Are M&Ss investments enough to turn the fortunes of its clothing division around?

Are M&S's investments enough to turn the fortunes of its clothing division around?

Today's first-half results from Marks & Spencer have offered a mixed picture for its clothing business. Like-for-like sales fell, but margins improved thanks to continued progress in the UK retailer's direct sourcing initiatives. While M&S is optimistic it can maintain margins and has upped its full-year forecast, will its investments in sourcing and a new rewards card be enough to revive the retailer's clothing fortunes? 

1. General merchandise LFL sales drop worse than expected

Marks & Spencer's decision to focus on margins and discount less weighed on clothing sales in the first half, resulting in a fall in general merchandise sales of 0.4%, and a 1.2% drop in like-for-like sales. The latter was worse than consensus estimates of a 0.9% fall, and Bernstein Research's estimate of a 0.5% fall. Unseasonal weather contributed to management's decision to focus on full-price selling. The pace of decline, Bernstein said, accelerated from the first quarter, where general merchandise like-for-like sales were at -0.4%.

Shore Capital analyst Darren Shirley, noted: “We‎ cannot deny that we would much rather be writing about stronger general merchandise trading from M&S, so seeing through the positive momentum that commenced at the start of calendar 2015. However, and we have been in this position many times before, it was not to be.

Nonetheless, he added: “Whilst we wait patiently for a sustained improvement in general merchandise same-store performance we must bang the investment case drum with one hand behind our backs. In doing so though we do not overlook the potential prize nor the M&S stock's sound and arguably more visible and sustainable income stream with capital expenditure running at measured levels.” 

2. Move towards more direct sourcing helps gross margin

Despite the fall in general merchandise like-for-like sales, gross margin expanded by 285 basis points to 56.6%, beating Bernstein expectations for a 220 basis point improvement. The primary driver in the increase was the focus on full price sales, and an improvement in buying margin as a result of continued progress in sourcing initiatives and M&S switch toward more direct sourcing models. This was helped by weaker hedged US dollar rates. 

Key to these sourcing gains is the hiring last year of former Next sourcing executives Mark and Neal Lindsey, who have helped get better deals with suppliers by cutting out middlemen. The retailer has also established a number of in-country teams to stimulate competition between clothing suppliers in a bid to encourage more efficient output, better designs and lower cost-price contracts.

M&S is confident is can maintain the gross margin improvement in general merchandise and has upped its full-year guidance to an expansion of 200-250bps compared to previous guidance of 150-200bps. This is against Bernstein expectations of 185bps. Operating cost guidance, however, has been maintained at +4%, after +2.2% growth in the first half. “The message is that management believes the overall opportunity is bigger, as not much progress was made on markdowns,” Bernstein analyst Richard Jaffe noted.

3. Clothing has become the Achilles' Heel of M&S

M&S has been working hard to turn the fortunes of its clothing division around, with a focus on improving product quality and style. In a bid to develop its in-house design capabilities, the retailer appointed Queralt Ferrer as the group's first director of design for women's wear, lingerie and beauty in September. This was part of a reshuffle under new general merchandise head Steve Rowe.

Sophie McCarthy, consultant at Conlumino, believes general merchandise has become the “Achilles' Heel” of Marks & Spencer as the performance of its clothing business appears to have fallen behind the market in terms of both style and proposition. She adds that while gross margin gains “provided shareholders with an increased dividend, it may only be temporary respite, as we believe the retailer needs to work harder to address the root of its issues here in order to stabilise the business.”

4. Sparks to provide some respite?

M&S's women's wear has shown some signs of a turnaround this year, but a fall in like-for-like general merchandise sales in its first-half has been something of a setback for the division. M&S might be hoping the launch of its new rewards card, Sparks, in time for the busy Christmas period will help revive its fortunes. The retailer may also be hoping the card will prompt more brand loyalty from its core customer base.

The card gives shoppers ten ‘sparks’ for every GBP1 spent at M&S. There are also 50 Sparks bonus points for using the clothing Shwop service in-store. Members are sent personalised offers through every fortnight, normally an in-store or online discount. More rewards are available the more 'sparks' a customer earns, such as new season previews, and the ability to buy sale items a day before they go on the M&S website.

Conlumino's McCarthy, notes: “New membership club Sparks could help in two ways. Firstly, it will likely provide the retailer with an in-depth knowledge of its customer via the influx of data it will receive from the card usage. Secondly, it aligns M&S with the wider trend of personalisation that is emerging in the clothing market; a technique online-only fashion retailer Very has led the way on, the approach aims to create value via exclusive deals and events, as opposed to the traditional price reduction strategy.”

5. Increased flexibility in M&S’s business model

“Not the easiest of halves given the weather, but the increased flexibility in M&S’ business model stands out – enabling it to deliver first-half profit before tax 5% ahead of consensus driven by general merchandise gross margin improvement,” notes Investec analyst, Kate Calvert.

Indeed, M&S appears to have good financial flexibility and, as Shore Capital's Shirley points out, the group's capital management priorities are: to operate a strong balance sheet embracing an investment grade credit rating and a net debt/EBITDA ratio within a range of 1.5-2 times; and sustain investment in the business but on a controlled basis, so capital expenditure within a range of GBP500-550m with a commitment to sustain strong capital discipline.