As I screen markets for opportunities, I find that much of the value on offer is clustered in Banks, Insurance, construction and Retail. A lot of the retail stocks in particular suffering from a combination of a cyclical downturn and a secular shift toward internet retailing. Many have gearing levels that threaten future viability.
Marks & Spencer looks and feels different. Returns by most metrics are reasonably high, cashflow has been strong and the dividend seems to be very well covered by both cashflow and earnings.
Fundamentals
The fundamentals of almost any business can be analyses by looking at sales, margins and returns.
Sales:
Revenue has grown at an average of 4% in the past five years, while operating margins have declined from 12.2% to 8.6% during the same time period (2007-2011).
| M&S plc | 2007 | 2008 | 2009 | 2010 | 2011 |
| Gross Margin | 38.9% | 38.6% | 37.2% | 37.9% | 38.2% |
| Operating Margin | 12.2% | 13.4% | 9.6% | 8.9% | 8.6% |
| UK Margin | 12.0% | 11.7% | 8.0% | 8.2% | 7.8% |
| Intl Margin | 14.3% | 16.3% | 12.9% | 14.7% | 14.6% |
The mix effect between revenue growth and margins has meant that Operating Profit of £1304m at the end of the last fiscal year (FY11) is broadly similar to the figure in 2007 (£1328m). During this time period, the capitalised value of operating leases has increased from £2983m to £4682m*.
* I arrive at this conclusion by noting that the annual lease rent bill has increased from £373m to £585m between 2007 and 2011. I capitalise this using a multiple of eight times, in order to arrive at a capitalised value for operating leases.
I am not overly worried by the M&S plc balance sheet, it is in reasonable condition. I am more perturbed by the fact that a 56% increase in the cost of property produced almost no increase in profitability. This is not what I had hoped to see at M&S.
I am not suggesting that this has all been rent inflation or floor space expansion – the reality is that it has been a bit of both. The point that I am getting at, is that this is a legitimate business cost (an investment so to speak). However, it has produced a pretty poor return. Given the decline in UK margins, I am going to presume that this is mainly a UK issue. Like many retailers with significant UK exposure, profitability has been pressurized.
In five years UK Operating Profit has fallen by 29%
Over the same time period, International profits have grown by 68%.
Net profit is unchanged in almost a decade, so while I am not saying that M&S will never grow again, it is best not to build in the expectation of growth.
Balance Sheet Metrics
Piotroski F Score = 6
| M&S plc | 2007 | 2008 | 2009 | 2010 | 2011 |
| Gearing | 1.18 | 1.47 | 1.16 | 0.95 | 0.71 |
| EBITDA/Interest Cover | 12.2 | 18.6 | 7.8 | 8.6 | 23.2 |
| Net Debt/EBITDA | 1.5 | 1.9 | 1.9 | 1.6 | 1.5 |
| Net Debt(incl Leases)/EBITDAR | 3.7 | 4.2 | 5.1 | 5.0 | 5.0 |
| Fixed Charge Cover | 3.5 | 3.8 | 2.6 | 2.6 | 3.0 |
When I look at the direction that the on and off balance sheet liability profile has taken in the past five years, I am left wondering if M&S is making the same mistakes in terms of floor space expansion that the likes of Home Retail Group have made?
Cashflow
| Cashflow as % of Sales | 2007 | 2008 | 2009 | 2010 | 2011 |
| Operating Profit | 12.2% | 13.4% | 9.6% | 8.9% | 8.6% |
| Depr & Amort | 3.3% | 3.5% | 4.5% | 4.5% | 4.8% |
| Share Based Exp | 0.3% | 0.3% | 0.2% | 0.3% | 0.3% |
| Other Cashflow | -0.1% | -1.4% | -1.4% | 0.6% | -0.6% |
| Net WC | 1.1% | -2.2% | 2.3% | 0.5% | 1.1% |
| Operating Cashflow | 16.8% | 13.7% | 15.1% | 14.8% | 14.2% |
| Interest Paid | -1.4% | -1.0% | -2.2% | -1.7% | -1.5% |
| Taxation | -1.8% | -1.8% | -0.9% | -1.3% | -1.9% |
| Net Operating Cashflow | 13.6% | 10.9% | 12.1% | 11.9% | 10.9% |
| Capex | -8.1% | -10.3% | -6.7% | -4.3% | -4.6% |
| Free Cashflow | 5.5% | 0.6% | 5.4% | 7.6% | 6.2% |
In the past five years, M&S plc has delivered median cashflow of £490m per annum. Looking at the cashflow as a % of sales reveals that cashflow stability has been driven by declining capital expenditure as opposed to stability of profitability.
If I value the company using my traditional no-growth dcf, then the present market capitalisation implies an 8.7% discount rate. This is hardly the level of deep valuation discount that I usually seek. In fact, this is where I think the average company should trade.
Technical Analysis
A few observations:
- MACD (Weekly) is improving.
- Stock is trading above short and intermediate moving averages for first time in 9 months, plus there is an MA bullish crossover.
- The lows in early September 2011, were not breached in the pre-xmas lows.
- So all in all, momentum is improving.
Valuation
| Share Price | 320p |
| G&D PE | 9.0 |
| PE | 8.5 |
| P/S | 52.3% |
| RoCE | 12.8% |
| RoE | 22.4% |
| FCF Yield | 11.9% |
| Div Yield | 4.9% |
(These are all trailing figures.)
I think that M&S is fairly priced at present. There are attractions, namely that returns are robust (but deteriorating) and cashflow has been stable. I am not sure that these are sufficient given the risks to the UK business in particular.
For the present, it is a watchlist stock.
Conclusion
There is not enough here for me to get my teeth into. It is a steady stock, where cashflow improvements have been garnered from declining capex. The balance sheet is far stronger than very many European listed retailers, however the balance sheet was much stronger a few years back.
The dividend is well covered by cashflow, so maybe that could be interesting.
I am not so sure that (i) growth will resume in next few years and that (ii) margins will improve.
Not one for my book.
valuestockinquisition 
Good article, John. I’ve never drilled down that deep into M&S – I like the stores, but always felt they were running to stand still against their competitors… You know, I believe most listed retailers in the UK, by definition, probably have a pretty good, and/or hard to grow, share of the UK market already – so I really think the thing to do is identify who can best leverage/defend their UK position to fund/drive international growth.
So your focus on Intl vs. UK segments is key and makes a lot of sense to me, and I know you’ve approached Mothercare, among others, the same way.
I still think Tesco is one of the best ways to exploit this particular investment theme. I just don’t think I have to rush into it. I last sold out of Tesco above 400p last year at a reasonable profit – for this particular reason…not because I saw what was coming this month! After all, it takes time for a new CEO to kick-start a possible step change in growth/returns for a business (and of course to address any underlying, possibly hidden, prior problems).
Hi John, thanks for doing this write-up. I think you know I’m quite keen on M&S so it’s nice to see a different perspective. I agree they’re likely to be zero (real) growth in the UK; they’re about as mature as mature can be.
I don’t own them yet but depending on various things I expect to buy in at some point if prices stay where they are. Let’s see what the next few years brings eh?