2023-12-29 04:53:13 ET
Summary
- Shares of British retailer Marks and Spencer have been on a tear in 2023, recovering previous lost ground amid good momentum in its main clothing and food businesses.
- The company is gaining market share in both lines and targets further gains and margin improvement over the next few years.
- While business is currently going well, the run-up in the share price leaves the stock fully reflecting medium-term financial targets with little margin of safety for investors.
Marks and Spencer (MAKSY)(MAKSF)("M&S") stock has been on a great run in 2023. The iconic British retailer has seen its primary London-listed shares surge just over 120% this year, with the USD-denominated ADSs up a few points more as GBP has gained against the greenback. While a welcome performance for M&S stockholders, a little more context is required here, with the 2023 share price gains only taking the stock back to roughly where it was five years ago before COVID. While the catalyst for positive recent returns has been a welcome improvement in both M&S's main business lines, the current share price now fully reflects management's medium-term sales and margin ambitions, leaving little margin of safety for investors.
M&S operates two main domestic retail lines: Clothing & Home ("C&H") and Food. C&H accounted for around 30% of M&S's sales in its last full fiscal year, but with this being a higher margin business than Food its contribution to adjusted operating profit is higher (~50% in fiscal 2022/23). Food contributes ~60% of sales and ~40% of adjusted operating profit, with M&S also having a modest International business (~13% of adjusted operating profit) as well as a loss making 50:50 JV with Ocado Group (OTCPK: OCDDY )(OTCPK: OCDGF ) called Ocado Retail. This is basically an online grocery service that delivers direct to customers' homes.
As mentioned in the introduction, M&S shares have been on a tear this year but only to the point of recovering previous lost ground. COVID was a significant drag, with the firm also having to suck up large costs to reposition its store estate. That led to a total cut of its dividend back in 2020. Organic growth is naturally anaemic here given M&S's geographic profile and business lines, but on top of that C&H had been struggling with very weak comps. The absence of a payout meant there was little support for the stock following the dividend cut in 2020.
The good news for M&S is that underlying business is definitely improving. One key trend to watch at fashion retailers is the proportion of sales that attract full prices as opposed to discounts. Fashion obviously tends to be quite fickle, so a relatively large share of full-priced sales and a growing top line can be a good sign that a company's products are still in vogue with consumers. C&H reported that its full-price sales mix was 82% in H1 2023/24 (i.e. the six months through September), representing the third straight half-year of 80%-plus mix and 14ppt ahead of 2019 levels (when like-for-like sales were falling as consumers were clearly not impressed with its offering).
It further reported that style perception has been improving in its core product categories. Menswear, womenswear and lingerie are up anywhere between 4-7ppt over the past two years according to third-party consumer surveys, with overall C&H market share up circa 40bps year-on-year to 9.5%. All said, that helped power H1 like-for-like sales growth of 5.5% as per last month's results release . With sales up and some inflationary pain points like transport costs starting to ease, C&H operating margin was up 230bps to 12.1%.
Food is also showing positive trends. M&S's net promotor score widened 3ppt year-over-year in H1, with volumes outpacing a falling market by mid-to-high single-digits in each month of the period. Market share was up 10bps to 3.4%. With average basket size also up, sales growth was solid, increasing by a little under 15% year-on-year in H1. That, in turn, helped power a 210bps expansion in adjusted operating margin, which clocked in at 4.3%.
While M&S continues to post welcome improvements in both its core business lines, my main issue with the stock is that the current share price already reflects management's medium-term operating targets. Those targets include 1ppt market share gains in both C&H and Food by FY 2028, with adjusted operating margins targeted above 10% in the former and above 4% in the latter. While margin targets look modest given H1 figures were already higher in both segments, bear in mind that full-year earnings will be weighted toward the first half of the year as per management:
However, as we enter 2024, we are not relying on the favourable recent market conditions persisting. The outlook remains uncertain with the probable impact on the consumer of the highest interest rates in 20 years, deflation, geopolitical events, and erratic weather. Notwithstanding this backdrop, we will continue to invest in trusted value for our customers and we are increasing our investment in the reshaping of M&S in the second half. Therefore, against more challenging comparatives, we expect profit before tax and adjusting items to be weighted towards the first half, as we remain laser-focused on our long-term ambition to reshape M&S for future growth .
Marks and Spencer, 1H 2023/24 Results Release
Now, these margin goals are not actually my main worry. The reason for that is that part of this includes around £400 million in planned cost reduction. As I mentioned near the beginning, M&S has been repositioning its store estate to better fit its business. This involves closures, moving current stores to more appropriate locations and so on. This has been a drag as M&S has a fairly high share of freehold and long leasehold real estate, but the positive aspect is that rental and occupancy costs should represent quite a lot of low hanging fruit in terms of cost cutting. I would worry more about sustained market share gains given how fiercely competitive the fashion and grocery markets are in the U.K.
Now, C&H holds a current market share of 9.5% as per above. On trailing-twelve-month sales of circa £3.8 billion, that puts the value of the U.K. market at around £40 billion in total. Assuming low single-digit annual growth and a one point gain in share, implied C&H top line would be around £4.5 billion by FY 2028, with adjusted operating profit landing at a minimum of £450 million.
For Food, current share of 4.3% maps to a total domestic market value of £180 billion. Again assuming low single-digit annual market growth, a one point gain in shares gets us to FY 2028 revenue of circa £9.9 billion, with a 4% margin leading to operating profit of ~£400m. Assuming £100 million in annual International adjusted operating profit (was ~£43 million in 1H 2023/24), we get to around £950 million in implied company-wide adjusted operating profit by FY 2028.
Currently, M&S has an enterprise value of circa £8.1 billion, which maps to a multiple of approximately 11x TTM adjusted operating profit. On a flat multiple, implied enterprise value would be circa £10.4 billion by fiscal 2028, which after subtracting net debt (~£2.5 billion) would lead to a share price of around £3.80 ($9.70 per 'MAKSY' ADS at current exchange rates) based on 2.1 billion shares in issue. The current share price is £2.72 (~$6.93 per ADS), implying circa high single-digit annualized share price growth out to FY 2028. M&S is tentatively reestablishing its dividend, having declared a £0.01 per share interim payout alongside H1 results, so I expect that to contribute low single-digits per annum on top of that.
The above would get us to double-digit annualized returns over the next few years - roughly the minimum level that many investors demand from their stock portfolio. With that fully incorporating management's growth targets with little room for error, I don't see the value in M&S shares right now. I would be looking for a 20% discount to build in a suitable margin of safety, corresponding to a current fair value of £2.18 (~$5.55 per 'MAKSY' ADS). Investors can afford to wait for a more attractive entry point here. Hold.
For further details see:
Marks and Spencer: Share Price Recovery Leaves Stock Fully Valued