Tag Archives: Brexit

4 reasons Steve Rowe’s strategy on M&S finally makes real sense

In full disclosure, in my time as an analyst I was never a buyer of M&S shares because amongst others I thought that the clothing business was in structural decline, M&S had an extremely poor track record in generating acceptable returns on incremental capital employed compared to its peers and its top management many times had ambitions beyond the company’s reach. So I have seen two CEOs come and go but never bought their ambitious plans. I must also say out of all the years I was a seller of M&S, I was wrong to be one during the time ex CEO Marc Bolland managed to finally get rid of the middlemen increasing direct sourcing and subsequently the buy in margin at M&S’s clothing business by a whopping 475bps!! That was over an 18 month period, but even then, even if I was wrong for that time I always thought that this mega gross margin increase, which by the way just got M&S closer to the levels of other more efficient businesses, was a one off and did little to address the structural challenges facing M&S. The stock had climbed up to 600p then but here we are again a year and a half later with the shares almost halving again.

With this intro in mind, I can’t believe I say that but now that the dust has settled I must admit I found Mr Steve Rowe’s strategy on M&S very sensible earlier this month. I think Steve Rowe has the most chances of success with his plan out of all the strategies and plans delivered in the past decade for M&S. He fits M&S just fine. He is a British CEO leading a very British brand and although I think he overdid it in his first strategy day last May disappointing investors by talking about Mrs. M&S in such a “wishy washy” way he recovered completely this month talking a lot of sense. Most and foremost he recognized M&S’s mistakes and weaknesses and instead of trying to argue for them he took action to mitigate them. This is noble and…value enhancing. 4 quantifiable (!) reasons I liked his strategy:

  1. He stopped the bleed internationally.

M&S is very British. Embrace it and move on. As an analyst I had done a study in the past showing that out of all of M&S’s ventures internationally in the past 20 years there was not once where M&S didn’t end up losing money. Brooks Brothers’ purchase, King Supermarkets’ purchase, its Canadian operations, its European operations you name it. Finally Steve Rowe is the CEO that closed the materially loss making International business recognizing it will never work and saving the company £45m of annual losses. Of course no CEO wants to say that he has no international aspirations but at least he chose to focus on the less risky franchise business. I personally still think investors should not factor in any major success internationally but shareholders can now safely assume M&S is £45m more profitable going forward.

  1. Delivered a plan to reduce General Merchandise stores

The clothing business is structurally challenged. Instead of arguing against it he recognized the negative base needs to reduce. There are two good things that could potentially happen here. 1. M&S will reduce space by 10% over the next five years. If the sales do transfer online (which is a good possibility) then it means that M&S will manage to save the costs of running that extra 10% space without losing sales. The cost savings could be substantial. M&S spends £823m annually in rent and property related costs so without even calculating any savings for staff expenses the savings could be c£82m p.a. by year 5. 2. If, as management claims, sales mix of Food:GM is 50:50 from 66:33 by year 5 then overall LFLs can also improve. GM LFLs have been negative year in-year out for as long as I can remember with the last two years delivering c-3% LFL p.a. If the negative mix reduces by 17% that means UK LFLs could improve by c50bps for M&S. This translates to c£20m of incremental profitability (£9,470m*41%*0.5%) (UK sales*41% UK gross margin*50bps LFL improvement)

  1. Spending responsibly

I need to give credit to Helen Weir here, CFO, whom I had first met at her capacity as CFO at John Lewis. She is disciplined and sharp. But I must also say that in terms of CFOs the last decade M&S is used to do well. I also liked Alan Stewart’s discipline and the projects he had undertaken had created value. Anyway the £400m of annual capex Helen Weir announced is the lowest in almost a decade while it is the first time I heard M&S really reviewing its approach to Capital Investment targeting shorter leases, evaluating underperforming projects and recognizing past mistakes. Now other than the potential to improve ROI there is another mathematical benefit to profitability from lower capex. This is lower Depreciation & Amortisation. Long term capex was reduced by c£150m which means that eventually D&A will reduce by as much but it will take time as D&A will be still impacted by an earlier spending spree over the last few years. If we assume an average depreciable life of c10y then D&A could be reducing by c£15m a year which means by the time the space will have reduced by 10% (in 5 years) D&A could be lower by c£75m.

  1. Reduced HQ costs

Steve Rowe went as far as to potentially displease some in the Head Office but his cost saving exercise will deliver another £30m a year.

It all adds up to big numbers within management’s control

If we add all of the above up then we are talking about £252m improved profitability by year 5, i.e. end of calendar year 2021. Sell side consensus PBT for March ’17 is £598m and hovers around such levels for 3years! So no growth for 3 whole years and then by March 2022 consensus PBT is looking for c£700m of PBT. According to the analysis above the PBT could be more like £850 in FY22, i.e. 20% higher.

