City view: How high can M&S shares go?

Marks & Spencer blew the market away yesterday with reasonable half-year numbers and improvements at the womenswear division. It shares have now rocketed 24% in just three weeks and currently sit at their highest level since April. But UBS has just upgraded its recommendation to buy and reckons there could be much more to come.

Revenue rose 1% to £4.9 billion in the six months to 27 September, and underlying pre-tax profit grew by 2.3% to £268 million beating consensus estimates for £252 million. Margin improvement helped, as did strong demand for its upmarket food where sales were up by 3.6% and 1% on a like-for-like basis. Said UBS:

The H1 PBT beat of 6% reflected the better gross margin in apparel (+150 basis points (bp) vs +100bp expected) and lower operating expenditure (+2.7% vs FY guidance of +4%). Despite lower Q2 non-food LFL, UK EBIT was also 6% higher than expected, with a partial offset from flat International profits. Food LFL was excellent at +1%, with gross margin up 25bp. The dividend was also up for the first time in four years.

FY15 PBT remains at £645 million, but is a better quality base given higher full-price sales, incorporation of the weather impact, and higher UK within the mix.

The key to the investment case is, however, the upside potential from general merchandise. Sales there fell by 2.3%, or 2.9% on a like-for-like basis, and clothing sales fell by 1.6% and 2.2% respectively. Marks admitted that "unseasonal conditions" in September hit sales by 2.5%.

Womenswear was up by over 1%, but online sales fell by 6%.

If the management team can improve the womenswear offer, there is scope for significant upside to UK profitability from higher non-food LFL and lower markdowns. Against this, there is structural pressure from demographics, industry capacity and the value retailers.

But with the rally over the past few days now 16%, M&S shares are clearly more expensive. Using UBS forecasts, they now trade on 14.6 times earnings forecasts for the 12 months to March 2015, dropping to 13.4 a year later. But UBS reckons M&S does not deserve to be trading at a discount to peers.

MKS trades on under 13x calendar 2014 PE, a small discount to peers reflecting its track record. This could now be set to change. Our price target is based on discounted cash flow (DCF), which takes explicit five-year estimates, long term sales growth of c2.5% pa, terminal EBIT margin of 7.5%, and 8.6% weighted average cost of capital (WACC). The FY16 free cash flow (FCF) yield is 8%.

UBS has set a price target of 500p on Marks, up from 465p. And the shares have smashed through the 200-day moving average and two significant technical resistance levels. Next stop is resistance at 481p, although the shares are beginning to look overbought, at least short-term, according to the relative strength index (RSI). But looking further ahead, UBS is bullish:

The upside scenario would be based on a stronger-than-expected recovery in UK macro, combined with a strong reception to new apparel ranges over the next few seasons. Using our March 2017E EPS base of 39.4p, and moving from 2% to 4% LFL for 2015-16E and 2016-17E, with minimal attached costs, would give 45p. Taking non-food gross margin to 55% by March 2017E, from 54% currently, would give 48p. Assuming the multiple could hold close to the long-term sector average (possible, given there could be further gross margin upside) and we could see a potential stock price of 575p.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.