Valuhunteruk

After holding some retail stocks, with fairly limited success, for most of the previous year I decided to close out the position and see how I felt about it a bit later. Later is now and so I am going to take another look. There have been quite a few interesting situations coming up but I am going to start with ones that I held for most of last year: Marks and Spencers (LON:MKS) and Debenhams (LON:DEB). I am going to go about the research much the same way as before, although somewhat abbreviated, and try to reach some conclusions about whether these companies are selling for value.

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Summary

• At the current prices for DEB and MKS there is no significant protection from a downturn in retail. The forecast for both retailers is for recovery, or at least for the outlook to stop getting worse, soon although for DEB this will still not come until after the current fiscal year. For investors this means that buying these stocks is still, ultimately, a bet on recovery in retail.
• However, if we are to compare the two then the potential for DEB is better. The projections for the current year are still quite bearish giving the company room against any worsening of the outlook whilst DEB’s financial condition is improving. If we were of the opinion that retail would recover then it would make more sense to buy a company like DEB.
• What is more, DEB has some significant opportunities to improve margins as well as having some plan, which it is trying to implement, about how these will be achieved. My interpretation of the current price and forecasts is that none of these possible improvements are priced in. Whilst these improvements may not happen we should recognize that these possibilities exist. MKS, for example, appears to have very little opportunity for improvement which limits the upside to an unexpected improvement in retail spending.

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The first thing to highlight is that MKS  seems “cheap”. A 3yr avg ROE of over 20% and a book multiple of 1.8x is “cheap”. A net income 3yr CAGR of 5% and an earnings multiple of 8.4x is “cheap”. However, looking at forecasted earnings we can see that the expectations for net income are pretty bleak. In that sense, if expectations become reality, then MKS is not quite as cheap as it looks. Looking at other metrics we can see this more clearly. EBITDA five years ago was actually about £30m higher than it is now and the £1bn or so in sales growth that was achieved has come with a significant deterioration in the gross margin. In other words, we have to look a bit closer to see if MKS is really cheap.

As already mentioned, the gross margin has really come under pressure dropping to 38.6% from 42% five years ago. To quantify this, if MKS made the same margins on last years sales, profit would be up just under £400m from the current level. The company has shrunk S&D but this has no net effect as Admin costs have risen by just as much. Regardless, over the past five years, the factor holding MKS back has been poor margins not poor sales.

MKS’s balance sheet has been under some pressure too. MKS has, what I would say, is just the right amount of debt. Conservative but not too conservative. Excess cash can be a real problem but the company has built up a decent contingency balance of just under £400m. Sensible but not too sensible. The problem has been with some balance sheet items growing much faster than sales. Most importantly, inventory turns have dropped off quite quickly. MKS is a big fish and is doing well to push its trade creditors hard (the trade creditors line has risen far faster than inventory) but working capital is still eating up cash. Operating leases and rental expenses have also been growing far faster than sales. Again, MKS is able to drive a hard bargain but the maturity of these leases is shortening fast with 75% of leases being due after five years in the last year relative to 97% five years ago. I have presumed this is due to the switch to food-focused stores which are smaller but we should be concerned as rental expenses can be a source of significant operating leverage.

Looking to the forecasts, sales are projected to grow 11% over the next three years and EBITDA margins by 78bps growing from 13.25% to just over 14%. So although some bounce in margins is predicted the basic consensus appears to be for the decline in margins to level out and for stuff to stay pretty much the same for the next three years. In terms of net profit it looks like, and this more speculation, that the projection is for D&A costs to grow slower than sales (widening the EBIT margin), tax and interest costs to grow slightly leading to a thinner net margin. With this in mind, if we are going to invest in MKS we have to be expecting either faster sales growth or faster margin growth. Given the large drops in margin and the continued growth in sales, I would say that the main focus should be on the potential for margin growth.

So to restate the important points about margins, the majority of the drop has been at the gross margin level. Changes below the gross level (i.e S&D or Admin) have pretty much cancelled each other out. Our first concern should therefore be to determine whether the changes in gross margins are secular or cyclical. For example, has there been some change in operations that have permanently lowered potential gross margins such as a new business line/product or is the drop in gross margins just due to the business cycle? Looking at historicals, we can see that the current gross margin isn’t that extraordinary. In 2005, gross margins were at the same level they are now and in every year before 2005 they were actually lower than they are now. Between 2000 and 2008, the majority of growth in the total operating margin actually came at the gross level. Therefore, the margins for MKS appear highly cyclical and are correlated to the business cycle.

Whilst MKS  does appear to have moved to a permanently higher level of margins the forecasts suggest strongly that the current sentiment is for a quite weak recovery over the next three years (EBITDA margins grew 83% over the last cycle but are projected to grow 6% over the next three years). In other words, what we are getting with MKS is a bet on recovery in retail. If you think that consumer confidence is going to improve significantly then MKS is well priced as in that scenario gross margins will grow much faster than projected in the current forecasts. It may be the case that there is room for operational improvements but my reading of annual reports and the picture from historicals is that MKS is actually run as well it could be…unfortunately, the market seems to know this too.

