Stockwatch: M&S shares available at a big discount

by Edmond Jackson from interactive investor |

Trading below the net value of its assets, our companies analyst asks if it is time to buy the shares.

My tentative idea to buy Marks & Spencer (LSE:MKS) shares at 188p last October – in a basket of UK domestic stocks hard-hit by Brexit fears – has been clobbered again, this time by Covid-19. M&S shares have attempted several rallies through March and April but failed to make a move about 100p stick. From a chart standpoint, and at 88p, you would steer clear.

However, on a narrative/fundamentals view, some aspects continue to entice. Although earnings and dividend considerations are out the window, for the short to medium term, and notwithstanding £4.1 billion net debt (inclusive of lease liabilities), the stock is at a 30% discount to net tangible asset value (NTAV) of 137p a share – according to the 28 September 2019, interim balance sheet. 

M&S can be criticised for aspects of marketing on the clothes side but its tie-up with Ocado (LSE:OCDO) – operational from September – should benefit the foods side of the business, with an older UK demographic likely to continue avoiding larger supermarkets.

Source: TradingView. Past performance is not a guide to future performance.

Financial risk is at least under control

An historic Altman Z1 score of 1.47 implies serious risk of financial distress in the next two years but, looking forward, a 28 April “strengthened liquidity” update cited agreement with M&S’s lending syndicate of banks providing a £1.1 billion revolving credit facility, to “substantially relax or remove covenant conditions” for tests over the next 18 months. 

This, the company said, would “secure liquidity for the likely duration of the Covid-19 crisis and underpin the recovery strategy and accelerated transformation in 2021". Management reckons that, even with more adverse assumptions, the business will have significant undrawn credit for 18 months. 

In the last financial year to 30 March 2019, £1.5 billion net bank debt generated a £77.8 million net interest cost versus £601 million operating profit before adjusting items. While the table below shows operating margins declining from 6.8% in 2015 to around 1.5%, adjusting items have distorted profit measures – see the big gap between reported and normalised figures.

Broadly it is fair to separate them so, to get a sense for underlying performance, although M&S needs to break what has become a habit, otherwise critics can point to chronic re-positioning and the like: businesses always need to adjust.

Encouragingly, in this regard, last November’s interim results showed adjusting items declining from 35% to 9% of operating profit, and a productivity programme was said to be over half-way to achieving at least £350 million of repeatable savings, hence UK operating costs easing 3.3%.

The normalised operating margin fell from 6.5% to 5.6% however and, in pursuit of balance sheet strength, the interim dividend was cut from 6.5p to 3.9p. So, the narrative has been frustratingly mixed, where highlighted improvements are seemingly offset by challenges elsewhere. So, to drive a stock re-rating, M&S needs to tilt the balance more positively.

A mixed narrative on food versus clothing/home

In the last financial year, food constituted 57% of group revenue and 48% of UK gross profit. Interims then showed a pleasing revenue trend for this side: up 3.3% in the second quarter and ahead of the market after an implied weak first quarter – given total interim revenue edged up only 1.2%. 

Possibly this reflected price cuts of over 10% on more than 400 high-volume lines, although it could also be seen as catch-up or simply remaining competitive while Aldi and Lidl’s sales growth storms ahead. M&S food is generally seen as good but pricey, which is fair enough as Ocado’s substitute for Waitrose, and offering a wider range, but needing greater competitiveness overall. There’s currently more emphasis on fresh and ambient ranges.

So, it has not been great to read in a 28 April update that the food side has been adversely affected due to café closures, plus a “slowdown in travel and some city centre locations”.

This implies that the location of M&S food halls at the rear of in-town department stores perhaps is not working as working as well as dedicated supermarkets that people can drive to, or local convenience stores. Unlike other food retailers having to hire extra staff however, which bumped up their costs, M&S has been able to re-deploy clothing staff to food counters.

