Marks & Spencer’s comeback rests on more than navigating the challenges raining down on the retail industry. The high street stalwart has been in turnaround mode for more than a decade.
The discount attached to M&S, shares of which trade at only nine times forward earnings, is firmly embedded. Multiple obstacles have been placed in front of the group: stuttering growth in its clothing and home division; weighty lease liabilities; and meaty not-so-exceptional costs that come with reshuffling the store estate. That’s not to mention the absence of a dividend.
Cost inflation and tighter consumer spending, together with the restart in business rates, mean there is no improvement in earnings prospects in sight, at least in the near-term. Analysts expect adjusted pre-tax profits to decline this year, with Shore Capital, the house broker, forecasting £405 million and another fall to £303 million next year, down on £463 million last year.
The chief task facing Stuart Machin, the retailer’s boss, is to arrest the anaemic performance of the clothing and home division. Like-for-like sales were 13.7 per cent higher over the first half of the year and 8.6 per cent up in the third quarter. How should investors view progress by the ex-food business? On one hand, sales volumes for clothing and home were still in positive territory over both periods and were ahead of the broader market, even if price inflation did a chunk of the heavy lifting.
But, as analysts at Numis point out, consensus profit expectations for this year imply an improvement of only £23 million in the second half of the financial year, ex-the Ocado retail joint venture, compared with the first six months, far weaker than the £100 million step-up typically recorded. And that’s despite an implied £200 million rise in revenue over the second half of the year.
The culprit? Poor clothing and home profits, the broker suspects. Specifically, more cash thrown behind cutting prices, clearance activity and a bigger contribution from third-party brands, which carry a lower gross margin. If true, that could slow headway even more.
The retailer is punching for an operating margin of 4 per cent in food, which it hit last year, and more than 10 per cent in clothing and home, which is further out of reach. How does it hope to get there? Partly by cutting back the number of clothing ranges it stocks. Increasing the proportion of online sales, which have risen from 18.5 per cent of the total five years ago to about a third, and partnering with third-party brands could boost the top line more sustainably, too.
M&S is looking to cut back full-line stores by about a quarter to 180 and to increase Simply Food stores by a third or so to 420 over the next five years. Long, unexpired leases have complicated efforts to cut rents. The average lease commitment for Next is about five years, for M&S’s more costly, full-line stores the average unexpired lease stands at about 18 years, if exceptional cases are excluded. Just over 40 per cent of its estate is freehold, which further complicates efforts. But shutting more costly high street shops in favour of more out-of-town locations alone should help to save £300 million in rent costs by 2028, the retailer reckons, out of a bill that stood at £2.3 billion at the end of October.
Reshaping a worn-out store estate is a priority. The retailer is also working to regain its investment grade credit rating. Analysts have forecast a return to dividends when results for the full year are released in May, with a payment of 4.25p a share, less than half the amount paid for the 2020 financial year.
ADVICE Buy
WHY Shares are cheaply valued given the progress made in strengthening the balance sheet
CVS
Private equity firms have offered strong competition to CVS in the race to buy up veterinary practices in Britain and Ireland. Now the animal health treatment specialist, one of the largest groups on Aim, London’s junior market, looks primed to become a takeover candidate itself.
There has been a wave of private capital entering the sector seeking to capitalise on the increasing amounts of cash that people are willing to pay not just for medical care for their pets but also ancillary products, such as insurance and higher-value food.
At 20 times forward earnings, the shares trade a touch below the long-running average, despite margins and organic revenue growth rates being superior. Another tempting factor? The financial burden for any acquirer would be low, with net debt at £57.6 million, or 0.6 times adjusted profits last year, well below a target multiple of one.
That also leaves plenty of room for CVS to pursue its own expansion plans over the next five years, after it extended its debt facility to £350 million. A push into Europe and English-speaking markets such as the United States and Australia also could be on the cards. In November it set out plans to double its underlying profits over the next five years, to increase the margin to 19 per cent to 23 per cent and to lift revenue at an annual rate of between 4 per cent and 8 per cent.
Over the first half of its financial year, organic revenue growth was at the top-end of that range, at 7.5 per cent, while the margin was 19.5 per cent. True, revenue growth has slowed compared with 2021, but that marked a recovery against a slump in trading when the pandemic first hit. Unlike most lockdown fads, the rise in pet ownership should bring more sustainable rewards — puppies and kittens require more medical attention as they get older. The margins generated across its 500 practices range from below 10 per cent to about 40 per cent for souped-up facilities that have been more recently upgraded.
Boosting sales of more profitable laboratory diagnostics and pet crematorium services is another avenue to push margins higher. But scarcity is a significant part of CVS’s value.
ADVICE Buy
WHY The company seems a likely takeover candidate