No sparks from Marks

May 20 2009 by Andrew Miller, The Journal

AS we struggle through a painful recession, the state of the UK’s retail sector is even more important than normal. Any revival in spending will be taken as evidence that consumer confidence is on the mend, and – rightly or wrongly – that the worst is indeed over.

In this context, the publication yesterday of Marks & Spencer’s preliminary results (for the financial year to March 28) was eagerly awaited – if with some trepidation. Bad results would have cast a pall over the UK retail sector as a whole, and the economy too.

In the event, Marks & Spencer’s results were not a disaster, but were not wholly reassuring either. The headline numbers were just about in line with market expectations, with profits before tax coming in at £604m against market expectations of £605m, and earnings per share bang in line at 28p. The company’s dividend was cut by 33%, in order to shore up the balance sheet. While painful, the decision to cut the dividend was widely expected and was undoubtedly correct in today’s business environment.

There were also few shocks about current trading. Marks & Spencer’s management said that current trading was in line with the fourth quarter of its financial year (ie January to March). This implies that general merchandise sales are down by nearly 5% year-on-year and that food is down by nearly 4%. This is in line with our expectations, and these numbers also provide something of a reality check. Some had hoped for something rather better, given previous numbers from the British Retail Consortium that indicated stronger-than-expected clothing sales (across the whole sector) in April.

Despite all this, worries about future profitability remain. Marks & Spencer’s food operations have been reducing margins to make pricing more competitive. This strategy appears to be working to some extent, although we are still surprised by the extent of the resulting fall in food profitability during the second half of the financial year.

The management is now forecasting that the group’s overall profitability will fall by 0.5 % during the current financial year. This official forecast may add to worries that something worse is possible, particularly as the firm hasn’t been very good at forecasting profitability in the past.

Management’s claims to have reduced the company’s debt by £600m have also been treated with some scepticism. Much of the debt reduction appears to be due to a reclassification of the liabilities within the pension property partnership. It is worth noting that the debt rating agencies do not accept this reclassification.

As we approach the low point of the recession, markets try to look through all the bad news towards a better time. Hence economically-sensitive sectors tend to get the benefit of the doubt, in anticipation of better days and earnings ahead. This has certainly been the case with Marks & Spencer, shares in which have performed extremely well this year. However, we think the reality has a long way to go before it catches up with the stock’s price, and thus would defer buying it.

Andrew Miller is regional office head of Barclays Wealth