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Marks & Spencer: How safe is the dividend?

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With a dividend yield of around 6.2%, Marks & Spencer (LSE: MKS) is among the highest yielding stocks in the FTSE 100. But before jumping on board with that eye-catching yield, there are a few things investors need to know about the company.

Challenging market conditions

The high street is going though a difficult period amid a squeeze on incomes and the shift to online shopping, and M&S is no exception to the trend. Adjusted pre-tax profits fell for the second consecutive year to £580.9m, the company reported on Wednesday, as a fall in sales and higher costs squeezed earnings.

The company has been restructuring itself for some time now, but its efforts have been criticised as inadequate, particularly with respect to store closures and growing its online presence. It now says that over 100 stores will close within the next five years, up from its earlier target of 60 stores, but analysts warn that this may still not be enough to adapt to the rise of online shopping.

And amid challenging market conditions in the retail sector, there’s every reason to expect that more difficult times lie ahead for the company. Restructuring is a costly task, and already the costs are mounting. Exceptional costs climbed to £514.1m in the latest year, up from £437.4m in 2016/7, which meant pre-tax profits fell by 62%, to just £66.9m, once adjusted items were included.

Free cash flow

All-in-all the picture painted above doesn’t exactly give investors much confidence about the long-term sustainability of its dividends. However, a dividend cut isn’t imminent either, as the cash coming into the business still comfortably covers shareholder payouts.

Even after taking account of adjusting items, M&S generated £417.5m in free cash flow for the 12 months to 31 March. This enabled the company to cover cash dividends paid over the past year by a little less than 1.38 times, and meant it had £114.1m left over after shareholder payouts.

Still, the longer-term uncertainty remains. Without a successful turnaround in its financial performance, it cannot sustain the current level of dividend payouts indefinitely.

Digital capability

Meanwhile, rival retailer Next (LSE: NXT) seems to be in better shape. Its online business is growing at an impressive pace — up 18.1% in the first quarter, and it recently raised expectations for its full-year underlying pre-tax profits from £705m to £717m.

Among the high street clothing chains, Next has one of the biggest online operations, with just under half of all its sales coming from online customers. This puts the company in a competitive advantage against its high street rivals, as its superior digital capability means it is better placed to capture more of the fast-growing online market.

Profits still falling

Despite strong online growth, profits will likely still come under pressure from falling in-store sales and shrinking margins. With retail profitability increasingly under the microscope, Next will need to show it has a tight control on costs.

Even after an increase in its forecast for the full year, pre-tax profits are expected to decline for at least another year. This combined with a rise in capital spending means the company will probably not be paying a special dividend this year. And as such, investors can only look forward to an ordinary dividend of 158p, giving its shares a yield of 2.7%.

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Jack Tang has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.