Cube Midcap Report (6 Nov 2019) – Pedal to the metal at M&S #MKS #INTU #RDW #MGNS

Cube Midcap Report (6 Nov 2019) – Pedal to the metal at M&S #MKS #INTU #RDW #MGNS

Good morning, it’s Roland here with today’s Midcap Report.

On my list for today are updates from:

I aim to complete this report by noon 1pm.

Marks and Spencer Group (MKS)

  • Share price: 193p (+6%)
  • Market cap: £3.8bn

Half-year results

Today’s half-year report from Marks & Spencer starts with a report of “far reaching change – delivered at pace”.

CEO Steve Rowe has made much of the scale and pace of change of the turnaround plan he’s devised with chairman Sir Archie Norman. Change is certainly needed. The share price has been in continuous decline for the last 4.5 years, as indeed have the firm’s profits, which have fallen from £506m in 2014 to just £29m last year:

MKS 5yr chart (06/11/19)

Source: Google Finance

However, the shares were up by about 6% in early trade today, following the publication of the group’s half-year results. And I have to confess that for some time I’ve been wondering whether there’s value on offer for investors in this retail stalwart. Let’s take a look at today’s half-year results to find out more.

Results highlights

The results highlights show a fairly mixed picture. Underlying performance is down, but a reduction in restructuring costs and other adjusting items means that statutory profits are up:

MKS H1 20 results summary

I’ll circle back to the group’s financials in a moment, but first I think it’s worth taking a look at the bigger picture.

Drilling down into the segment information, we see a familiar story — Food sales and profits are up, while Clothing & Home is down.


  • In Q2, “volumes grew by 3.3% and were ahead of the market”
  • H1 Revenue +1.2% to £2,845.8m
  • H1 LFL sales +0.9%
  • H1 Gross profit +4.8% to £881.3m

Food now provides almost half the group’s gross profit. Although gross margins are lower than for Clothing & Home, both margins and profits are moving in the right direction despite price cuts on more than 400 high volume lines.

The company’s claim that the Food turnaround is on track and starting to deliver results seems fair to me, based on today’s figures.

There’s still a lot to prove, however. The company is trying to recapture the reputation for innovation and quality on which M&S Food was built. It’s hoping to become a mid-upper range grocery retailer with a strong online presence, through its acquisition of a 50% stake in Ocado Retail.

The Ocado deal required a £580m rights issue and will cost up to £750m. It’s a bold step and isn’t guaranteed to succeed, but I’m inclined to think that it’s the right decision. M&S Food has considerable brand equity and I see this as a viable business. To me, it makes sense to try and leverage this online and shoot for big growth.

Clothing & Home:

  • “In a declining market, the business underperformed”
  • H1 Revenue -7.8% to £1,569.5m
  • H1 LFL sales -5.5%
  • H1 Gross profit -9.4% to £895.6m

These are not figures to celebrate, but at least we’re seeing some honesty from top management. Mr Rowe says that “the Clothing & Home business has historically been too slow to market”. There have been “too many slow-moving lines”“misaligned with a family customer profile”“poor availability on the most popular sizes”.

H1 was pretty dire. CEO Mr Rowe admits that the Clothing & Home turnaround is behind schedule but insists that recent actions and product improvements are starting to hint at “the scope and potential for recovery in the business”.

Recent actions include “improved availability” and a double-digit reduction in options, with improved stocking levels for the 100 most popular lines.

The group’s mix of own brands has also been simplified and freshened up. The flagship Per Una range has been relaunched — the company says this has “significantly declined since its peak”.

Pricing and availability have both been improved. The company says that in October (the first month of H2) full price and planned promotional sales rose by 2.7%.

I’m still struggling to understand whether the M&S clothing brand can be rejuvenated.


M&S hopes to become a “digital first” retailer and is targeting one-third of UK sales online.

Progress was very poor during the first half of the year, though. Online revenue only rose by 0.2%, below expectations. The company says this was due to “issues with availability and product mix in a slower online market”.

Depressingly, the firm says that website traffic was up by 8% but conversion (i.e. the percentage of visitors who make a purchase) was lower. At least some of this extra traffic came from paid search (e.g. Google Ads). This means M&S was spending money to attract new visitors, who then couldn’t find anything they wanted to buy. Not a great look.

As with the in-store clothing business, I think that M&S still has a lot to prove as an online fashion retailer.