What could screw it up?

What else? Clothing performance. But to erode £150m of incremental profitability (to bring us back to £700m of PBT in FY22) GM sales need to reduce by c7% on a LFL basis in the next 5 years. Now that’s not unheard of but with Mr Row reducing prices by 17% on average in 1700 lines and by reducing the space mix towards Food he has taken two important actions to try and fight negative LFLs.

The near term looks good…

I still abide by my cautious view about UK retailers in a post Brexit era but in other matters the weather is pretty cold and helpful for apparel retailers. Imagine M&S post a positive LFL clothing performance in 3Q in January, the stock will soar because people will start believing more and more into this turnaround plan. Additionally if Mr. Hammond delivers a pro growth budget with fiscal easing and delivers tax and VAT cuts then M&S shares can also benefit.

The risk reward is skewed to the upside for M&S’s shares

I like that Steve Rowe didn’t deliver a strategy assuming clothing sales will improve or that M&S can thrive internationally but instead delivered a strategy where the outcome is big but within his control. The £252m we calculated above is a 40% leeway in March ’17 profitability. At the same time M&S shares trade shy of 12x (and with Brexit I argue that’s as high as any UK general retail stock can go) but with a credible strategy the multiple can expand as people place more faith. This trigger can be 3Q LFLs. We know October was good. We just need a reasonable November and December which we may have as weather helps. Successful or perceived successful turnarounds can attract multiples north of 15x PE. That’s another 25% leeway from where we are today. Add the two together we are talking for more than 60% share price upside maybe and a good part of it within the next one or two years! I don’t even believe I claim that but it is not illogical.

Brexit will be tough but then people will turn to self help stories…I own M&S and I will be reavaluating my position above 400p or if everything suddenly falls to pieces of course. But don’t forget that around these share price levels all these rumors about some Private Equity buying M&S may start kicking back in. It may be farfetched and I certainly don’t really believe it but interest rates are still very low and hence the same logic for the rumors can apply.

Author: Chris Chaviaras

Disclaimer: The author owns shares at M&S

(Bearish) Letter from America

Brexit continues to make the headlines even in the US. Many key US corporations reported earnings yesterday and some, who offer a readacross to UK names, were pretty disappointing. The most important in my view was that of the world’s largest manufacturer of appliances, Whirlpool, who announced a pretty bad quarter and the stock was down 11%. Q3 EPS fell 5% short of analysts’ expectations but more importantly the company provided a pretty cautious outlook. Now why do I bother writing about it? Well it reinforces my view that the UK consumer should brace for some pretty challenging Christmas ahead (see http://hereticinvestor.com/is-christmas-coming-this-year/)

Why do I say so?

Well Whirpool’s management says so. The weakness in Q3 (July-September) was due to “temporary U.S. demand softness as well as Brexit-related currency volatility and demand weakness in the U.K.” Brexit makes the headlines already in the US corporations’ releases with severe effects on share prices. It is important to keep an eye on what the manufacturers say because there is a big readacross for the retailers who sell their stuff. It is the first actual tangible warning about demand the way I see. Whirpool’s sales in Europe, Middle East and Africa were down 13% in Q3 (-6% ex FX) and ongoing profits down 32%! These are some big moves!! EMEA is c25% of Whirpool’s sales. I am not sure how big the UK is for them but the fact that it features as one of the two main reasons, which resulted to the company profit warning, makes it serious.

Implications about the housing market and the wider UK economy

I don’t want to read too much from one company’s results but if demand for appliances is so negative then it means that the housing market is not at its best. If the housing market, a major constituent of the British consumers’ wealth, is getting softer then the implications about the wider consumer demand are pretty grim. I can’t quantify that at the moment but sense check that. Because of Whirlpool’s weakness yesterday (together with Sherwin-Williams, a paint manufacturer, whose shares were also down 11% on the day), Home Depot and Lowes, the two biggest DIY companies in the US were down 3.5%. It will be interesting to see what the two companies actually report on the 15th and 16th of November (Q3). Home Depot is used as a yardstick for investors’ sentiment on Kingfisher here in the UK so weakness there may easily negatively impact Kingfisher here albeit with a lag.

Do Sprint and Apple results matter for Dixons Carphone?

