) as it invested in overhauling its business systems, improving its supply chain and sprucing up stores. Capex investment peaked in 2013 at £830m. Since then there have been marked falls in spending as investment projects have entered less cash-hungry phases. This reduction in spending has boosted cash flows. This year, capex is expected to be down to about £450m from £525m in the year to April 2016 (these figures are based on M&S’s own calculation of capex, which is slightly different to the more standardised capex calculation used in the cash clinic). That represents £75m more cash next year, all other things being equal. In fact, capex last year would have been £470m if it was not for M&S spending £56m to buy out a warehouse joint-venture partner.

The other noteworthy reason for improved cash conversion has been a significant increase in depreciation and amortisation (see box below), which is a reflection of the step-up in capex since 2012. The depreciation and amortisation charge is taken against reported profit but not cash flow.

Indeed, M&S is now at a point where its capex is now less than its depreciation and amortisation charge (see chart 6 below). As can be seen from the 20-year chart, this has not happened all that often over the past two decades.

 

Chart 5: Sources of cash

Chart 6: 20-year depreciation & amortisation to capex

 

 

THE DIAGNOSIS

Are capex cuts a cause for concern?

While the recent free cash flow trend looks encouraging, there are two concerning, albeit slightly contradictory, questions coming out of what we’ve seen in the cash clinic so far. Firstly, the fact that profits are being pushed down suggests that M&S is failing to make strong enough returns from its investment splurge to offset the rise in depreciation and amortisation caused by the spending. High non-underlying charges add to concerns over a poor investment record. This issue can also be seen from the decline in the company’s lease-adjusted return on capital employed (ROCE) over the past 10 years (see chart 7, below). The declining returns raise the daunting and somewhat existential question of whether this is yet another retailer that has simply had its day.

The second possible concern is whether the fact that capex has dropped to historically low levels compared with depreciation and amortisation is a sign that M&S is now underinvesting in its business. While management is making noises that suggests it expects capex to remain low for some time, chart 6 illustrates that historically capex has quickly bounced back when it has got as low as it currently sits against depreciation.

Scope to keep cutting capex

A look at historic spending gives some clues about where investment is likely to continue to be needed and the potential for M&S to continue to generate cash by cutting capex. Chart 8 (below) shows that since 2012 a considerable amount has been spent on the group’s IT and supply chain and a fair bit has also gone on international expansion. In both cases, this spending has been declining and contributing to rising free cash flow (see charts 1 & 2). Another big area of spending has been UK store improvement and this has plummeted in recent years.

Spending on IT and the supply chain looks like the prime area for any further large cuts. The company has decided not to go ahead with the fourth part of its costly GM4 buying and merchandising systems overhaul. Pulling the final stage of this project contributed £23.7m to last year’s bumper non-underlying charge. What’s more, the company should finish the rollout of its strategic distribution network in its financial year to April 2018.

The future of international spending is currently under review, and the company intends to let shareholders know what its overseas strategy will be in the autumn, when it will also announce the outcome of its UK store review. However, there are grounds to think M&S may focus on a less capital-intensive approach based on the fact that its capital-light franchise operations made an £87m profit last year, while its owned stores ran up a £31m loss.

There’s limited scope to squeeze such large amounts from UK store environment spending, given last year’s £55.8m fall to £36.9m, which reflected many of M&S’s design initiatives reaching completion. However, investment looks likely to stay at low levels as part of what management calls “a trend towards a lower level of capex spend going forward”.

 

Chart 7: Declining ROCE

Chart 8: Capex breakdown

 

Other capex considerations

M&S’s ongoing UK store review will hopefully improve the efficiency of its estate. That said, the fact that the company owns a lot of freeholds and long leaseholds could limit its room for manoeuvre and increase the cash costs associated with any restructuring. The UK store review has already resulted in a £26.7m non-underlying charge relating to nine store closures.

Cash flows will stop benefiting from disposal proceeds from the sale of a warehouse in White City, which have been coming in over the past three years at the rate of about £30m a year (M&S’s ‘in-house’ capex figure actually nets these disposal receipts off, whereas our cash clinic capex figure ignores them, which we think is more conservative). And free cash flow will be reined in by an anticipated pick-up in the tax rate, which broker Investec estimates at about £14m.

All in all, though, the ending of a period of heightened spending on IT and the supply chain, as well as the possibility of a continued reduction in international investment and continued low spending on the UK store environment, suggests to us there’s meaningful further scope for management to boost cash generation by pushing down capex.

The elephant in the room: Trading troubles

While the cash clinic has so far focused on M&S’s ability to generate cash by cutting spending, the trading outlook provides fewer grounds for confidence.