So if we thought MKS was “cheap”, DEB is even “cheaper”. DEB has a 3yr avg ROE of 17% against a book multiple of 1.27x and net income CAGR of 7% against an earnings multiple of 6.9x. What is more we can see that on a forward basis DEB is even “cheaper” as, unlike MKS, its earnings are expected to grow. Whilst DEB has the unfortunate distinction of a worse financial position than MKS, net debt of 3.59x equity, it also has the unfortunate similarity of declining gross margins with 2007 GM 430bps up on 2011. However, we should bear in mind that net profit actually increased £38m since the same period. We can draw two preliminary conclusions from this: first, underlying operations are under pressure and second, the financial condition of the company could have significant influence on returns to shareholders.

As with MKS, our main concern should be margins. Getting a picture of how margins have changed is difficult due to the short financial history of DEB and its reporting choice of taking the majority of costs at the gross level. Part of the reason for DEB’s thin gross margin is clearly due to these reporting choices but it seems likely that some part is also due to its business model. Whilst it has made efforts to increase sales of its own bought lines, more on this later, some 20% of sales are still concessions which naturally leads to lower gross margins. It is difficult to say more than this though. Pressure on margins has also come from S&D costs but these have increased only in the LFY. The reason for this increase is a combination of a one-time gain relating to a new distribution centre and increased costs from online sales. However, margins have been declining over the past five years so our concentration should be on the outlook for gross margins.

Whilst operating margins have shrunk rapidly, net margins have improved as financial expense has fallen by roughly £50m over the past five years. This is due to a combination of declining interest rates and a new £650 credit facility arranged in Nov ’10. This new facility comprising a term loan and a revolver appears to be cheaper than the old term facility. It is also worth noting that there has been some interest rate hedging so DEB may have locked in some of the benefits of low interest rates.

Looking to the balance sheet, we note that whilst inventory growth appears to have matched growth in sales, DEB seems to hold quite a significant amount of inventory given its sales. One reason for this could be its aggressive use of supplier balance sheets, its trade creditor balance is usually slightly bigger than the inventory balance. DEB runs with a negative cash cycle but working capital still seems to eat up a lot of cash. More broadly, net operating asset growth has matched sales growth but this does not include the most substantial asset and liability which are operating leases. Operating leases and rental expenses have continued to grow slightly faster than sales perhaps expressing the company’s ambitions for the near future. We should bear in mind the operating leverage that comes with rental expenses and although the situation is manageable given 3 years of slow sales and continued in operating leases and DEB is in a tough spot.

As the operating and financial sides of the business are so intertwined we have covered the main financial issues. The only point to add is that the company has run down is cash balance significantly over the past three years to pay debt. At this stage, this appears to have been quite a good investment.

The forecasts for DEB are slightly more ambitious than MKS. The top line is projected to grow quite significantly with 20% sales growth over the next three years however, EBITDA is projected to slower at 10%. As a result, margins are projected to decline over the next three years however, most of this drop is forecasted for 2012. After 2012, margins are projected to grow slowly. The bottom line is projected to grow 3% faster than EBITDA perhaps due to declining D&A costs as the upside from declining interest expense has been achieved. The most important facet of the forecast are the margins where the projection is for the next three years to differ significantly from the past three years. However, we should also bear in mind that the projections for sales growth seem pretty ambitious too. If DEB does make anywhere near the forecast though it is clearly cheap as the forward P/E ratios suggest.

As with MKS, our question should be: are these changes in margins secular or cyclical? Since margins have been falling since 2005, which was nowhere near the peak in the business cycle, we know that there are some underlying problems that seem to have given DEB a permanently lower margin. We have mentioned already the issue with concessions. The company lists own-bought sales percentage as KPI so we know this has increased by 10% from 2007 to 80.4% in the LFY. Growth in this metric has slowed recently but it could be a way to increase gross margins substantially. It is also true that DEB, in the past, seems to have competed quite heavily on price which is a model that appears to be coming apart in the current climate as people trade up in quality whilst making less frequent purchases. DEB appears to be responding with its fast-growing “Designers at Debenhams” lines and its effort to refurbish its stores. In my unskilled opinion, both of these initiatives are working. So whilst DEB clearly did not avoid the downturn in the business cycle, the business appears to have some longer-term issues that it needs to solve as well.

Taking into account all these factors, DEB appears to be a fairly good investment at this price although with some caveats. The most important thing with DEB is that the forecasts are still fairly bearish and if conditions stay roughly the same then nothing terrible will happen. What this means is that we seem to have a slightly more favourable risk:reward if we want to bet on a recovery in retail. More hopefully, there appears to be some significant room for operational improvements. If even slight operational improvements are achieved then this price is going to be very cheap. However, the fundamental question is still: do you want to invest in retail?