Interactive Investor

Stockwatch: how much upside for this restructuring retailer?

16th November 2021 11:39

Edmond Jackson from interactive investor

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With the share price motoring on the back of consumer demand and management initiatives, our companies analyst assesses prospects for this FTSE stalwart.

After comparing the downside risk of two pub group stocks recently, I want to examine mean reversion on the upside. How reliable is underlying net asset value (NAV) versus market price as a benchmark for decisions, and up to what point? 

It appears to be very useful – at least if you’re starting from a chart trough, and if the underlying commercial story is improving. 

Parallels between M&S and BT 

A year or so ago, I made buy” cases for Marks & Spencer (LSE:MKS) and BT (LSE:BT.A) at chart lows that coincided with discounts to NAV. At 102p, BT appeared to trade at a 46% discount to net assets; additionally, the board had declared its intent to reinstate a progressive dividend policy, starting at 7.7p a share in respect of the March 2022 year. That implied the stock had to rise, because such a yield was too high relative to overall risks.  

With M&S, I had drawn attention to a 30% discount to net tangible assets even at 88p in May 2020; I reiterated this at 96p, which constituted a 21% discount that September. The medium-term prospect of Ocado (LSE:OCDO) replacing its Waitrose partnership with M&S was a commercial kicker set to capitalise on lockdowns, akin to BT benefiting from a restructuring plus full fibre roll-out.  

Despite both companies supporting pretty high debts and BT facing a soaring pension deficit (due to wider monetary conditions destroying bond yields), they had strong long-term cash flow credentials that managers’ restructuring efforts were able to restore.

BT shares doubled by mid-June this year, then retreated below 140p. They currently trade near 170p. I believe competition issues are partly responsible, and BT does tend to attract trend followers. That NAV has since reduced to 122p shows the risk of restructurings causing write-offs and absorbing cash. 

M&S has undergone two re-ratings based on improving commercial narrative: last August it rose to 180p after an update cited a strong start to the April 2022 financial year, with the food and clothing & home divisions both doing well. Alongside pent-up consumer demand, management credited its Never the Same Again” initiatives. After last Wednesdays interim results to 2 October, the stock has risen to 235p – nearly twice underlying net tangible assets per share of 119p – as both sides of the group continue to motor.  

Clothing & Home is more critical for sentiment   

By this point, I think it fair to say, earnings and cash flow/dividend prospects have taken over from NAV, in terms of where M&S shares trend next. 

Food sales are up over 10%, or nearly 17% ex the hospitality and franchise element. Management reckons this is not just a bounce-back in consumer spending but due to market share gains by food categories at the centre of its strategy; additionally, three new fulfilment centres are boosting Ocado Retail, with further capacity becoming available. 

Food comprises 61% of group revenue and 40% of operating profit, on a 4.6% margin. Yet the margin on clothing and home is 10.2%, putting this side at 50% of profit – so it is more significant for stock sentiment going forward. Prospects depend on the resilience of UK discretionary consumer spending – for formal wear especially, the extent to which socialising can happen without a surge in Covid cases, and managements success in selling into this.  

The international side is on an 8.2% margin, constituting 8.5% of group sales and 10% of profit. Though it has rebounded 26% like-for-like, in comparison with the 2019/20 year it is 6% down – not exactly great if overseas development is another key hope for M&S longer term.  

Balance sheet thwarts dividend recovery 

Interim net profit was £160 million versus a like-for-like £72 million loss the previous financial year. And free cash flow has seen a strong recovery, up from £88 million to £288 million over that period.  

If M&S meets the consensus expectation for £346 million net profit for the full year, then at 235p it trades on 13x implied earnings per share (EPS) of 18p – which looks fair enough, given that EPS had flattened pre-Covid and we need to see how sustainable this turnaround proves.  

Until its April 2019 financial year M&S had paid a near 18p dividend, which if restored would imply a prospective yield around 7.6% – similar to what BT promised before its stock re-rated.  

Yet the balance sheet needs to radically improve before a responsible board can recommence payouts.