Sprint was another name that reported results yesterday and the stock fell 6%. I believe this is more “travel and arrive” though as the stock is up 80% YTD with Sprint actually raising guidance substantially expecting EBIT of $1.2-1.7bn vs. $1-1.5bn before. Dixons Carphone has a deal with Sprint to operate 500 new Sprint stores, which can actually be very profitable in the next 3 years if indications about Sprint’s profitability continue to be positive. One bad thing though was that Sprint’s net additions of postpaid subscribers were 344k, versus estimates of 403k new customers. Dixons Carphone will need to help Sprint reverse that with their valuable “Know How” (as they did with Best Buy mobile), otherwise profitability may eventually struggle.

The news on Apple are mixed. Apple sold 46.5 million iPhones in the quarter ending September. That’s better than analysts’ expectations for 44.6 million iPhones but still 3% down y/y. iPhone 7 participated only in the last two weeks of the quarter so it is early to assess its success, which is important for Carphone, but nonetheless iPhones do seem to struggle (despite Samsung’s phones exploding…)

Conclusion/My view

As I said in my post about Christmas in the UK I find the upcoming festive season to be challenging from a UK consumer’s demand perspective and I still expect UK retailers’ shares to touch their post Brexit lows. We are not yet at the point of maximum pain. Big tickets will suffer the most. I am very surprised how well Kingfisher’s shares hold up vs. most other UK retailers!

In anticipation of the Chancellor of the Exchequer’s  November budget…

I believe there is no way Mr Hammond will not announce fiscal stimulus although I am not an economist. We can debate what the Budget may look like at a slightly later stage (we still have a month ahead of us) as this can be another catalyst for consumer names but till then the news is not bright…

Author: Chris Chaviaras

Disclaimer: The author doesn’t hold any shares of the aforementioned companies

Is Christmas coming this year?

I remember a phrase a CEO of a well-known British retailer told me a few years ago, ahead of an uncertain Christmas trading period. “It may be late, but it always comes”. Fact. I don’t dispute facts, not for a second. But what kind of Christmas will we be having this year? From a consumer point of view of course… It certainly looks challenging to me. Why do Christmas matter so much? Some retailers make the bulk of their profits that period and for all it is an extremely important trading period that defines momentum into the beginning of the following year.

Uncertainty over Brexit will hit consumer confidence and hence spending

Britain will be invoking Article 50 to exit EU for all we know. Will it be a “soft” exit or a “hard” one? I certainly don’t claim to know more than you do but news headlines are already increasing and they will get fiercer with time. I know for a fact that uncertainty doesn’t help consumers’ psychology and when the mood is not great then spending probably takes a hit. Let’s try to quantify that towards the end of this article.

The sterling weakness will cause price inflation for the consumer and margin erosion for the retailers

The sterling has fallen off a cliff. Now other than boosting my adrenaline to the limits by me spread betting on the “cable” (no I certainly won’t be doing that again), it hasn’t really touched on people’s everyday lives. But it will! An economist would probably say this is a good thing for the economy (nominal growth!). Well I am an equities guy I don’t see it that way. Inflation will put strain in people’s purchasing power. I bet the retailers will seek to pass on some of the cost pressure they feel from the strengthening USD to the consumers otherwise margins will also fall off a cliff. In 2011 (when cotton prices skyrocketed and many apparel retailers raised prices by 5-10% to offset the cost) the price elasticity of demand worked in their favor. But in 2011 things were improving and the savings ratio was more than double what it is today (see later on in this post). Now things are uncertain at best. Uncertainty and higher retail prices. Not a great combination!

So what will retailers need to do? The £/$ is down c20% post Brexit and most apparel retailers source 2/3 of their product from the Far East paying in US$. If they keep their prices stable then they can suffer up to a 500bps margin erosion. Alternatively they can raise prices by 5% and maintain their level of absolute profitability (assuming that consumers don’t buy less product after the price increases which is very unlikely) or they need to raise prices by 13% to maintain the level of gross margin they had (check the example’s table below). Now of course we need to take into account negotiations with suppliers who could be supportive and get some of the hit but the point doesn’t change. The movements are very big and the retailers will need to mitigate the damage through both suppliers and consumers. Otherwise here is an exercise for you. Go put a reduction of 500bps of margin (or even half that) to any retailer’s revenue that you can find in their annual report and see what happens to profitability. It can be an Armageddon!

In the example I am using a potential retailer who makes a 60% gross margin (usually apparel retailers have a bought in margin as high), with 66% of their Cost of Goods Sold (COGS) sourced in USD assuming that sales grow only by the amount of price inflation with volume growth being zero (economic theory will tell you that rising prices will cause volume declines).


