Why Marks and Spencer’s shares would have to fall to 300p before I’d invest

Marks and Spencer is one of those companies that always seems to either need or be in the middle of a turnaround. However, despite all the endless talk of turnarounds, one thing that hasn’t turned around yet is its results.

Admittedly the recent 2016 results weren’t terrible, but they weren’t exactly awe-inspiring either.

Revenues, normalised earnings and dividends were all up a bit, but only by low single-digit percentages, and that has more or less been the story for most of the last decade.

Growth is slow but relatively steady

After suffering an understandable decline in profits and dividends after the financial crisis, the company has found it impossible to mount a rapid recovery.

Over the period covered by the chart above, Marks and Spencer’s growth statistics, compared to the FTSE 100, are:

• 10-Year growth rate = 0.1% (FTSE 100 = 1.6%)
• 10-Year growth quality (consistency) = 67% (FTSE 100 = 50%)

The 10-year growth rate is an average across revenues, earnings and dividends, and 0.1% per year does seem very low. In fact, it’s so low that it breaks one of my rules of thumb:

• Only invest in a company if its growth rate is above 2%

However, to some extent, its growth rate is extremely low because of the decline in earnings and dividends at the start of the period.

Perhaps a fairer estimate of the company’s historic growth rate, and perhaps its future growth rate, is its historic revenue growth rate.

Looking only at revenue, Marks and Spencer’s 10-year growth rate is 2.1%, which is slightly above my rule of thumb minimum growth rate of 2%.

However, 2.1% is still low and is not significantly different from the rate of inflation. In other words, Marks and Spencer has maintained its size in inflation-adjusted terms but hasn’t actually grown at all.

To be fair, this unexciting growth rate is not exactly a surprise; Marks and Spencer operates almost exclusively in the UK and within the UK it already has a store on every street corner (or at least it can feel that way sometimes).

It’s going to be difficult for the company to open lots of new stores without cannibalising sales from its existing stores. As a result, growth within the UK is more likely to be in line with growth in the UK’s aggregate wages, i.e. population growth plus inflation.

There is of course the option of international growth, but historically Marks and Spencer has not exactly set the world alight with its overseas adventures, and I don’t see how that’s going to change any time soon.

Capital expenses are high but return on capital is average

Other than growth, I prefer to invest in companies that don’t have to invest a lot of capital to grow their business (which I look at during my value trap analysis), and where returns on any capital that is invested (i.e. the company’s profitability) are high.

Unfortunately, Marks and Spencer has neither of those traits:

• 10-Year capex/profit ratio = 117% (over 100% is “high”)
• 10-Year return on capital employed = 10.8% (FTSE 100 approx. 10%)

In other words, Marks and Spencer typically spends more on capital investments than it makes in post-tax profits, and the return on those investments is about in line with the market average.

There are a couple of not-very-scientific conclusions I could draw from this:

The first is that Marks and Spencer probably has relatively high fixed costs, even without including the rent paid for each store. It has to continually spend large amounts of money updating existing stores, fitting out new stores and improving IT systems and supply chain infrastructure.

High capex requirements and high fixed costs can lead to volatile profits, cash flows and dividends. However, in Marks and Spencer’s case, it seems to have avoided that volatility to some extent (although by no means completely) by having very steady revenues.

Perhaps its focus on small ticket, repeat purchase items like food and underwear gives it a stream of incoming cash which is steady enough to negate some of the negative aspects of its high capex requirements.

The second conclusion I could draw would be from its average profitability, as measured by its return on capital employed (ROCE). ROCE for Marks and Spencer is about average at 10.8%, although that isn’t particularly good relative to other retailers listed on my stock screen.

This mediocre profitability could mean that while the Marks and Spencer brand is strong enough to secure the company a steady stream of customers looking to buy M&S food and clothing, the brand is not so strong that those customers will pay above market rates for those products.

The company’s financial obligations are worryingly large

Large financial obligations are a key risk, which is why I look at both corporate borrowings (i.e. debt) and defined benefit pension liabilities.

Marks and Spencer has borrowings of £2.1 billion and pension liabilities of £8.1 billion. For the sake of comparison, its most recent 5-year average earnings were £0.5 billion.

Putting those figures in terms of the ratios of debt and pension liabilities to 5-year average earnings gives the following:

• Debt ratio = 3.8
• Pension ratio = 15
• Combined debt + pension ratio = 18.8

I use three rules of thumb which limit how much debt a company can have before I’ll refuse to invest (note that M&S operates in the cyclical General Retailer sector):

• Only invest in a cyclical company if its debt ratio is below 4
• Only invest in a company if its pension ratio is below 10
• Only invest in a company if its combined debt + pension ratio is below 10

Marks and Spencer’s borrowings are quite close to the maximum I would be willing to allow, but more importantly, its massive pension scheme is way beyond the level I’m comfortable with.

Having said that, the scheme is currently in surplus, is closed to new members, and the company is looking to close down any further accrual of benefits to existing scheme members.

If that goes ahead as planned then the pension scheme risk may not get any worse, but even at its current size, a small 10% deficit would leave the company with an £800 million hole to fill from average earnings of only £500 million.

Conclusion and target purchase price

My initial reaction is that I probably wouldn’t buy Marks and Spencer because of its large pension scheme.

However, sometimes I do like to break my own rules of thumb, just for the sake of experimentation to see if they’re still valid or not. So there is perhaps a small chance I would buy Marks and Spencer, but only at the right price.

To calculate my target price I have to have some opinion about a company’s future and so far I haven’t spoken at all about Marks and Spencer’s current (turnaround) situation, its new CEO or its future prospects.

A very short summary of my opinion would be:

I think the most likely outcome is that Marks and Spencer’s future looks more or less like its past; it will sell food and clothing, probably growing steadily over time, but only at something close to the rate of inflation or GDP growth.

With that assumption in place, I find the current share price of 400p only mildly interesting.

At that price Marks and Spencer’s dividend yield is 4.7%, which is certainly better than the FTSE 100’s dividend yield of 4.1% (with the index at 6,300).

However, a 4.7% yield combined with perhaps dividend growth of 2% suggests a possible return on Marks and Spencer’s shares of just 6.7%.

That isn’t terrible, but it is pretty close to the expected market rate of return of perhaps 7% over the long term.

I just don’t see the point of investing in a company if the expected rate of return is little better (or even a little worse) than the market rate of return.

Of course, the actual return from Marks and Spencer’s shares could be much better or worse than that, but why bother to take on the risk of investing in a single company when a much lower-risk index tracker is likely to produce similar returns?

For me to invest in a slow-growth company like Marks and Spencer, I would need a much lower share price and a much higher dividend yield because:

1. A high dividend yield will offset the low dividend growth returns and
2. A high dividend yield will provide a carrot to attract other investors who might then push up the share price, boosting my capital gains

For Marks and Spencer to get into the top 50 stocks on my stock screen (which is where I usually select my next purchase from) its share price would have to fall below 300p.

At 300p the shares would have a dividend yield of 6.2%, which I think would make a much more attractive entry point.

Of course to get below 300p per share Marks and Spencer would probably have to run into some fairly obvious and significant problems.

However, as long as those problems appeared to be fixable and unlikely to damage the long-term prospects of the company, I would be more than happy to invest if the shares did fall below 300p (but I would still probably want the pension liabilities to somehow be cut in half).