Let’s deal with the good news first: the company does have a very profitable food business, which is producing impressive rates of growth. The food business has latched on to consumer trends for convenience food shopping and demand for responsibly-sourced, healthy and pre-prepared products. What’s more, with only about 4 per cent of UK market share and considerable under-penetration in a number of geographic regions, there should be plenty of potential for ongoing profitable expansion.

Indeed, the company says the internal rate of return from new openings is still over 25 per cent and 250 new food-only ‘Simply Food’ stores are expected to open by the end of the current financial year, with a further 200 planned for the year after. While food represents the obvious growth opportunity for M&S, the end market is grappling with price deflation, which provides challenges, and management has said it expects full-year gross margins to be flat.

The real, and much publicised, area of concern is the clothing and homeware business. The pressure on the business can be seen in the declining contribution the division has been making to company sales over the past five years (see chart 9, below).

However, the breakdown of M&S’s UK gross retail profits over the past three years shows that all the investment it’s been making has actually helped grow the clothing and homeware business’s gross margin, which has more than offset the decline in sales (see chart 10 below). But such big margin gains will not continue, with a 50-100 basis point gross margin improvement pencilled in for this year – although in light of recent trading, this may be optimistic.

The new chief executive, Mr Rowe, believes the best of the gross margin gains, especially from better buying, have already run their course. Fortunately, in the near term currency hedging should offset much of the impact of sterling’s post-Brexit weakness on internationally-sourced products.

 

Chart 9: Revenue breakdown

Chart 10: UK gross profit breakdown

 

New boss, new strategy

Mr Rowe thinks a past focus on improving margins by selling clothes at higher prices has come at too big a cost to sales and made the company overly reliant on promotional activity to shift stock. He hopes to restore top-line growth by lowering key prices and cutting sales events. This will put pressure on profitability and management thinks there will be a lag before it sees the desired response from its customers who have become used to waiting for sales before reaching for their wallets and purses.

A dire first-quarter trading update reflected the initial pain of this strategy, coupled with a generally weak high-street trading backdrop. Like-for-like clothing sales fell nearly 9 per cent. However, the timing of Easter and the decision to delay the summer sale both had a significant impact – and broker Peel Hunt estimates underlying like-for-like falls were ahead of its forecasts at -4 per cent. Internet sales growth has also been slowing, having fallen in each successive quarter from 38.7 per cent in the first three months of the last financial year to just 0.5 per cent in the first three months of the current financial year. M&S claims to be the UK’s number two online clothing retailer, with a 7 per cent share of the market.

Another short-term concern for profitability comes from the new boss’s opinion that the company may have squeezed its operating costs too much over recent years, and especially cut back too far on staffing levels. This could herald cost increases, and results from a review of the cost base are due in the autumn – given the effects of operational gearing, this makes falling gross profits a bigger potential problem for the bottom line and a bigger potential threat to earnings forecasts.

THE VERDICT

M&S’s cash flows certainly look much healthier than its earnings. However, cash flows will inevitably be hit by the strategy of sacrificing clothing sales and margin in the hope of reviving the business in the longer term. Still, ahead of the recent update Investec was forecasting that an 8 per cent fall in operating profit this year and a 6 per cent fall in 2018 would only translate into a 4 per cent and 1 per cent fall in net operating profit.

Management says it has already seen some encouraging signs from lines where prices have been reset. Comfort can be found in the fact that Mr Rowe has a good reputation as a retailer, based on his success as head of M&S’s food business. However, the market has seen M&S try and fail to revive its clothing business over several years, so there are plenty of reasons for investors to be sceptical.

Still, the plan to focus on the basics of product and pricing can be seen as sitting well with management’s desire to keep cash generation strong to fund capital returns while investing where trading returns are strongest: food. The approach is somewhat reminiscent of the strategy used by WH Smith (SMWH) to deliver substantial upside for its shareholders.

There are several external factors to consider, too. The collapse of BHS and the fact that many of its stores were located close to those of M&S could help trading. A balmy, picnic-filled summer could also prove beneficial, assuming the current fine weather continues – hardly a certainty. Perhaps the biggest known unknown, though, is the potential impact of Brexit on the UK economy over the longer term. The (very) early signs aren’t great.

More cash please, vicar

Investors in M&S face a number of uncertainties based on both the ongoing review of a number of key parts of the business, as well as over the question of whether the new plan for the clothing business will actually revive its fortunes. Ultimately, it’s M&S’s ability to improve trading on which the company’s long-term fortunes rest, but a cash-flow analysis of the stock certainly suggests there is more of a cushion for shareholders than the profit-and-loss account on its own suggests. While there is definitely uncertainty and risk associated with the shares, including the potential for a profit warning this year, if things don’t pick up, the company’s cash generation potential means the basic dividend looks very interesting and the prospect of a further special dividend does not look quite as crazy as the recent first-quarter trading update may suggest.