MKS: This is not just…

I bought into Marks & Spencer (MKS) earlier this year. There were three key reasons for my investment – technology; an inflection point for the balance sheet; and valuation.

The Strategic Report of the Marks & Spencer 2020 Annual Report opens with: “The aim of our transformation is to restore M&S to sustainable, profitable growth and this has not changed. However, in the new landscape – where the way we work and how customers shop may never be the same again – we are learning from the crisis to ensure that M&S is changed for good“.

COVID-19 will have many enduring effects. One of them is how people engage with retail. The pandemic accelerated the long-term trend towards e-commerce. For a company founded in 1884, MKS seems like an unlikely winner from this trend. However, a number of strategic initiatives give me cause to believe that it will emerge as a winner.

Before we get to that, let us briefly recap on how MKS was positioned going into the pandemic. Its financial year-end is March, so the FY (end-March) 2020 results are helpful in this regard. “Today we operate a family of businesses, selling high-quality, great value own-brand products in the UK and in 62 countries, from 1,519 stores and 44 websites globally“. In FY20 the Group turned over £10bn of revenue, of which £6bn was UK Food; £3bn UK Clothing & Home and £1bn International.

Topline growth had been elusive in recent years, ranging between £10.0bn and £10.7bn in the past 8 years (to FY20). If you discount FY20 due to COVID-19 effects, operating profit had also been static for this period, ranging between £0.7bn and £0.8bn.

Something had to change.

In the H118 results, management unveiled its strategic priorities for the coming years, which were:

• Focus on becoming the UK’s essential Clothing retailer
• Accelerate our UK Clothing & Home space rationalisation plan
• Reposition our Food business including slowing our Simply Food store opening plan
• Work with key franchise partners to build a growing, profitable International business
• Become a digital first organisation, with a third of our Clothing & Home sales online
• Substantially reduce our cost base

A key milestone in MKS’ journey since then was the establishment in February 2019 of a 50-50 JV with Ocado. This deal was transformational for the UK Food business, marrying MKS’ well regarded food proposition with Ocado’s best-in-class technology. The JV commenced business with revenues of £1.5bn and a base of 700k customers. There were clear synergy benefits for M&S on both the revenue (cross-selling) and cost (purchasing power) sides. M&S agreed to pay a total consideration of £750m (of which £187.5m is deferred). MKS financed this deal through a £600m one-for-five rights issue at 185p.

Fast forward to March 2020. Going into a pandemic that has sparked a surge in online grocery sales, the Ocado JV proved its worth. In March, the JV announced that revenue in the 13 weeks to end-February were +40% y/y. Capacity at the JV is planned to grow by 40% in 2021, supporting growth.

The technology advantage of the Ocado tie-up is clear. While the other UK supermarket groups have also reported strong growth in online since the onset of COVID-19, their models are much less efficient (less automation), giving MKS a structural margin advantage.

In April, MKS announced an investment in automated warehouse capacity for its Clothing & Home business, which may do for C&H what Ocado did for Food.

Let us turn to the second part of the investment case, namely the balance sheet. At first blush, the balance sheet looks to be in a woeful condition. Net debt is c.£4bn. The company is junk rated. Looking under the bonnet reveals that the picture is materially better than it first appears.

Net debt was £3.9bn at end-September, but £2.5bn of this is lease liabilities (mainly on stores), leaving £1.4bn of net financial liabilities (within the latter there is £0.3bn of cash, £1.5bn of bonds and £0.2bn of pension liabilities).

I’m unmoved by the lease liabilities. These are on the stores and are simply a cost of doing business for an omni-channel retailer. I’m more focused on the bonds, and these are very interesting where the investment case is concerned.

As of 12 May 2021, MKS’ bonds had a weighted average maturity of 5.6 years and a weighted average coupon of 4.46%. The distribution of this is very nicely set out in a way that the Group can steadily deleverage, transferring value from the debt holders to equity holders.

What do you mean by that? This December a bond (£164m outstanding) with a 6.125% coupon will mature, wiping £10m a year off the annual debt servicing costs.

In 2023 a £300m 3% bond rolls off, saving £9m/year.

In 2025 a £400m 4.75% bond rolls off, saving £19m/year.

In 2026 a £300m 3.75% bond rolls off, saving £11m/year.

Is it too simplistic – naive even? – to think that the Group will steadily tip away at the debt? What about capex? As mentioned, the Group has a cash pile of £0.3bn, enough to cover December’s maturity and half of the 2023 bond. Over the past five years MKS has generated pretty consistent operating cash of £1bn/year, typically invested £500m/year (excluding the Ocado JV) and cash interest paid looks like it’ll be £0.2bn (and falling) from here. That leaves ~£0.3bn a year for debt reduction and dividends. Splitting that 1:1 would cut financial liabilities from £1.4bn to ~£0.5bn by end-2025.

That brings us to the next point. MKS was cut to junk after the onset of the pandemic. This triggered automatic coupon step-ups in some of its bonds, adding to its interest costs. However, those same bonds have coupon step-down features, so if the investment grade rating is restored, MKS’ interest bill will fall. I’ve outlined above how a sharp reduction in financial liabilities is likely.

There’s a third point to consider. MKS took a £157m inventory write-down provision in its FY 2020 results, but reversed £49m of this in the H1 2021 results because “sell through of Clothing & Home stock has been much stronger than anticipated”. The Group also launched 46 new international websites in March, which suggests to me that efforts are intensifying to turn stock into cash.

All of this suggests to me that the balance sheet is: (i) In much healthier condition than first appears; and (ii) financial metrics are about to get noticeably stronger.

Finally, valuation. Today (May 12) MKS closed at £1.526. This is ~0.75x the £2.03 NAV I expect it to report when FY 2021 results are published later this month. I also think the Group will do underlying (pre-exceptional) EPS of 14.2p in FY21, which puts the Group on just over 10x underlying earnings (on the same basis, FY20 underlying earnings were 16.6p (i.e. attributable earnings adding back net exceptionals)).

I think paying just over 10x underlying earnings for a company whose technology proposition gives it a structural advantage over peers; and whose balance sheet is likely misunderstood and is about to get materially stronger, is a bargain. Hence, I’m long.