Meanwhile, clothing and home products continue to affirm bearish suspicions. In the last financial year, they constituted 34% of group revenue and 52% of UK gross profit, yet total interim revenue slumped 7.8% due to supply chain issues and apparently trying to reach too wide an audience.

Management aims for a realignment to “the family customer” with fewer stock units, contemporary styling and astute pricing. Own brands have been tidied up and revamped, with a new launch last October said to have garnered encouraging customer response. 

It is frustrating how this crux for the M&S recovery rationale is likely to be compromised in the short to medium term by reduced clothes’ shopping. Why take any health risk, shopping, when social life is anyway compromised? 

Ominously, on 20 March, M&S declared the next 9-12 months would see its clothing, home and international operations “likely severely impacted” despite “confidence that the post-crisis future of the business and our transformation programme remains as strong as ever".

Yet this is likely substantially priced into a stock that is on a 30% discount to NTAV. Moreover, the board does promise to keep reviewing scope for a return to dividends. If the clothes marketing plan is now finally credible, this could be the stock price’s trough.

Marks & Spencer Group            
year end 30 Mar 2014 2015 2016 2017 2018 2019
             
Turnover (£ million) 10,310 10,311 10,555 10,622 10,698 10,377
Operating margin (%) 6.7 6.8 5.5 2.4 1.5 1.6
Operating profit (£m) 695 701 584 253 157 162
Net profit (£m) 525 487 407 117 25.7 33.5
IFRS3 earnings/share (p) 30.8 28.3 23.7 6.9 1.5 2.0
Normalised earnings/share (p) 34.5 32.2 37.4 36.1 36.8 31.2
Price/earnings multiple (x)           2.8
Operating cashflow/share (p) 66.3 74.2 70.6 62.6 49.9 55.0
Capex/share (p) 37.7 40.6 32.0 24.1 20.5 18.4
Free cashflow/share (p) 28.6 33.6 38.5 38.6 29.4 36.6
Dividend/share (p) 16.3 17.2 17.9 17.9 17.9 13.3
Covered by earnings (x) 1.9 1.6 1.3 0.4 0.1 0.2
Net Debt (£m) 1,904 1,808 1,806 1,747 1,575 1,365
Net assets per share (p) 159 186 203 186 174 158
             
Source: historic Company REFS   and company accounts            

Can the 20 May full-year results at least halt the stock’s rot?

Although I cannot definitively point to overall reasons why M&S has proven its turnaround credentials, a key reason I flag the stock for consideration ahead of its annual results, is it having reached that category where “news only needs to be less-worse than feared, for price to rise”. 

The shares trade on a 30% discount to NTAV and a lot of bad news is already out there. It is also possible that the consumer economy does now steadily recover, and that we do not see a worst-case 'second-wave' scenario of Covid-19. Finally, might M&S clothing/home might have its marketing sorted, while the Ocado partnership will prove useful for food.

Preliminary results will include “a further update on the very significant measures being taken to reduce costs and protect cash flow during the crisis period…” and also “…measures being taken to accelerate the transformation programme and change ways of working…”.

Much also depends on the overall risk appetite for stocks; whether the easing of lockdown restrictions means a very steady improvement in public activity, or the US and Europe see their Covid-19 re-infection rates bump up, lockdowns return and financial markets take fright.

Cyclically adjusted EPS makes the stock look cheap

Basically, a market price of around 88p implies, on a rough-and-ready reckoner of 10x earnings, that M&S will not in the longer run be able to achieve any better than high single-digit earnings per share (EPS). All things considered, that seems overly negative so long as “adjusting items” are indeed being quashed.

Source: TradingView. Past performance is not a guide to future performance.

At the very least, I think shareholders have reason to take heart. Cynical traders, even those who dismiss much long-term recovery potential, may see 'cigar butt' rally potential if prelims reasonably assuage fears.

There is a scenario, at least, where turnaround in business does gain traction from 2020, and to average into the shares. In which case I reiterate: Buy.

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

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