Qualiport

M&S A Sell?

by Bruce Jackson (TMF Googly)

Kilburn, London -- It's certainly been a busy few days here in Qualiport land. Yesterday we had 2 out of our 8 companies reporting, and for conflicting reasons both have been in the news. We've finally discovered who's Warren Buffett's mysterious UK company. And we've also had some interesting news from one of our Qualiwatch companies.

But first things first. Marks & Spencer (LSE: MKS). Results for the year to March 31st 1999, released yesterday, were in line with much reduced expectations. On sales flat with fiscal 1998, at £8.2 billion, operating profits sank 43% to just £600.5m, giving M&S an operating margin of 7.3%, compared to 12.7% in 1998. Fully diluted adjusted earnings per share (EPS) -- what a mouthful, but that's the best EPS number to use -- dropped by 42.1% to just 15.7p, well below the level achieved way back as far as 1993. To say that M&S took a backward step in the last 12 months is a huge understatement.

Before we go on, let's not underestimate how much of a bad year M&S has just had. This is horrendous! Put another way, M&S has to grow EPS by a whopping 72.6% just to get back to the per share earnings achieved in 1998. That's clearly not going to happen in one year. If the company grew EPS at a compound rate of 12% per annum, which is a respectable rate of growth, it would take 5 whole years to reach the 27.1p of 1998. Looking at it this way, we are lucky the shares are only down 27% since we bought them at 554p just over a year ago.

It is a new, far humbler M&S management that reported yesterday's results. They have been clearly shaken into action by the company's "unacceptable fall in profitability and market share." We've already heard that many typically middle management jobs will go, and there will be a streamlining of the previously centralised but laborious decision-making process. However, the big question remaining is whether this will be enough to restore the company's battered fortunes.

The M&S brand remains strong but has undoubtedly taken a bit of a beating over the past 12 months, as customers have voted with their feet. Like for like sales -- the key measure when it comes to retailing -- continue to be stuck in negative territory. April 1999 saw them fall by 7.2%, with the first 2 weeks in May showing a recovery to a still negative 2.6%. As you can see, getting that 12% per annum EPS growth that M&S needs every year for the next 5 years just to achieve 1998's level of profitability won't be easy.

At this stage, I've been deliberately focussing on the numbers. All the words and the best will in the world are one thing, but the numbers never lie. And the bad news doesn't stop with the income statement. Turning to the balance sheet, stocks continue to rise, albeit by a relatively small amount. Other adverse changes in working capital (higher debtors, lower creditors) see cash from operations again less than accounting operating profits. The end result is that from a net debt position of £319m in 1998, M&S is now in debt to the tune of £1,181.6m. Whilst this level of debt is manageable, it is clearly going in the wrong direction.

As you can guess by now, I'm not exactly thrilled to be holding shares in M&S. The business has clearly deteriorated since we first bought it. That is one of the Qualiport's selling criteria. The international expansion has faltered, and the company is reducing its capital expenditure as it scales back planned new store openings. The big unknown is whether M&S can do a Next (LSE: NXT). That retailer had an untimely profit warning back in March 1998, causing the shares to drop dramatically. Their 1998 first half profits slumped by 35%, and the shares tumbled to as low as 352p. Today they stand at 792p -- some recovery. That is not entirely surprising given yesterday's trading statement, which said that sales for the first 15 weeks of the new financial year are up an enormous 14% on a like for like basis.

M&S is a lot bigger than Next and will therefore be harder to turn around. The shares currently trade on a fiscal 1999 price to earnings ratio (P/E) of 25.6, which hardly makes them look cheap. I suspect the dividend yield is helping hold up the share price, as it now stands at net 3.6%, which is above the market's average of about 2.4%. Even still, in my books a yield of 3.6% isn't reason alone to buy the shares.

M&S remains on Qualiport double secret probation and could be headed for the chopping block. I want to do some valuation calculations first, but I suspect we can invest our money into a better company and achieve better returns. That company could be something like Misys (LSE: MSY), down 15% since we purchased it. If that's the case, selling M&S is a no-brainer.

However, before making a decision, I'd like to invite feedback to the Qualiport message board. I know I risk being accused of short-termism -- selling the shares after only a year, not giving M&S a chance to recover, and dumping possibly the best-known brand name in the country. But I'm trying to look at the facts and take emotion out of the equation. I'll also be wandering over to the M&S message board and making a rare appearance amongst the majority of M&S bulls.

Moving quickly on...

Dell Computer Corporation (Nasdaq: DELL) yesterday reported first-quarter results that merely matched Wall Street's expectations. That's usually bad news, in the short term, for Dell's share price, as the market is used to them beating earnings expectations. Sales grew a stellar 41%, and diluted EPS rose 45%. Nevertheless, on a quarter to quarter basis, gross margins fell from 22.4% to 21.5% as aggressive price cutting took its toll on per unit profitability. This was well flagged in advance of he results.

As of writing, the Dell share price was off 10% today. A couple of analysts reduced their EPS forecasts to around 70 cents for the year ended January 2000. The valuation model I did when we first bought Dell remains largely unchanged, although I do owe it a bit of tweaking. At about $40, the shares are trading on a forward P/E of 57. That's not cheap, but this is still a great company, growing at well above the industry rate and still generating oodles of cash.

Warren Buffett has finally revealed his UK hand, and the mystery share is...

Allied Domecq (LSE: ALLD)

I've written a couple of things about that company recently, so I will simply point to those links, should you wish to read them.

A possibility?
Reality?
An arbitrage situation?

Briefly, Buffett remained true to form by buying a company that looks cheap. However, if he was looking for good management and a good past track record, he's barking up the wrong tree. As to the logic behind the buy, we'll probably never hear it from Buffett himself. This is such an insignificant purchase for him (£120m) that it won't get a mention in next year's Berkshire Hathaway letter to shareholders.

Qualiwatch company Glaxo Wellcome (LSE: GLXO) is, bit by bit, inching ever closer to our target buy price of 1500p. Today the shares closed at 1729p, still over 15% ahead of where we'd like to see them. At the annual general meeting (AGM) on Monday, Glaxo reported that sales for the first four months of the year were up just 2%. For many other companies on a P/E rating of 35, that would have meant disaster for the share price. But not Glaxo, as itis in the market's darling pharmaceutical sector. Glaxo reiterated the target of double-digit sales and earnings growth for the whole of 1999. All I can say is that they'll have to get a wriggle on if they've got any hope of achieving that target. I still think we might, just might, see Glaxo at 1500p sometime this year.

Friday's report will be penned by Rob Davies (TMF Essex). He's had nothing to do with the poor performance of this portfolio, so don't blame him! I'll be back next Wednesday to pick up the pieces.

Company  Change    Bid
     DELL   +$0.90   $44.00 
EMA     +0.05    12.75
IIG     -0.03     2.65
MKS     +0.05     4.02
 MSY     -0.11     4.94 
PIZ     +0.07     9.32
RTO     -0.11     2.56
ULVR    -0.08     5.55

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