Retail stocks like Marks & Spencer (LON: MKS) can often be very difficult ones for long term investors because they operate in fiercely competitive environments in which previously established advantages can rapidly erode. The most obvious recent example of this is with Tesco. It wasn’t so long ago that the supermarket giant was well on its way to racking up a quarter century of consecutive annual dividend increases. These days it struggles to generate barely any profit and free cash flow at all; and it hasn’t paid out a dividend since 2014.
In that sense Marks & Spencer might not strike you as a particularly attractive long-term investment. Granted it’s a household name and stalwart of the UK high street, but a cursory glance at the long-term share price chart tells its own story. At around £3.85 per share the stock is currently trading at around the same price as it was back in the mid-1990s. When you add in all the dividend payments you’re looking at an investment that’s maybe kept pace with inflation over the past couple of decades. Overall it just seems like an awful lot of risk holding a cyclical stock for such paltry returns.
As you might imagine the problem in M&S’s case has been growth. As I commented in a recent post on Sainsbury’s stagnant profits needn’t be the end of the world for shareholders. The problem with Marks & Spencer though is that profits have actually fallen quite substantially over the past ten years. A decade ago the company were pulling in £8.5 billion in annual revenue and £950 million in pre-tax profit. Last year the firm generated £10.4 billion in revenue but only £483 million in group profit before tax.
The reason behind that drop largely rests on the company’s well publicised difficulties with its fashion arm. The problem with clothing is that it’s subject to the whims of changing consumer tastes in a way that certain other defensive items aren’t, and this seems to be the root cause of the issue at M&S. On the bright side the food segment has been quite successful. The Simply Food brand is popular with customers in the UK, the quality is good and it generates a healthy profit for the group. Gross profit margins may be lower than with clothing, but still it does make Marks & Spencer a fundamentally better proposition than the UK supermarkets.
The only other real bright spot is that the company still manages to generate decent levels of free cash flow. In fact at around the £500 million per year mark it has barely changed at all over the past decade, and will provide the company some much needed breathing space as it attempts to restructure the business by pulling out of several loss making international markets and by concentrating more on selling food.
The big question for prospective investors is whether the company can arrest the decline in profitability. Low, or even zero, growth is something that can be handled provided the price is right but collapsing profits are a different matter entirely. In practice this really means getting the clothing division back on track.
So how is M&S doing on that score? Well, results so far for fiscal year 2016/17 suggest a significant challenge ahead. The half year report back in November showed underlying profit before tax down 18.6% on the comparable figure in 2015/16; primarily a result of falling profits in the troubled Clothing & Home segment as well as rising operating costs in the UK. Underlying earnings per share were down by a similar figure.
On a more positive note things look to have improved slightly judging by the most recent trading update released in January. Clothing & Home sales were up 3.1% over the thirteen weeks to December 31st and 2.3% on a like-for-like basis. Food continues to perform well for the company, with total sales up 5.6% on the back of new Simply Food store openings. Like-for-like sales were up 0.6%. Across the UK as a whole total sales were up 4.5% and 1.3% on a like-for-like basis.
That pretty much brings us up to speed before annual results come out next week. Basically food has been a bright spot for the company, but it’s not enough to offset the issues with clothing. Getting profits back on track will require the company to get to grips with the latter, but faced with an uncertain consumer outlook and the planned restructuring this may take some time to achieve.
4.85% Dividend Yield, Valuation
Given the questions marks over trading conditions and growth outlook getting the price right becomes ever more significant. As it stands analysts’ estimates point to earnings per share of 29 pence for fiscal year 2017, which in turn implies a forward P/E ratio of around 13x earnings based on the current share price. Is that enough to make the stock cheap? Quite possibly, but with a couple of big assumptions.
First up is the 18.7 pence per share annual dividend. If we assume that stays intact, which is a pretty big assumption for any retail stock, it means investors are already locking in 4.85% annual returns. So how safe is that distribution? Well, on the plus side it is still covered quite healthily by free cash flow. As mentioned above M&S has actually done a good job of maintaining free cash flow even as profits have declined. As it stands the dividend is covered twice over on that front, leaving a solid amount of cash left over for other uses. On the downside net debt of £2 billion plus future restructuring costs means any significant dividend growth is likely off the table for a while. Barring a significant drop in both profits and free cash flow the current level is probably fairly safe though. If Marks & Spencer was planning to cut it likely would have already done so.
The second assumption is that the company manages to at least halt the decline in profits. Paying 13x annual earnings and 11x annual free cash flow sounds fine if profits are stable; much less so if they are still falling. As always, growing profits ahead of market expectations is the only sure fire way to make a valuation look cheap. The jury’s still out on that one but we’ll get a fuller picture when the company releases annual results next week.