Surprising Profits Make Me Want To Buy Marks and Spencer Group Plc Today

I have to admit I’ve not always been a big fan of Marks & Spencer Group (LSE: MKS) (NASDAQOTH: MAKSY.US). However, I’ve recently started to wonder whether my view on the company is correct. Am I missing something?

After all, this is a firm that sold more than £10bn of food and clothes last year, on which it generated an operating margin of 7.5%, or £756m.

Surprisingly profitable

M&S is actually surprisingly profitable. UK sales are a near 50:50 split between clothing and food, and the firm’s gross margin on General Merchandise (clothing) was 51.8% last year, while its gross margin on food was 31.7%.

In contrast, Sainsbury’s reported a gross profit margin of just 5.5% last year, while NEXT earned a gross margin on its sales of 31.3%. Although these figures are not directly comparable, due to the way that M&S breaks down its sales, they do provide a clear indication that M&S knows how to sell stuff at a decent mark-up.

The firm’s challenges are to convert more of its sales to free cash flow, and to reverse its declining clothing sales.

More free cash

M&S has been investing heavily in international stores, refurbishing UK stores and new IT systems to support its updated website and supply chain operations. All of this costs money, and in 2012/13, the firm’s capital expenditure totalled £829.7m.

Capex is expected to fall to £775m in 2013/14 and to around £550m per year from 2014/15. This should increase free cash flow by around 17p per share, and M&S has indicated that this could be channelled into improved shareholder returns.

Selling more clothes

M&S food sales rose by 3.9% last year, but clothing sales were down by 2.4%. As a result, food revenues were larger than clothing revenues, for the first time ever.

The company’s current Autumn/Winter collection is the first attempt by the firm’s new management to reverse the decline in clothing, but it’s too early yet to say whether this will be a success.

What’s next?

The big risk is that M&S clothing sales will continue to decline, but I think that the firm will eventually get on top of this — and in the meantime, growing food and international sales are helping to reduce its dependency on UK clothing sales.

In my view, shareholders should trust management, sit tight, and wait for further progress.

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> Roland does not own shares in any of the companies mentioned in this article.