Consumers are not even aware (well most of them I reckon)

The other very important thing is that a really challenging Christmas period is kind of not widely expected, either by the retailers or the consumers. The UK is a nation of spenders, granted that, and “Brexit” has been voted by the majority of the British people so in the view of most consumers Brexit is not a disaster, hence the mood has not yet worsened. Also unemployment at 4.9% is close to historical lows. Consumer confidence is actually close to all-time highs. Only 19% of the Brits expect the situation to get a lot worse in the next 12 months (see http://www.gfk.com/en-gb/insights/infographic/uk-august-2016-consumer-confidence-landscape ). If I am right this is very likely about to change. I don’t want to sound too gloomy but emotions will gradually give the baton to the reality of price inflation and uncertainty. Take a look at the consumer confidence chart in this link (hit http://www.tradingeconomics.com/united-kingdom/consumer-confidence and click Max in the graph). From July’s blues post Brexit to September’s “it is all fine” it is too much emotion too soon. Even if the mood settles somewhere in the middle it is not great news.

What is very alarming is the close to historically low savings ratio (% of net disposable income the UK households save at a certain time). What does it mean? Consumers have very little leeway in retaining their spending level if their income gets squeezed. This could warrant abrupt behaviour on their spending patterns. Put simply, the consumer has not saved much for a rainy day. I don’t want to be too cliché but last time the savings ratio was so low was just before Lehman’s bankruptcy. Well sure but now we are not faced with such a radically negative event like a big investment bank’s collapse (dejavu?), are we? Anyhow I really can’t see where the positive news are coming from for the consumer. And before I get accused of thinking that 52% of the UK population made the wrong decision, I don’t claim that. I don’t know that. But I am certain we won’t find out whether Brexit was a good or a bad choice this Christmas or maybe even next Christmas.


Many UK consumer discretionary share prices can hit or cross their post Brexit lows

So what kind of sales declines should we expect to see? Well go back to a time when consumer confidence was falling rapidly with a combination of a savings ratio as low as it is today. You have to look at the 2008 era (I know Lehman’s collapse time. Darn so much coincidence making me so cliché). Back then, for a period of 5-6 quarters non Food LFLs (Like for Likes is a measure looking at sales coming from existing stores) were down 4%. DIYers like Homebase and B&Q were recording LFLs of down up to 10%. Well from experience I can say that every percent of sales decline can cause on average a negative swing of c3-4% on earnings all else equal. So we may be looking for earnings declines of more than 10% and for some retailers a lot more than that. Let’s look at the valuation.

The share prices of many UK consumer discretionary companies like Next, M&S, Kingfisher, Dixons Carphone, Sports Direct etc. have actually been weak for the last couple of weeks, if you check their price charts, and their forward Price/Earnings ratios hover around 11x, which many may see inexpensive. But before someone calls the UK retail space cheap and a “buying opportunity” we need to define where earnings estimates are heading. There is a high risk that earnings are heading south in a potentially big way as we established above (sure there will be particular names  which could actually differ). The market is usually early to spot uncertain times, hence the 11x PE from c15x a year or so ago but there is still room for downside to the P/E levels if investors start factoring in a deteriorating consumers environment. There can be a multiple contraction of 1x, which can translate to another c10% downside to share prices.

If we add both together then for some retailers we can see share price declines of 20% or so. It has started already, as many companies have already lost 5-10% of their local highs. Whether there is some sort of recovery in the next few days, time will show, but my verdict is that shares of many UK retailers can touch their post Brexit lows before we start fishing for buying opportunities!

Conclusion: I would exert extreme caution with UK consumer stocks right now and for the next few quarters.

Let’s leave it there for the time being, this post is a lot bigger than I wanted it to be initially. The fun part about UK consumer discretionary stocks is that they are almost all unique cases. Self-help stories, restructuring cases, distressed plays or growth names. Every one of them is treated differently by investors who have diverging expectations. I will be touching on specific names at later posts. The overwhelming theme though is that sales declines, maybe major ones, will be very difficult to avoid and reliance on cost cutting will intensify. UK consumer names who are exporters, like ASOS and Boohoo, who benefit enormously from a weak sterling, will fare a lot better. They don’t come cheap (how expensive is expensive? Is a whole new topic) but they are severely less impacted by the UK consumer’s upcoming troubles. But I have told you that a lot later than you would have liked to if you look at their share price charts.

Of course there are names worth owning in the midterm because they can react to a potentially tough environment or they have a particular good story behind them. Also worth remembering that a good company does not necessarily make a good investment and a bad company does not necessarily make a bad investment.

But many retailers will find that they need to keep pedalling hard just to stay still.

One caveat…

It’s getting cold out there so some may want to play the short term benefit UK apparel names may experience. Don’t fall into that trap!

Author: Chris Chaviaras

Disclaimer: The author has no open positions on any UK consumer shares at the moment.