Jefferies International has downgraded its rating for Marks & Spencer Group PLC (LON:MKS) to ‘hold’ from ‘buy’ over concerns that the retailer’s UK online grocery joint venture with Ocado PLC (LON:OCDO) may represent “a very expensive way” for the group to defend food volumes.
The US broker’s analysts also said they are worried by the message implicit in M&S plans to right-size its dividend and the deal's funding structure.
READ: M&S set for big rights issue, divi cut to fund online grocery joint venture with Ocado
M&S confirmed on Wednesday that it will pay £750mln for a 50% equity stake in Ocado’s UK food retail business that generated sales of £1.48bn and underlying earnings (EBITDA) of £34.2mln - after £48.3mln of fees paid to Ocado Smart Platform in 2017/18.
The FTSE 100-listed retailer said it will fund 105% of the upfront consideration via a £600mln fully-underwritten rights issue and also plans to cut back its dividends to free up cash.
Jefferies analysts said the downgrade reflects the around 10% earnings and free cashflow dilution they expect to emerge from the joint venture.
In a note to clients, they added: “We are of the view that the £70mln of EBITDA synergy ambitions underpinning the deal rationale may prove rather difficult to deliver in full.”
The analysts said: “We are also concerned that the scale of growth ambitions implicit in potential CFC - customer fulfilment centre - openings (up to £4bn of extra capacity in the coming decade) is inconsistent with the mass market positioning that such growth would require.”
“In our mind,” they continued, “the main synergy driver is the volume benefit of MKS replacing Waitrose's own label offering within Ocado.com.”
Skewed demographics
The analysts said the companies confirmed that represented around £370mln of sales in 2017/18 – versus M&S’s food sales of £6bn - which suggests a fairly ambitious synergy target.
They pointed out that Ocado UK has grown sales by around £1bn in the past decade - at reducing EBITDA margins.
The analysts concluded that Ocado remains a great customer offering, but with very skewed demographics.
They added: “We don't see the replacement of Waitrose with M&S as changing that brand appeal. And as a result we don't feel bullish about the potential for M&S to supercharge its food growth via the jv.”
Jefferies reduced its target price for M&S to 280p from 310p, with the stock currently trading at 265.90p, up 0.2% on the previous close, having tumbled 12.5% on Wednesday.