Is M&S entering value territory?
Marks & Spencer at 439p (last seen) after Q3 results. Food, glorious food, but inglorious general merchandising. Operationally, an improved performance. My view: watch and wait to buy.
Marks & Spencer (MKS) results, when they come, have the problem of being viewed mainly in relation to one aspect of its business mix – that is to say, its general merchandising return. When results come round, everyone, it appears, wishes to know predominantly if General Merchandising has at last been restored to full commercial, competitive life (generally assuming that the food retail business will always do well) and with a more lowly weighted interest in Marks.com, the online business. That also had a torrid couple of years as the company migrated from selling from a non-proprietary website as online ‘tenants’, to its own proprietary and branded M&S website, Marks.Com.
That order of priority is understandable (particularly in the mergers and acquisition departments of big investment banks) but it is also a blinkered one. It is a bit like waiting for England to win the World Cup.
However, as time goes by, this company should be more reasonably viewed against broader operational yardsticks of progress such as progress in operating margins, cash flow, capital spending, dividends and development of its online offer.
So I shall make some observations on those aspects, after a canter through the results of the third quarter performance to September 28th last. The fourth quarter and annual results for the current year ending March 28th 2016 are time tabled for publication on 7th April this year.
Q3 Results:
As most of us now know, the food retailing side did well and the general merchandising side did poorly.
Food, glorious food:
Food sales were up 3.7% in money terms and up 0.4% in ‘like for like’ terms. The Christmas period saw a spectacular 17% increase in sales. Marks has established itself as the chic supplier of quality, differentiated food and related products largely under its own brand name. The fashion ability that eludes it in general merchandising has been applied with significant effect to its food retail business.
General Merchandise:
The General Merchandise business saw sales drop an awful 5% and ‘like for like’ general merchandise sales by an even more awful 5.8%. The explanation for that is to be found in a number of quarters: first the weather (enough said I think); related and perhaps some unrelated stock control and supply problems in meeting customer demand; and finally, fierce price cutting from ‘Black Friday’ through to Christmas Eve. Like NEXT, Marks & Spencer did not join in price cutting promotions before Christmas, in order to maintain margins.
On line:
The on line ‘Marks.com’ business saw sales jump by almost 21% proving that this was an area in which it is making strides after early start-up problems. It is no doubt partly responsible for the NEXT comment about competitors beginning to catch up with the NEXT Directory online abilities.
The dedicated online distribution centre located at Castle Donington was reported as performing well, with volume dispatches at a record. As an ancillary marketing initiative, the company also launched a membership loyalty club named ‘Sparks’. The company says that it has signed up 3.3 million members, which is a lot. It represents 5% of the entire UK population (the last published number of 64 million) and 8.7% of the UK working population (last calculated as being 38 million).
Overseas:
Finally, the international side of Marks & Spencer had a challenging period but increased sales by 2.9%.
Cash flow:
Looking more closely at the operating numbers, we see that although net income in the third quarter fell year on year by 24% to £171million, operating cash flow actually increased 20% year on year. On the subject of cash flow, the depreciation charge contributed a stabilising 50% of it in the third quarter. Moreover, the reported operating cash flow figure of £546 million was more than three times the reported net profit figure for the quarter. It means that the share price is selling at only 14 times the third quarter operating cash flow alone. Annualising that quarterly amount to a nominal and illustrative amount of £2.2 billion (by multiplying it very crudely by four) indicates that, on such basis, the shares would be selling at only 3.5 times such conjectural annual cash flow. The merit of this bit of illustrative arithmetic is to highlight its progress last quarter in cash generation potential in relation to the share price. Weak cash generation has been a problem for the company over the last four years. It is estimated that the cash flow for last year was some 70p per share, valuing the equity at the current price of 439p at just over six times.
Dividends:
The quarter’s accounts show that the cost of dividends was larger than the net profit in that quarter. However, it was only just over a third of the value of the operating cash flow, which lends encouraging support to expectations of a continuing progressive dividend policy. The growth in dividends resumed only last year.
The share price at 439p (last seen) also had the support of significant balance sheet attributable assets at an estimated per share value of 187p (133p on a tangible net asset basis) implying that the portion of the share price paid for earnings is 252p.
Gearing:
Total debt was down 9% (another encouraging development given that the last annual equity gearing figure is very much on the high side at 68%). However, the management also managed to increase the amount of debt that is long term in character, having clearly taken advantage of low interest rates whilst they are available.
So what should investors expect in terms of future earnings and dividends? On a market consensus basis, earnings per share are expected to increase 8% this year (ending 31st March 2016) to an estimated 31p with a dividend yield of 3.8%. The following year, earnings per share are estimated to increase by 7% to about 33p with a dividend yield of 4.2%. The shares are therefore valued on prospective price to earnings ratios of around 14 times for this year and 13 times the year after. Using the 252p above, the share price ‘ex’ the attributable assets reduces the ‘pure’ price to earnings valuation ratios to 8 times and 7.6 times.
The share price chart seems to be heading downwards into new territory. It is hard to see any conventional good news on the horizon. I guess that the shares may drift for a month or two as the new CEO takes the wheel and we await the full annual accounting for the company next April. The company is clearly making operational and financial progress and may look very cheap in cash flow valuation terms once we see the annual cash flow account. The share is yielding too much to be dear but perhaps not quite enough at the moment to trigger buying now. Moreover, the forward, estimated market price to earnings ratios look a touch high. My instinct is to watch for a better buying opportunity in the coming months in a skittish market. Otherwise, the shares look to be a hold on the basis of asset backing, improving cash flow and a real prospect of actually cracking the General Merchandise problem.
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