M&Ss GM division performed worse than analysts expected in its full-year

M&S's GM division performed worse than analysts expected in its full-year

Marks & Spencer could dramatically improve its general merchandise gross margin with the right systems, supply chain and buying processes in place, analysts believe, but earnings growth might be harder to achieve.

The UK retailer's general merchandise division performed worse than analysts expected in its full-year last month, after it revealed a 3.9% drop in group earnings, dragged down by a decline in clothing sales.

Negative territory
Bernstein Research analysts Jamie Merriman, Anthony Sleeman, and Rupert Galway-Cooper have noted that while positive like-for-like sales of 0.6% in clothing is better than a negative, the overall general merchandise business was still in negative territory, with gross margins down 120 basis points in the last six months.

"A small positive like-for-like (LFL) in clothing hardly seems worth cheering about," the analysts said. "In our view, the key question from here is whether or not M&S can deliver both positive LFL sales in general merchandise and significant expansion in gross margin."

The analysts believe, however, that with the right systems, supply chain and buying processes, M&S can improve its general merchandise gross margin, with bullish investors confident the retailer has a clear opportunity here.

The analysts noted that peer comparison suggests gross margins in apparel can be much higher than what M&S has historically delivered.

Gross margin expansion
In fiscal 2013/14, M&S' general merchandise gross margin was 50.7%, and over the past four years has been around 700-800 basis points lower than the average gross margin of Inditex, H&M and Next.

For its next fiscal, management has guided to 100 basis points of general merchandise gross margin expansion and suggested that around 75 basis points will come from sourcing improvements and 25 basis points from better markdown management.

In the current year, Marks & Spencer expects to increase direct sourcing from around 20% to 35% of product.

"In a best case scenario, we estimate that this could result in circa 90 basis points of gross margin improvement, given that Next earn a circa 6 percentage point margin on their sourcing business and M&S hope to increase direct sourcing on circa 15% of their products," the analysts noted.

They also believe M&S will continue to struggle to deliver profit improvement in the UK given the combination of increasing depreciation charges, a highly promotional apparel market and a price sensitive core customer who is used to buying on promotion.

"Indeed, despite supply chain improvements in recent years, promotions have been higher than expected and UK profit continues to fall," they noted.

Underlying profit before tax dropped 3.9% to GBP623m (US$1.05bn) for the year ended 29 March. Earnings were dragged down by a 1.4% drop in like-for-like merchandise sales, the majority of which is clothing.

"Since 2008/09, Marks & Spencer has suggested that supply chain and IT initiatives have resulted in GBP215m in cost savings. However, UK EBIT over that period has declined at a circa 2% CAGR."

GM turnaround
While more cost savings are likely ahead as M&S continues to make progress on its supply chain initiatives, the analysts expressed concern that higher depreciation charges as a result of its stepped up capex plans, and continued markdown pressure, will more than offset these savings.

"We believe the real question for M&S over the coming 18 months is whether the company is able to turn around the general merchandise division, which has underperformed the overall UK apparel market for several years.

"While there has been much change at the division, and we believe some of the initiatives being implemented make sense and will, in the long-term, benefit the division, we think this is an evolution, as suggested by our impressions of consumer reaction to the new collections, not a revolution," they concluded.