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:
- 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.
- 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)
- 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.
- 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