Stockwatch: Blue-chip turnaround with 6% yield

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Stockwatch: Blue-chip turnaround 6% yield retailer M&S shares capital upside
When does a plus-5% dividend yield raise the odds of capital upside? The market prices a yield tailored to perceived holding risks of a share. If the "reward" side of its profile tilts positively, capital upside is generated as pricing re-adjusts for risk, allowing you to lock in useful income.

The share may also have been sold off after bad news or investor jaundice. Additionally, if short-selling is involved then it only needs a few positions to close after better news to enhance buying.

Such technical market factors marry well with a contrarian theme of "the big unpopular company", first coined in the 1930s by value analysts Graham & Dodd, where big well-established firms with a strong record of cash flows and dividends see their shares languish due to a lack of growth appeal. This is the touchstone of investment value for traditionalists.

Snakes & ladders

Marks & Spencer (MKS) is a current example in the FTSE 100 index (UKX). As a turnaround story it's been around the block a few times, its five-year chart reflecting a volatile surge from about 300p to 600p as hopes prevailed. Then, weakness in the clothing/home products division and a loss-making international side triggered a fall right back.

A new chief executive, Steve Rowe, declared a strategic review to re-invigorate the customer experience, but the de-rating has reflected doubts as to achieving this, especially as online rivals poach sales.

MKS fell from 350p to 315p ahead of recent interims, then rebounded to 335pNote two, "segmental information", in the annual results to 2 April 2016 was hardly dire: gross profit from clothing/home up 3.9% to £2,180.7 million and food up 5.1% to £1,806.2 million. Free cash flow edged up 2.9% to £539.4 million.

But the latest interims show a divergence: gross profit on clothing/home down 5.2% to £1,004.4 million, while food still rose by 4.3% to £871.4 million; and free cash flow fell 32.2% to £173.9 million due to weaker business performance, higher inventories in clothing/home and other outflows.

Yet the shares had effectively priced this in, falling from 350p to 315p ahead of the interim results, since when they have rebounded to 335p.

Target price upgrade

Long-established big companies tend to have layers of fat and overlap somewhere. Analysts at Citigroup have upgraded their rating from 'neutral' to 'buy' along a rationale that, despite higher cash costs, central savings can generate a free cash flow yield of 6.5% in the year to April 2018 and 11% in 2019, enabling a dividend yield of 6%.

That's extrapolating quite some way (what if there's a recession?) but consensus does already anticipate a 6% yield, and Citigroup makes a fair point that delivering a strategic improvement plan will lead to earnings upgrades in the order of 25% over the medium term.

They target 365p as a mid-point between 340p based on current forecasts and 390p - i.e. 18% upside - if cost savings are delivered, based on a price/earnings (PE) multiple in the low teens.

M&S estimates 10% of its customers account for 50% of sales in both food and clothingIt doesn't assume sales taking off, but rather £80 million of additional operating profit from store restructuring, bearing in mind this will take five years and £250 million capital investment.

Management says: "Over the next five years we will transform our UK estate with about 60 fewer clothing and home stores, whilst continuing to increase the number of Simply Food stores.

"We will have more inspiring stores in places customers want to shop, that complement our growing digital offer."

Furthermore, they estimate only 10% of their customers account for 50% of sales in both food and clothing, hence there is scope to cut specific costs without serious revenue loss.

Nearer-term is scope for £60 million of head office savings in context of a £615 million annual cost base, albeit requiring cash costs of about £157 million to achieve - beware exceptional items.

This could involve merging two head offices in Paddington, also the online business into central teams, thereby streamlining marketing and retail occupancy costs.

Parallel with WH Smith turnaround

It's worth a read-across to WH Smith (SMWH) in the Mid-250 index, which has seen fairly static revenues in the last five years, but grown earnings per share (EPS) from a 60p to 90p range, with over 100p projected; benefiting from a rise in the operating margin from 8.5% to 10.7%.

Its stock rose from 470p in 2012 to 1,880p earlier this year, though has eased below 1,500p.

Bear in mind M&S may be a few years behind Smith's curve in terms of a retail turnaroundWhile suggesting a "bottom-up" parallel in cost-cutting at a well-established retailer, I concede a "top-down" similarity in how both stocks rallied strongly from 2012, but have seen declines this year.

It's unclear the extent to which this performance reflects a quantitative easing (QE)-led boost to investor spirits three/four years ago, and a subsequent consumer boom aided by house price rises - both of which are less likely to persist.

Such is the macro context, but bear in mind the micro-economics of how M&S may be a few years behind Smith's curve as regards to implementing a retail turnaround.

Execution, my dear Watson

For now, the interim results show underlying pre-tax profit/earnings down about 18.5% on near-flat revenue, the interim dividend held at 6.8p and covered 1.7 times by earnings. Management speak of "good progress against strategic priorities" with action to start to recover clothing/home revenues, and also grow the food side further.

Much will depend on how the new CEO performs after assuming office last April. To be fair, he is steeped in M&S corporate culture, having worked his way up from a Saturday job aged just 15.

The price recovery to 335p does already show the market attuning to how capable the new boss proves at cost-cutting, which, other things being equal, is able to support upside.

A circa-6% yield could be considered a fair enough return even if the stock remains flat; hence, genuine improvements in the M&S story will drive further upside.

For more information see the website.

Marks & Spencer Group - financial summary Consensus estimates
year ended 2 April 2012 2013 2014 2015 2016 2017 2018
Turnover (£ million) 9,934 10,027 10,310 10,311 10,555    
IFRS3 pre-tax profit (£m) 658 547 590 600 489    
Normalised pre-tax profit (£m) 745 563 594 706 707 610 627
Operating margin (%) 8.8 6.8 6.8 7.8 7.6    
IFRS3 earnings/share (p) 32.2 28.2 32.2 29.5 24.8    
Normalised earnings/share (p) 36.8 28.8 31.7 35.9 37.6 30.3 29.6
Earnings per share growth (%) -3.5 -21.7 9.9 13.4 4.7 -19.5 -2.2
Price/earnings multiple (x)         8.9 11.1 11.3
Annual average historic P/E (x)              
Cash flow/share (p) 68.1 63.2 61.9 71.7 67.6    
Capex/share (p) 45.6 51.9 38.2 40.6 31.8    
Dividends per share (p) 17.0 17.0 17.0 17.2 18.4 21.2 19.3
Yield (%)         5.5 6.3 5.8
Covered by earnings (x) 2.2 1.7 1.9 2.1 2.1 1.4 1.5
Net tangible assets per share (p) 138 114 116 142 163    
Source: Company REFS

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.