Why M&S and Debenhams have a 'big hill to climb'

As if recent trading conditions haven't been tough enough, it appears the longer-term picture for Marks & Spencer and Debenhams as true multi-channel retailers may be just as troubling.

Analysts at UBS have taken a closer look at how profits will be impacted by the growth of online sales, concluding that the transfer from bricks and mortar will be a "big hill for both to climb".

The bank's calculations are based on Next's recent guidance that the loss of in-store sales is much higher than the gain from additional online sales. For every £1 of channel shift, Next loses 13p of profit.

Next is fortunate to already have a 50-50 retail/online split, but others are in a worse position as they continue their transition to online.

M&S hopes to almost double online non-food sales from 18% to one-third of the total in five years. According to UBS, £550 million of sales could shift channel, which if using the Next calculations would cost M&S around £70 million or 12% of 2018 profits.

Source: interactive investor             Past performance is not a guide to future performance

UBS said it was difficult to know how much of this £70 million is in existing cost guidance, but if it is incremental then it warns M&S would show no profit growth at all over the next four years.

Debenhams has suggested that 30% could be a future online mix from the 16% currently achieved on £2.3 billion of UK sales. This would see £330 million of sales switch channel, costing a theoretical £43 million.

Source: interactive investor            Past performance is not a guide to future performance

While UBS is hopeful that all retailers can see some benefit from real wage growth in the second half of this year, the broker doesn't think this will be enough to offset the channel shift.

They have reduced their medium-term estimates for M&S and cut the price target to 275p from 340p with a neutral rating.

It said the retailer resembled a "piece of self-assembly furniture", with all the bits and the will to get the job done but with no guidance on how long it will take or whether the finished item will look like the one on the box.

Marks & Spencer's latest restructuring effort is being overseen by new chairman Archie Norman, who previously revived retail brands Kingfisher and Asda.

Some "immediate and burning issues" have already been addressed, such as too much discounting and poor stock availability, and the overall shopping experience.

The bank's base case for 2019 assumes positive M&S like-for-like sales in general merchandise after seven years of decline, whilst food underlying sales remain slightly depressed.

With Debenhams working with a much lower earnings margin, UBS has reduced its price target to 18p from 23p.

It has also cut its 2018 pre-tax profits forecast for 2018 by £3 million to £53 million to allow for a weaker second quarter due to weather and the timing of promotions. UBS warned that Debenhams' higher operational gearing meant the profit impact from moving online could be larger than Next's 13p in a £1.

Today's note is the latest downgrade to hit the retail sector, with Citigroup also targeting M&S and cutting its stance on Pets at Home, ASOS and B&M.