Restructuring progress

Mr Rowe and Sir Archie Norman are attempting to deliver sweeping change in all areas of the business, simultaneously. The group’s underlying infrastructure also needs comprehensive modernisation. It’s not an easy challenge.

Supply chain: Like its store network, M&S’s supply chain appears to be antiquated, inflexible and inefficient. The company says that in Food, “we still trade with high levels of waste and low levels of availability”. It’s trialling a new operating model for Food which aims to improve availability and cut waste. Initial results are said to be good.

The Clothing business faces similar challenges. Management say that “a fundamental rethink of the planning, flow, visibility and complexity of deliveries is required.

Store closures: Last year, the firm said that one-third of its full-line stores were opened before WWII and three quarters were more than 25 years old. Big changes to the store portfolio are required. The closed 35 full-line stores last year and a further 17 during H1. About 120 full-line store closures are planned in total.

Financial performance

Profit: Today’s figures show an underlying operating profit margin of 5.6%, versus 6.5% for the same period last year.

This fall in margins comes despite a 3.3% reduction in operating costs. I suspect the main culprit is the Clothing & Home division, where sales fell by 7.8% and gross margin fell by 1.1% to 57% during H1 (vs H1 2018/19).

There was a big reduction in adjusting items during the half year, which fell from £111.7m to £23m. Most of these costs relate to the group’s wide-ranging restructuring programme. As a result, statutory pre-tax profit for the half year rose from £101.3m to £153.5m.

However, I think this is one of these rare cases where the adjusted pre-tax profit tells a more important story — excluding adjustments, profit before tax fell by 17% to £176.5m. In my opinion, this is a more accurate reflection of the group’s trading performance. Not great.

Free cash flow: It’s worth remembering that when adjustments are booked to profits, some are non-cash and some reflect expected future cash outflows. For example, the net cash outflow from adjusting items was £57.9m during H1, more than double the accounting charge of £23m.

Until now, one of the enduring attractions of M&S from a value investing perspective has been the group’s strong free cash flow. However, today’s figures show a marked worsening of cash generation. Using the group’s own metrics, underlying free cash flow fell by 69% during H1, from £295m to just £92m.

This excludes adjusting items — when these are included, my sums suggest that pre-dividend free cash flow fell from £249m to just £23m.

Why has free cash flow crashed? Assessing this on a six-month basis rather than over a full year is probably a little unfair. But for a large, established business, I think there’s still some value in comparing two six-month periods.

In this case, we see that cash generated from operations fell by 30% to £423.6m. The company says this is due to a lower operating margins, lower depreciation, stock builds and higher tax payments. Some of these factors are expected to reverse in H2. Here’s a breakdown of the numbers involved:

MKS 1H20 cash flow analysis

I’m concerned by this. I’m willing to give M&S the benefit of the doubt for now, but I’d want to see evidence of a much stronger H2 performance in the year-end figures.

Debt: Net debt excluding IFRS 16 lease liabilities fell by 8% to £1.6bn during the period. Including lease liabilities (which I think is reasonable), net debt fell by 3.7% to £4.1bn.

However you look at it, Marks and Spencer now carries substantial gearing relative to broker forecasts for a full-year net profit of £360m.

My verdict

This section looking at M&S has turned out to be rather longer than I expected. To wrap up, my view is that the group’s Food business is viable and has potential.

However, I’m not yet convinced that the same is true for the group’s Clothing & Home business. H1 performance was pretty bad and this has had a serious impact on cash generation. I think it’s worth taking a look at the broader picture – M&S clothes now face a whole host of competition that never used to exist. It’s an ageing brand with diminishing appeal, huge lease liabilities and large shops that need modernisation.

Reversing this decline promises to be be difficult and expensive. In the meantime the Clothing & Home division appears to be dragging on the performance of the whole group.

I think the jury is still out on M&S in its current form. Having looked at today’s results, I’ll be staying on the sidelines until the full-year results are published.

I’m nearly out of time now, so just a few quick comments on today’s other midcap stories.

Intu Properties (INTU)

  • Share price: 33p (-17%)
  • Market cap: £453m

Trading update

Amazingly, the market cap of this property group has now fallen below the £500m cut-off I use for these midcap reports. So future coverage may be limited.

However, I’d like to take a look at the latest figures from this troubled and heavily-indebted retail property REIT.

Intu’s new chief executive Matthew Roberts strikes a bullish note, as you’d expect. He talks up the quality of the group’s centres and says that “the feeling on the ground” is more positive than investors might perceive.

