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Fitch Affirms Marks and Spencer at 'BBB-'; Outlook Stable
October 13, 2017 / 5:48 PM / a month ago

Fitch Affirms Marks and Spencer at 'BBB-'; Outlook Stable

(The following statement was released by the rating agency) LONDON, October 13 (Fitch) Fitch Ratings has affirmed Marks and Spencer Group Plc's Issuer Default Rating (IDR) and senior unsecured rating at 'BBB-' and the Short-Term IDR at 'F3'. The Outlook remains Stable. The affirmation and Stable Outlook are supported by M&S's strong brand name, relatively stable customer base, its large scale, reputation for high quality in food and its steady credit metrics and profile. EBIT margins remain steady and we believe the group generates above average EBIT margins from its premium food operations, which are expanding market share slightly. The food operations are performing well, but the ratings are constrained by the competitive environment facing the Clothing and Home (CH) division based on consumers' growing preference to shop in digital and convenience formats. There has also been an inability to capture fashion trends and attract the younger consumer. M&S nevertheless remains a leading player in the UK clothing sector, and there are at last signs of trading stabilisation in this part of the group's operations. Leverage and fixed charge cover metrics should remain solid in 2017/18 and within the parameters we have set for a 'BBB-' rating, while free cash flow (FCF) should remain positive in the next two years. KEY RATING DRIVERS Management and Execution Key: In our view M&S must continue to develop and implement a robust strategy so as to maintain its market share in food as well as revitalise its CH offering. We view execution risk as moderate, while the new strategy will take time to implement and bear fruit. The move to rationalise brands, reduce catwalk fashion and prioritising fit and quality would appear to be in line with the requirements of its existing customer base. General Merchandising Slowly Recovering: M&S has been losing market share in CH (currently around 7.4% in womenswear excluding lingerie) for a number of years but trading in recent months would appear to demonstrate a stabilisation of the sales trend. M&S has been reducing the number of discounts and promotions, switching to a more "low price and then hold" strategy. It has embarked on a more focused range, concentrating on children's clothing and homeware, while improving fit and finish. M&S retains a prominent share of the UK underwear market, accounting for nearly 28% of all UK sales. Rightsizing Oversized Store Network: Fitch believes that M&S has too much CH space in its high street store network and intelligent rightsizing of space will need to continue under its strategic plan. M&S closed 10 full-line stores in 2017 and has in recent years replaced CH space with food. Around 30 full-line stores will close within the next five years and 45 will be converted to the Simply Food format. However the ability to transfer further significant square footage to food sales in existing stores is probably limited, although M&S is partly addressing the issue by opening new Simply Food stores. It anticipates opening up to 250 Simply Food stores in the next four years, provided these can achieve the required return thresholds based on three- to four-year paybacks and ten-year lease terms. Challenges in Food Remain: M&S's food operations remain resilient but trading conditions remain challenging. Product innovation should help the group maintain leadership in convenient quality food. Competition is fierce with new entrants challenging food retailers at all levels and a recovery in competitiveness from Tesco PLC ('BB+/Stable'). M&S is not immune to this, nor is it fully protected from changing consumer habits. Reinvesting its profits into new high-quality and convenience products has helped retain shoppers so far, but we are unsure whether this is sustainable in the long term, particularly with powerful new entrants such as Amazon. Steady Revenues and Margins: Overall, we believe M&S should continue to operate within its rating sensitivities, supporting the rating affirmation at the current level. Fitch expects group revenue to rise moderately at between 0.6%-1.0% per annum by the financial year ending in April 2019 (FY19), with small reductions in food gross margins largely offset by better performance from clothing and general merchandise (including homeware). In food, the group has been able to expand its market share slightly to 4.5% to March 2017, thanks to its niche position in quality and convenience. The group does not breakdown margins by segment, but we believe M&S generates above average EBIT margins in food, close to premium peers such as Waitrose which enjoy EBIT margins of around 3.8%-4.0% versus a European average of 3.0%. We expect group EBIT margins to remain steady at around 6.0% over our two-year horizon to FY18. Rising Cost Base: As with other UK retailers, M&S's cost base is faced with rising costs from increasing business rates and the new apprenticeship levy. M&S is less affected by the onset of the Minimum Living Wage (MLW) as it has consistently paid its staff above the average rate for the sector. This combination is being countered by cost-saving strategies such as optimised buying, improved logistics and head office rationalisation, which should save around GBP30 million in total per annum. In addition, M&S is using its now smaller marketing budget in a more targeted and efficient manner, such as the more focused Christmas sale campaign. Steady Credit Metrics, Leverage: Fitch expects funds from operations (FFO) margin to remain steady at around 9% to 10% over the rating horizon to FY19. This is sufficient to cover forecast lower capex of around GBP400 million and dividends of around GBP310 million-GBP330 