Interactive Investor

Stockwatch: can Marks & Spencer shares continue to climb wall of worry?

2nd June 2023 10:23

by Edmond Jackson from interactive investor

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A recovery at the high street favourite offers the prospect of both generous income and capital growth. Targets may be conservative, thinks analyst Edmond Jackson who updates his rating on the shares.

M&S 600 GettyImages

There remains quite some disconnect between stock behaviour and analyst opinion. 

In response to recent annual results to 1 April, Marks & Spencer (LSE:MKS) shares jumped 13% to 185p, capitalising this mid-cap retailer at £3.6 billion. It settled around 180p as markets fell, but the reaction has remained keener among investors than most analysts. M&S has nearly doubled from 93p last October. 

The behavioural situation strikes me as classic “climbing a wall of worry”. It is where stock sentiment becomes jaundiced after a business struggles, hence may only need steady improvements in operations to drive a re-rating. 

This applies to M&S as it evolves from a “deep value” play - when many doubted its ability to turn around the clothing and home side - to the latest annual results confirming this is happening, with food also doing well.   

Affirming patience with ‘discount to net tangible assets’ investment approach 

When I first made a “buy” case at 88p in May 2020 it was based on a 30% discount to net tangible assets, plus the medium-term prospect of Ocado Group (LSE:OCDO) substituting its Waitrose partnership with M&S.  

I re-iterated this at 96p in November 2020 at a 21% discount to September’s net tangible assets, given Covid lockdowns had emphasised the Ocado tie-up as timely and with potential to habitualise ordering a wide range of M&S food online.  

The discount was significantly a function of the clothing side struggling to evolve from reliance on essentials and formal wear, to embrace for example “athleisure”. Yet it offered a margin of safety to tuck the stock away and potentially get lucky.  

2022 outcome beat makes it harder to doubt turnaround 

Annual sales rose 10% close to £12.0 billion against consensus for £11.8 billion, with food up 8.7% and clothing/home by 11.5%.  

Net profit rose 17% to £363 million against consensus for £328 million.  

The expectation remains (or is yet to be upgraded) for £12.2 billion sales in the current April 2024 year; albeit with an upgrade to the net profit forecast, from £300 million to £313 million. 

Management guides current year profit (presumably pre-tax) lower, if only by £5-10 million, given the consumer spending outlook remains uncertain amid persistently high inflation. 

Yet the outlook statement makes it sound as if £50 million of higher energy costs and £100 million staff pay increases can be offset by over £150 million savings in a structural cost reduction programme, while investing in customer service and digital development. Doubtless that will mean exceptional costs. 

The reported operating margin has eased from 5.3% to 5.2%, although it has not been over 5% since April 2016 when M&S had a 5.5% margin. Supply chain modernisation, re-shaping stores, also higher energy/staff costs, have weighed.  

So in terms of a commercial story, this latest release may have punched the best in terms of “surprise” element unless M&S again defies expectations. 

The analyst consensus reckons only on £365 million net profit by April 2025 which in inflation-adjusted terms would be quite a slip on the £363 million just achieved. 

Normalised earnings per share (EPS) of 18.4p then, implies a price/earnings (PE) ratio below 10 times and a 6.7p dividend a 3.7% yield – potentially good value if the commercial story keeps advancing. The CEO of one year currently asserts “sustained trading momentum across all parts of the company”. 

Net tangible assets were 135p a share last April, with only £163 million intangibles and no goodwill on the balance sheet. 

Marks & Spencer Group - financial summary
Year-end 1 April

20162017201820192020202120222023
Turnover (£ million)10,55510,62210,69810,37710,1829,16710,88511,931
Operating margin (%)5.52.41.52.92.5-0.45.35.2
Operating profit (£m)584253157298255-37.5578620
Net profit (£m)40711725.741.723.7-198309363
Reported EPS (p)23.76.91.52.51.2-10.115.117.9
Normalised EPS (p)37.436.136.837.022.14.520.818.2
Earnings per share growth (%)16.2-3.41.90.4-40.3-79.8366-12.6
Return on total capital (%)9.24.32.74.63.1-0.68.29.7
Operating cashflow/share (p)70.662.649.973.150.144.667.850.6
Capex/share (p)32.024.120.518.417.210.612.720.2
Free cashflow/share (p)38.538.629.454.832.834.055.230.5
Dividend per share (p)17.917.917.913.63.90.00.00.0
Covered by earnings (x)1.30.40.10.20.30.00.00.0
Cash (£m)2674832214522666931,2161,081
Net debt (£m)1,8061,7471,5753,8023,8133,3552,5462,547
Net assets/share (p)203186174152190117149143

Source: historic company REFS and company accounts

Long-term chart offers scope for further mean-reversion  

If “mean reversion” is a valid concept, then scope exists to recover a circa 300p to 500p sideways trading range since the 2009 recession. Mind, it is tempered by dilution from a 1 for 5 rights issue at 185p four years ago. 

Quite often in turnaround situations a high PE is sustained where the market is confident of commercial recovery. For it to be below 10 times, medium-term EPS expectations show doubts lingering. 

Admittedly, you have to go back to 2015/16 for M&S net profit to be over £400 million. 

Doubts persist in the analyst community 

Past worries over marketing failures in clothes have shifted to energy and wage costs; yet management is taking out other costs. 

Food has been helped by perception of better value-for-money and greater choice. However, this side is relatively more labour and energy intensive. Clothing and international businesses have also benefited from better ranges and execution. 

Market share gains in food look to have benefited from Tesco and Morrisons’ past tactic of “investment in price” (subsequently abandoned), hence the margin could slip. Basket analysis has shown various M&S items cheaper than Lidl even.  

Quite for how long that can persist, given Morrisons has since become particularly expensive (under new ownership) and Tesco also nowadays seems to have hiked prices, is unclear. 

Yet I am inclined to think that even higher food and drink prices when eating out should support demand for good quality meals at home.    

There is concern that the joint venture with Ocado is not working as well as it could; also, that M&S lacks physical retail space to compete on product variety as shoppers make smaller more frequent trips. Despite a plan to open 30 new stores, chosen locations may not be as optimal for food sales as mid-town or retail parks.  

Rising interest rates are also cited as a concern. Well, looking at the 1 April balance sheet, there was £3,628 million debt (no leases) offset by £1,068 million cash; the income statement shows generated only a £39 million net interest charge on £515 million operating profit.  

So I would tend to regard higher interest rates as chiefly a risk to consumer discretionary spending – on clothing and home items – than reducing profit. 

Overall, these concerns strike me as classic “wall of worry” which M&S could yet surmount.     

Scope remains for dividend of at least 10p for 6% yield 

In previous “buy” pieces I noted a very strong record in free cash flow despite M&S’s post-2016 dip in overall performance. I suggested that if a turnaround gained traction, then a dividend more like 10p a share might be possible. 

At stock prices below 100p it implied a double-digit yield, and M&S’s overall recovery since then shows we should not necessarily write off a high yield as flagging high risk.   

Free cash flow has dropped from around 55p to 30p a share in the last financial year, but remains a robust context for reinstating the dividend - as is guided for, from this autumn. The table above shows dividend per share had been nearer 18p pre-Covid. 

Patient investors can therefore target M&S as a possible source of income as well as capital growth. Consensus looks for 5.5p a share in respect of the April 2024 year, then 6.7p, but that may be conservative. I retain a 10p (and higher) target even if it has to build first. 

My stance tempers to “hold” on a short to medium-term basis – what with the chancellor embracing a possible UK recession from higher interest rates to cool inflation. Overall, I think M&S rates soundly as a core portfolio holding for most investors. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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