Qualiport

Bruce Jackson (TMFGoogly) takes a look at Marks & Spencer's Christmas trading statement and announces a new Qualiport share selection process.

Rentokil Update

This is somewhat of a black week for Rentokil Initial. For the first time this year and only the second time in history (going way back to 19th December 1997), over the course of the week the Qualiport failed to beat the Footsie.

All has not been lost however. Having bought the shares at 255p, they have now risen to 290p. After deducting buying fees and taking into account today's bid/offer spread, Rentokil has still outperformed the Footsie by over 60%. Be sure to check out the current numbers.

The Marks & Spencer Trading Statement

Last week we rejected the biggest and arguably the best retailer in the country, Marks & Spencer, on the grounds of valuation. All our calculations were done assuming a share price of 600p, as this was the price it was trading at 3 weeks ago. It has subsequently fallen to 558p, no doubt on the back of the Fool UK Qualiport snub.

OK, maybe the fall from 600p has got a little something to do with rumours of a disappointing Christmas sales period. Well, all the speculation, concern and whispers were finally laid to rest today as the retail giant released its much anticipated trading statement.

Total sales for the 17 weeks to 24th January 1998 were up 6.4%, compared with the 6.2% increase for the half year to 27th September 1997. Before today's news, earnings per share (EPS) for the full year to March 1998 were forecast to be 28.5p, an increase of 6.3%. Get the message? Yep, you guessed it. Marks & Spencer will grow by about 6% in the 1998 fiscal year. If only all share analysis was that easy!

I'm being a bit blasé. There are a couple of potential pitfalls in simply taking sales increases and assuming they will extrapolate directly into profit increases. The main trap is that the company may be increasing sales at the expense of margins. A knock down post Christmas sale would break all sales records if M&S were practically giving away shoes, underwear and food. But, although turnover would increase rapidly, that wouldn't result in profit growth if, for example, M&S were selling food at below cost. Of course the opposite can also happen -- increased sales with increased margins equals even greater profits.

Luckily for us, M&S are one of our best companies when it comes to investor relations, corporate governance and open accountability. After all, their Chairman, Sir Richard Greenbury, was asked to chair the study on director's remuneration now known as the Greenbury Report. In today's trading statement, M&S stated that gross margins were maintained, but countered that the costs of the post Christmas exceed plan by £15m, and the effect of the strength of sterling would cost the company more than the £20m previously advised. These amounts are relatively small in the whole scheme of things at M&S and won't significantly change 1998 pre tax profit forecasts of about £1125m.

In response to the trading statement, which contained no real surprises, shares in M&S were marked down 20p to 558p. This undoubtedly was due to the 15% sales reduction in the Far East, an inevitable consequence of ongoing economic problems in that region. As a lot of their planned expansion is slated for Asia, analysts are worried that the slowdown may take a while to reverse. There is no reason to believe that M&S are not going to push ahead with their plans for that region -- they obviously have a longer term outlook than the City Wise.

With their share price having dropped 7% from the 600p at which we decided to reject them, the big question becomes at what price would we be prepared to buy the shares? Looking at it another way, if Fool UK could raise the money to buy M&S outright, how much per share would we be prepared to pay?

The long term growth rate of M&S is between 8% and 12% per annum. Earnings per share for the year ending March 1998 are expected to be 28.5p. Because they are a quality company with excellent management and their earnings are reasonably predictable, we would expect to pay a premium for M&S. When buying Rentokil, their full year 1997 P/E was 25, a 25% premium to their stated 20% growth rate. In hindsight, this may turn out to be a bit of a bargain. For M&S, which has similarly predicable earnings as Rentokil, a premium to their P/E of between 25% and 50% would seen appropriate. Putting that all together...

Low Price - 8% growth and a 25% P/E premium. P/E = 10 x 28.5p (EPS) = 285p Mid Price - 10% growth and a 33% P/E premium. P/E = 13.3 x 28.5p = 379p High Price - 12% growth and a 50% P/E premium. P/E = 18 x EPS 28.5p = 513p

Share prices of between 285p and 513p is a very wide range, but at least it gives us some idea of the current valuation of M&S. At today's close of 558p, they still trade above the highest price we would be prepared to pay to take-over the company. If and when they come back into play (ie. fall below 513p), we'll take another look at Marks & Spencer's valuation and prospects.

Going Forward

We are planning to change the Qualiport share selection process. This may not happen overnight (or over a week), but unless Rentokil gets a few mates soon, the portfolio stands very much undiversified and therefore unFoolish. Although we're not expecting any bad news from Rentokil, all portfolios should be sufficiently diversified so as to spread the risk should one or more shares have a Powerscreen type disaster.

So, instead of picking a share a week to analyse, we will be looking at businesses within a sector in order to pick one that is a quality company and reasonably valued. No easy task given the market today closed at an all time record high, but we'll give it a shot anyway.

But, before then and since we're already looking at the retail sector, next week, for one week only, we'll be looking at the second biggest retailer -- The Boots Company. In the 5 years to 31st March 1997, Boots had a total shareholder return of 74.6%, compared with 80.1% for M&S.

Until next week...

Fool on,
Bruce Jackson (TMFGoogly) Qualiport Numbers

Rec'd      #     Stock      Bought     Now     Change   Change
                             £          £        %         £

19/12/97  1565  Rentokil      2.55     2.90   +13.7%     +0.35
19/12/97  1565  Rentokil  4,040.63 4,538.50   +12.3%   +497.87


                   Week          Year         History

Qualiport          -1.7%         +9.9%        +12.3%
FTSE 100           +1.9%         +4.6%         +7.0%