Versus October 2020, total debt has eased only slightly from £4.04 billion to £4.01 billion, with net debt benefiting from a jump in cash from £309 million to £952 million. This debt generated a net £95 million interest charge relative to £282 million interim operating profit, so yes, cash needs to be used to cut debt before boosting dividends. 

Working capital movements show a lumpy 23.5% jump in trade payables to near £1.9 billion – a whopping figure compared with trade receivables flat at around £256 million. I dislike the extent of that imbalance, even before the question of whether profit might be enhanced by delaying payments to suppliers. 

Current liabilities are 116% of net assets, which obviously needs to improve.  

From the interim statement: First, we will invest in the transformation of the business to return to sustainable profit growth. Alongside this, we will prioritise the recovery of balance sheet metrics consistent with an investment grade rating. We will assess the reintroduction of dividend payments in this context, although this remains unlikely in the current year.”  

Given the state of M&Ss balance sheet and dependence on UK consumer demand, I cannot see material dividends being likely before 2024, although boards are apt to reintroduce payouts when trying to affirm turnaround actions.  

BT is 140% geared, and in addition its pension deficit amounts to half of net assets, which are based 115% on intangibles – yet its board is paying out, albeit on the strength of cash flows. 

Marks & Spencer Group - financial summary
Year end 3 April

  2016 2017 2018 2019 2020 2021
Turnover (£ million) 10,555 10,622 10,698 10,377 10,182 9,167
Operating margin (%) 5.5 2.4 1.5 2.9 2.5 -0.4
Operating profit (£m) 584 253 157 298 255 -37.5
Net profit (£m) 407 117 25.7 41.7 23.7 -198.0
Reported EPS (p) 23.7 6.9 1.5 2.5 1.2 -10.1
Normalised EPS (p) 37.4 36.1 36.8 37.0 22.1 4.5
Earnings per share growth (%) 16.2 -3.4 1.9 0.4 -40.3 -79.8
Price/earnings multiple (x)           53.2
Return on capital (%) 9.2 4.3 2.7 4.6 3.1 -0.6
Operating cashflow/share (p) 70.6 62.6 49.9 73.1 50.1 44.6
Capex/share (p) 32.0 24.1 20.5 18.4 17.2 10.6
Free cashflow/share (p) 38.5 38.6 29.4 54.8 32.8 34.0
Dividend per share (p) 17.9 17.9 17.9 13.6 3.9 0.0
Covered by earnings (x) 1.3 0.4 0.1 0.2 0.3 0.0
Cash (£m) 267 483 221 452 266 693
Net debt (£m) 1,806 1,747 1,575 3,802 3,813 3,355
Net assets/share (p) 203 186 174 152 190 117

Source: historic company REFS and company accounts

Commercial narrative key to M&Ss stock trend 

Technically, M&S stock looks well-bid, yet fundamentally it is in a no-mans land where NAV no longer justifies buy”, and nor is there sufficient grist to assume dividend prospects can (unlike BT a year ago). 

Despite the chief executive and chairman having been in place since 2016 and 2017 respectively, their initiatives do look to be achieving greater traction now.

Macro uncertainties remain, and will influence the extent to which disposable income or savings will enable better performance to continue, as higher inflation and taxes beckon in 2022. Clothing purchases are easily deferred and older relatives tell me they have blind-tested Aldi versus M&S prepared food and cannot say which is which. 

A sell” stance would be premature given the range of possible scenarios. Management says it is moving on from a fixing the basics” phase of the transformation and has confidence in the next one. Unless the post-Brexit economy succumbs to stagflation, we are learning to live with Covid and a better-honed M&S should have scope to capitalise. 

A case for locking in some gains 

Risk-conscious investors may, however, want to consider how far the stock now broadly reflects what is known. That is, that higher council tax and NI contributions, together with inflation possibly reaching 7% into 2022, will take the edge off spending, and also potentially favour value” retailers. Hence a case to take some profits within a long-term stance of: Hold. 

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

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