However, footfall and occupancy is only part of Intu’s problem. The real, pressing issue is the group’s balance sheet. The next major debt maturity is due in early 2021. Mr Roberts admits that his focus is on creating liquidity and says that raising equity “is also likely to form part of the solution”.

Balance sheet: Intu’s last set of accounts show net debt of £4.7bn held against assets valued at £8.4bn. This gives a loan-to-value (LTV) ratio of 57%, which is more than double that of operators such as Landsec and British Land (disclosure: I hold BLND).

Rental income is expected to fall by 9% this year and to continue falling, at a slower rate, next year. Given this, I don’t expect that lenders will be keen to offer more debt. This means that Intu will have little choice but to sell assets or raise fresh equity.

Both options look difficult to me. In addition, there’s some risk Intu could breach its debt covenants. In June, the firm said that a further 15% fall in capital values would result in “a covenant shortfall of £83m”.

Alternatively, a 10% fall in income would create a £26m shortfall on the group’s interest cover covenants.

There’s a lot of risk here. This is why the stock now trades at an 84% discount to its EPRA NAV of 210p per share.

Operating metrics: Mr Robert’s upbeat tone is not matched by the group’s operating performance, in my view.

The number of new leases signed so far this year is 25% lower than last year. And the value of these leases is 40% lower than during the first nine months of last year.

The figures for the last three months suggest this trend is continuing, with new rent of just £5m and rent levels 3% lower than that paid by the previous occupiers.

In addition, occupancy is continuing to fall and the average unexpired lease term is reducing. This means that earnings visibility is deteriorating — it could make it harder for Intu to secure refinancing.

Even the one apparent bright spot — the increase in footfall — may not be as impressive as it seems. Intu says that UK footfall only rose because of the opening of extensions at intu Lakeside and intu Watford. Excluding these gains, UK footfall has been flat.

My verdict

Intu may offer value on a sum-of-the-parts basis. But I think the equity is worth very little and may end up being wiped out altogether.

The group’s need for cash means that it could become a distressed seller. Covenant breaches could result in a debt-for-equity swap or a take-private deal, perhaps led by 27% shareholder John Whittaker (Peel Group).

I don’t know what will happen, but I think this is a good time to remember that equity holders always end up footing the bill in distressed debt situations. I can’t see any reason to buy the shares at the moment.

Redrow (RDW)

  • Share price: 606p (-0.8%)
  • Market cap: £2.1bn

AGM statement

Today’s AGM statement from FTSE 250 housebuilder Redrow provides yet more evidence that the new housing market still seems to be performing well.

Redrow says that trading has been resilient so far this year despite Brexit uncertainty. The firm reports an average private selling price of £389k (2019: £388k) and says that sales rates are up slightly on a like-for-like basis.

In addition to private sales, Redrow has also completed a £119.5m sale to a large rental landlord.

The order book is up by 8% to £1.3bn, although this is partly due to delays relating to London property that have are expected to result in a second-half weighting to completions.

I rate Redrow as one of the more attractive housebuilders, but I don’t see much reason to buy at the moment, given the potential economic and political headwinds on the horizon.

Morgan Sindall (MGNS)

  • Share price: 1,340p (+3%)
  • Market cap: £609m

Trading update

I rate construction and infrastructure group Morgan Sindall as probably the most attractive UK listed firm in this sector.

It’s profitable, has a strong balance sheet and generates attractive returns on capital employed. Unlike some rivals, it’s avoided the pitfalls of dodgy acquisitions, unprofitable contracts and leverage.

One reason for this may be that founder and chief executive John Morgan retains a 10% shareholding in the group. So his interests are well-aligned with those of his shareholders.

Q3 trading/FY outlook: Third-quarter trading was strong and the group now expects to deliver a performance slightly above previous expectations.

The daily average net cash balance for the full year is expected to be in excess of £100m. If only rival firms would display this kind of financial discipline and transparency.

The secured workload for the group was £7.3bn at the end of September. This was 10% higher than at the end of 2018, but 2% below the level seen at the end of June.

My verdict

I continue to rate Morgan Sindall as an excellent and well-run business. Is this the right time to buy? Cyclical risks would suggest to me that now probably isn’t the best time to buy. But I could be wrong.

I’ve no plans to buy shares in Morgan Sindall. But I’d certainly rather own MGNS than INTU, MKS or even RDW!

That’s all I’ve got time for today. Thanks for your company.

I’ll be back tomorrow with another Midcap Report.



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