In recent years, we have become used to a low level of inflation. However, since the EU referendum the economic landscape has changed and a higher level of inflation is likely in future years. In fact, since the referendum, inflation has risen from 0.3% to 1% and the Bank of England now forecasts that it will reach 2.8% by 2018.
In such an environment, M&S (LON:MKS) could endure a challenging period. Disposable incomes may fall in real terms and cause its sales to decline, while its new strategy may not help it to overcome what could become an increasingly competitive retail sector. Therefore, in my view M&S lacks appeal over the medium term, with a mix of external and internal factors being to blame.
The Bank of England’s decision to cut interest rates to 0.25% in the aftermath of the EU referendum has contributed to sterling’s weakness. The pound has depreciated by 17% versus the dollar and 14% against the Euro since 23 June.
This could cause a rise in inflation according to the Bank of England. Its current forecast is for inflation to reach 2.8% by 2018, although other estimates put this figure much higher. For example, The National Institute of Economic and Social Research estimates that inflation will hit 4% next year. Despite this, a rate rise may not be on the cards, since the Bank of England has stated that inflation may prove to be a necessary evil over the medium term.
Clearly, sterling’s weakness is not entirely due to monetary policy action. Confidence regarding the UK’s future economic performance has also fallen since June and this has negatively impacted the pound. As negotiations between the UK and EU begin and the UK leaves the EU in 2019 (or later), confidence in the UK macroeconomic outlook could deteriorate further. This could cause sterling to weaken and inflation to rise significantly.
Impact on retailers
Although inflation of 2.8%-4% is not grossly high by historical standards, it could cause disposable incomes to fall in real terms. Wage growth in the UK is unlikely to be high since the Bank of England forecasts that unemployment will rise over the short to medium term. Higher competition for jobs could mean that even inflation of 2.8% puts disposable incomes under pressure and consumers begin to become increasingly price conscious, as was the case during the credit crunch.
For premium retailers such as M&S, this could cause their customer base to seek out cheaper alternatives for at least part of their shopping basket. For example, they may choose to trade down to no-frills supermarkets such as Aldi and Lidl, or buy clothing from Primark or TK Maxx. This means that M&S may have to either invest in pricing and stomach lower margins, or else maintain its prices and see its sales figures fall even further than they already have.
As well as the potential problems which M&S faces from higher inflation, the retailer has faced a tough 2016. This week’s first-half results saw M&S’s underlying profit before tax fall by 18.6%. In response to its disappointing performance, M&S has announced a new strategy which I believe will fail to provide a boost to its bottom line over the medium term.
M&S plans to pivot towards food and away from clothing and home. It plans to reallocate around 25% of its clothing and home space to food over the next five years in an attempt to boost productivity. This will cost around £50 million per year for the first three years, while the total number of M&S stores will increase.
In my view, this change in strategy is short-sighted. M&S’s food LFL sales growth in the first half of the year was minus 0.9%. Although this is a better performance than the fall in LFL sales for clothing and home of 5.9% during the same period, I believe that M&S is seeking to paper over the cracks when it should be seeking a solution to the longstanding problems it faces when it comes to its clothing department.
For example, 60% of people surveyed recently said they saw M&S’s clothing offer as ‘old and uncompetitive’. While dedicating less space to clothing may help to lessen the impact of M&S’s sales decline in this space, the reality is that M&S will remain a major clothing retailer. Therefore, it will require a new strategy to boost its clothing sales and cannot rely on its food division to pick up the slack – especially when food recorded a fall in LFL sales in the first half of the year.
As a result of M&S’s disappointing recent performance and challenging outlook, its valuation is relatively low. For example, M&S has a forward P/E ratio of 11.2. This makes it a relatively cheap stock, but it lacks obvious catalysts to boost its profitability or to warrant a higher rating.
In fact, it is easier to make a case for further difficulties in M&S’s clothing and food divisions. Inflation is likely to rise due to reduced confidence in the UK economy as well as a dovish Bank of England. This could cause UK consumers to become increasingly price conscious and demand more competitive pricing from M&S. If M&S holds its prices then shoppers may switch to cheaper options, thereby reducing its sales performance.
Further, M&S is struggling even without higher inflation. Its first-half performance was poor and the decision to trade clothing floor space for food space is unlikely to be the answer to its disappointing overall performance. It may make things better in the short run since LFL food sales are falling at a slower pace than clothing LFL sales. However, M&S needs a more radical approach to its clothing division, since it will continue to be a key part of the business even after its strategy change.
Therefore, M&S lacks investment appeal in my view. It faces a mix of internal and external problems which I believe are not yet fully factored into its share price.