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Marks & Spencer's turnaround is too slow

The retailer is closing stores and cutting costs, but a recovery still looks a distant hope
June 27, 2019

We are not convinced by the turnaround strategy of embattled high-street stalwart Marks & Spencer (MKS), which has involved pushing down operating costs while cutting capital expenditure to the bone. High fixed costs linked to its extensive estate of 1,487 stores combined with ongoing like-for-like sales declines have fuelled persistent earnings downgrades over recent years. Meanwhile, the company has signalled it will increase anaemic levels of capital expenditure, which have helped support recent debt reduction. Meanwhile, we struggle to see how a rights-issue-funded investment in Ocado's lossmaking UK business will change the group's fortunes any time soon. 

IC TIP: Sell at 210p
Tip style
Sell
Risk rating
High
Timescale
Long Term
Bull points

Like-for-like falls across divisions

Cut to dividend

Persistent forecast downgrades

Capex cut to the bone

Bear points

Net debt reduction

Cost savings

M&S generates 90 per cent of sales and almost 80 per cent of earnings in the UK, with gross profits split fairly evenly between its upmarket food business and its clothing and homeware division. Neither business has been doing well and the company is in the process of aggressively trying to restructure its operations by cutting costs and closing uneconomic shops.

Costs associated with these efforts have meant that, over the past three years, on average more than 80 per cent of underlying operating profits have been absorbed by exceptionals. At the same time, capital expenditure has been slashed, and has recently been running at levels well below those seen in the aftermath of the credit crisis (see chart below). Reducing investment in the business has helped bring down net debt, which dropped £280m last year to £1.6bn, but the squeeze on capex is now expected to loosen, with management guiding towards spending of £350m-£400m next year; still low by the standards of the past decade. The recent low levels of investment also does not bode well for phase two of the recovery plan, which is to attract new customers. 

Savings amounted to about £100m last year, which is expected to rise to £250m by 2021. The trouble is, given the group's thins margins and high level of fixed costs associated with its large store estate (occupancy costs last year were £652m, for example, and the wage bill rolled in at £1.45bn), the savings have not been enough to offset falling sales. Last year like-for-like sales from food fell 2.3 per cent and clothing and home like-for-likes were down 1.6 per cent. This was due in large part to reduced discounting, which was intended to protect the margin. Gross margins did hold largely steady – down 15 basis points in food to 31.1 per cent and up 20 basis points in clothing and home to 57.1 per cent.

However, high fixed operating costs mean the bottom line is hugely sensitive to like-for-like sales changes. Indeed, over the past five years underlying operating margins have dropped from 7.6 per cent to 5.8 per cent. On a reported basis the operating margin came in at just 1.6 per cent last year. What's more, as trading news has got progressively worse, shareholders have had to deal with persistent forecast downgrades. Our chart below chronicles the pain felt during the past 12 months alone, which has seen both current year and next year's consensus EPS forecasts scaled back by 21 per cent. 

In the short term, it is not yet clear where an improvement will come from. The company's international business also reported falling sales and profits last year; down 13.9 per cent and 6.1 per cent, respectively. Management will have its fingers crossed that it will reap rewards from its decision to buy 50 per cent of Ocado's (OCDO) UK retail operation. However, the deal does not give M&S ownership of Ocado's technology, which is where many see the real value in the online group. What's more, the historic losses reported by Ocado's business means, at £750m (including a £188m deferred consideration) M&S may be paying a high price for its joint venture share. Shareholders have already felt the consequences in the form of a £600m rights issue at 185p and a two-fifths dividend cut. Rumours that Amazon (US:AMZN) is planning a more aggressive push into the sector means online competition could soon mimic that seen on the high street.

Marks and Spencer (MKS)   
ORD PRICE:210pMARKET VALUE:£4.1bn 
TOUCH:210-211p12-MONTH HIGH:317pLOW:185p
FORWARD DIVIDEND YIELD:5.1%FORWARD PE RATIO:11 
NET ASSET VALUE:165pNET DEBT:58% 
Year to 30 MarTurnover (£bn)Pre-tax profit (£m)*Earnings per share (p)*Dividend per share (p)
201710.661428.718.7
201810.758128.718.7
201910.452325.513.9
2020*10.247318.810.7
2021*10.247319.510.7
% change  +4 
Normal market size:7,500    
Beta:1.54    
*JP Morgan forecasts, adjusted EPS and PTP figures