Should I buy shares in Marks and Spencer?

Shares in Marks and Spencer jumped almost 7% on Monday after broker Morgan Stanley upgraded the stock to 'overweight' for the first time in more than five years.

The upgrade was attributed to two main reasons: the shares have rarely been cheaper and the retailer's general merchandise division has improved. In fact, much of the group's recent share-price underperformance (the shares have lagged the FTSE 100 (UKX) by 14% in the last three months) related to concerns about its trading in general merchandise.

Attractive valuation

Morgan Stanley analyst Geoff Ruddell noted shares in M&S were trading at 12-year lows relative to the market, excluding a period in 2008 when the entire retail sector, Ruddell reckoned, became "very over-sold".

Ruddell calculated the stock was trading at a price/earnings (P/E) ratio of around 10 times, "well below historical average levels". Over the last 20 years, for example, the average P/E ratio has been c. 15.1 times, while over the last 10 years it has been around 12 times.

He also pointed out the dividend yield was now the most attractive relative to the retailer's peers, as shown in the graph (see right. Click for enlarged version).

General merchandise improvement

M&S's general merchandise division has not reported positive like-for-like sales since the third quarter of the 2010/11 financial year.

"To its credit, the M&S senior management team has not attempted to blame external factors for its underperformance and has acknowledged that the business has made mistakes with regards to both its product selection and its merchandising," Ruddell acknowledged.

Chief executive Marc Bolland has shaken up the division's management team, appointing John Dixon as managing director and Belinda Earl as style director.

Although it is now almost nine months since Dixon and Earl were appointed, the lead times in the M&S clothing business are such that it will not be until the autumn/winter 2013 season (which will begin to go into stores from August) that the new team will be able to have much impact on the business.

"We are optimistic that they, and the senior team that Dixon has assembled, will be able to make a meaningful difference," stressed Ruddell. "Although Dixon does not have a 'product' background, he has been with M&S for 26 years and is a proven operator, having previously led a very effective turnaround of the group's food division.

"In our view, the combination of Dixon and Earl, who has very strong product credentials, having been trading director and ultimately chief executive of Debenhams, has the potential to be a powerful one."

Another advantage of the poor sales performance of the last 18 months means M&S is now facing some very soft comparables. As shown below, the comparable base effectively gets 800 basis points softer from the fourth quarter of the 2012/13 financial year.

A further reason for optimism is that M&S's long-term record in clothing is not nearly as poor as some think. Over the last 10 years, it has actually gained a small amount of market share in value terms and has substantially increased share when measured by volumes.

Finally, many elements of the general merchandise turnaround plan are yet to come to fruition. "When Bolland arrived at M&S, the company's online platform was provided by Amazon, and ending this arrangement required M&S to serve three years' notice to Amazon and to build its own platform from scratch," explained Ruddell. "This new platform, together with a huge new warehouse for fulfilling internet orders, is nearly ready and is on schedule to go live early in 2014."

According to Ruddell, it only required like-for-like sales to improve for investors to regain confidence that the turnaround plan was working.

"If the division starts delivering healthy sales growth, investors would realise that there is nothing inherently wrong with having a focus on older customers (the fastest-growing and yet the least competitive demographic in the UK clothing market)," he said. "We believe investors would begin to see that the internet may represent more of an opportunity than a threat to M&S."

He added: "If the division starts delivering healthy sales growth, investors might be persuaded that it had made sense to refit the stores."

In November 2010, six months after joining M&S, Bolland had announced a significant increase in the group's capital expenditure plans, in order to fund a refreshment of the store estate.

The management has made clear that it expects the 2013/14 financial year to be its last year of elevated capital spending and from 2014/15, capital expenditure should fall back to a more "normal" £600 million per annum. Thus, M&S has the potential to become a very interesting cash-generation story in due course.

"M&S is planning very little UK space growth in the coming years and has made clear that most of its international expansion will come via franchising (which requires no capital)," commented Ruddell. "It will soon have a refreshed store estate, a modern online platform and a new IT and logistics backbone.

"Its capital requirements therefore should be fairly modest, and we would not be surprised to see capital expenditure fall below depreciation in due course."

Ruddell also pointed out that more than half of M&S's sales now came from its food division, which has performed well in recent years. The like-for-like sales have, for example, been above that of Tesco in each of the last 11 quarters.

In summary

"We believe that if the new team in general merchandise is able to resolve the performance issues that have developed over the last 12-18 months, the M&S transformation story can quickly get back on track," Ruddell summarised.

"We think it is perfectly plausible that, 12 months from now, the bulls will be able to argue that M&S is a modernised business with rapidly improving cash flows and returns on capital, a low-risk international growth story and the potential to introduce a multi-year share-buyback programme.

"We would expect the share price to react very well to any such reappraisal of the M&S investment case."

What if the turnaround doesn't happen?

There is a possibility sales in the general merchandise division will not significantly improve. For example, the new management team was only put together over the summer and has yet to put out a collection for which it is responsible, as outlined above.

Secondly, some believe the poor recent performance in M&S's clothing business is due more to structural pressures than poor execution.

"The rise of value operators (such as Primark) at one end of the market and 'mass-premium' operators (such as Zara) at the other has made the 'mid-market' positioning of Marks and Spencer increasingly challenging, and some bears would suggest that there is little that management can do about this," Ruddell explained.

He added: "Although the initial share-price reaction to such developments might well be negative, we believe that many commentators would soon conclude that the transformation plan had not worked and that a change of strategy was likely.

"We are not at all sure how exactly this scenario would play out, but we would expect it to trigger a widespread expectation of M&S turning its focus from growth (which has been the central theme of Bolland's transformation plan) to cost reduction."

Would cost reduction work?

Between 2005 and 2008, Alan Stewart, now M&S's chief financial officer, was chief financial officer (CFO) at stationer WH Smith and one of the original architects of its strategy to drive earnings-per-share growth via cost reduction.

"In the scenario where M&S's current transformation programme was seen to have failed, we believe it would come under pressure to consider a similar approach," voiced Ruddell.

The table below summarises the profit and loss WH Smith's high street division in 2003/04 (the year Kate Swann took over as chief executive and the year before Alan Steward joined as CFO) and its most recent financial year. As can be seen, profitability has more than doubled, despite revenue having fallen by more than 30%.

"Although it is debatable whether WH Smith's cost-cutting strategy is good for the long-term future of the company, there is no question that it has been good for its share price, which has outperformed the sector index by more than 200% since the beginning of 2004," Ruddell said.

"If commentators believed that M&S could be the 'next WH Smith', we believe this would have a positive impact on the share price.

"It is our contention, therefore, that even if general merchandise sales do not improve, there is unlikely to be very much downside to the M&S share price."

Other analyst views

In January, when M&S reported its Christmas trading figures, the stock divided opinions. At the time, Jean Roche, analyst at Panmure Gordon, saw 340p as a buying level for the stock. While he continued to rate the share a 'hold', he thought private equity interest could be piqued again.

However, Investec's Bethany Hocking reiterated her 'sell' recommendation, explaining: "We had been (slightly) warming to the stock, but the statement demonstrates the size of the challenge ahead to stem the declines at M&S. There remains an awful lot to do to stop further profit deterioration."

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.