million, leaving a positive FCF margin of 1.0%- 2.0 %. We further anticipate FFO adjusted net leverage to be in the range 2.8x to 3.3x in the next three years, which should mean improved headroom against the negative sensitivity of 4.0x. Any additional investments, capex or further return of shareholder funds that are not funded by other sources of cash could place pressure on this headroom. Partnerships for International Operations: The international operations continue to face obstacles, and M&S is now addressing these by encouraging the partnership model with local partners, such as in India. In November it also announced it was exiting owned stores in 10 loss-making markets. These markets had accumulated losses of GBP34.7 million in 2017. UK Retail More Competitive: UK household budgets are under pressure from low wage increases and increasing inflation due to the fall in sterling following the Brexit referendum, and consumers have become cautious and increasingly looking for value-for-money products. In addition, there is a structural move towards more experiential and leisure spending and away from non-food purchases and in particular clothing. This had led to fierce competition between retailers, underlined by relentless price-cutting and margin erosion. Fitch expects this tough environment to remain for the next two to three years, as the UK retail environment continues to change and as players consolidate. This trend is likely to be accelerated by the growing presence and market share of pure online retailers. Strong Brand, Customer Base: M&S benefits from strong brand recognition, particularly in premium food, a relatively stable customer base and large scale. The group is also strong in premium convenience foods, one of the better performing segments of food retail. We expect the group to continue adapting its product offer to changing customer demands despite fierce competition in both food and clothing. With a reputation and clear emphasis on quality M&S generated GBP10.6 billion of revenue in 2016, and is the largest retailer in its peer group with over 32 million customers, of which 7 million are registered with M&S.com. DERIVATION SUMMARY M&S is a long-established UK food and fashion retailer operating in the premium range UK food market and the UK and international mid-range men and ladies clothing and merchandising market. Despite high competitive pressures and digital growth, M&S's high-quality food offer gives it some trading resilience and has allowed it to gain market share to 4.5% in the UK. The group benefits from strong brand recognition and its operating margins in the UK food sector are probably higher than the average of its peers of around 2.5%-3.0%. Its clothing offer has needed revitalising in recent years in the face of strong competition from peers such as Next Plc, New Look ('CCC') and new pure online retailers such as ASOS and Boohoo.com. We expect the UK clothing market to remain challenging as fast fashion and online players continue taking market share from more traditional retailers. These will need to also adapt to fast-changing fashion trends and rapid product design and introduction. It will also have to ensure that its store and web-based systems are fully integrated given customers' preferences for multi-channel retailing. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: - group revenue to conservatively increase 0.6% per annum to FY19, based on broadly flat growth across both UK and international; - operating costs to increase by around 3% in FY2017/2018; - group EBIT margins (combined food and non-food retail operations) steady at around 6%% during our two-year rating horizon, with gains in CH offset by flat margins at International; - capex of 4% of revenue (around GBP400 million pa); - free cash flow margin of between 1.0% and 2.0%% of revenue; - restructuring costs of around GBP50 million per annum to FY19, related to closure of general merchandise sites RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action -Stabilisation of EBIT margin above 7% (6.5% in FY16) due to recovery in market share in Clothing and Home on a sustained basis, together with cost base improvements - FFO fixed charge cover sustained at or above 3.5x (2.9x) - FFO adjusted net leverage below 3.0x (3.7x) Future Developments That May, Individually or Collectively, Lead to Negative Rating Action -Group EBIT margin declining to below 5.5% (FY16:6.5%) due to continued pressures in gross margins and accelerated structural shift into food retail -FFO fixed charge cover below 2.5x (FY16: 2.9x) - Lease adjusted net debt/FFO above 4.0x (FY16: 3.7x) LIQUIDITY Satisfactory Liquidity: M&S's liquidity is considered satisfactory with GBP1.1 billion available under committed debt facilities (GBP200 million drawn at July 2017), which together with readily available cash of GBP418.6 million at FYE17 (which Fitch adjusts by GBP50 million as restricted cash), which is more than sufficient to cover short-term debt. FULL LIST OF RATING ACTIONS Marks and Spencer Group Plc --Long-Term IDR at 'BBB-' --Senior unsecured rating at 'BBB-' --Short-Term IDR at 'F3' Contact: Principal Analyst Sophie Coutaux Senior Director +33 1 44 29 91 32 Supervisory Analyst Jean-Pierre Husband Director +44 20 73530 1155 Fitch Ratings Ltd 30 North Colonnade London E14 5GN Committee Chairperson Pablo Mazzini Senior Director +44 20 73530 1021 Summary of Financial Statement Adjustments -Fitch has adjusted the debt by adding 8x annual operating lease expense relating to long term group assets. -Fitch also sets aside GBP50 million as restricted cash related to working capital requirements during the year. Media Relations: Adrian Simpson, London, Tel: +44 203 530 1010, Email: adrian.simpson@fitchratings.com. Additional information is available on www.fitchratings.com. 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