Qualiport

[ Wednesday, 26 May 1999 ]

Fool Sells

Last Friday, Rob Davies sat in the Qualiport driving seat and led us through a very amusing scenario for Marks & Spencer (LSE: MKS). It revolved around such figures as the Finance Minister of Trascanistan and his chief financial adviser, Mr S. Limey, who was advising him to buy the company for £11 billion, its current market capitalisation. If you missed it last week, I urge you to give it a read. Whilst you're there, check out the news release regarding Misys' (LSE: MSY) US foray into the Internet world. And finally, pop over to the Misys message board, particularly this post from our very own Dr David Berger (TMF FoolUK).

When buying shares in a company, you are buying a part-ownership of that company. If you had the financial resources, you should feel comfortable buying the whole company. Rob was effectively saying -- and this is my take on it -- that our friend the Finance Minister of Trascanistan should buy the whole of M&S. After that, he would restructure it, gear it up with debt and sit back and wait for the cash to roll in.

Unfortunately, as a shareholder and part-owner, I haven't got that luxury. I've got to leave it to the incumbent M&S management to make those decisions, and they certainly aren't going to leverage the company to the hilt and use it as a cash machine. I wouldn't want them to, either. I'm looking for long-term, sustainable growth, and I want to see money reinvested in the business to fuel future growth.

The problems of M&S have already been well documented here, in the press and on the company's message board. The unique thing about the company is that everyone has an opinion on it. We've all grown up with M&S. We've all shopped there, and many of us have seen firsthand the problems the stores are currently having. And then there's the debate about whether management will be able to turn things around. They have a plan in place to address the problems, and they seem determined to lift the performance of the company. That debate will run and run.

When the Qualiport originally bought M&S, back just over a year ago, I definitely put the mockers on them by saying:

"We can also assume that they won't... have the wrong style of clothing in stock at the wrong time of year. M&S' stable diet is essential clothing for Mr and Mrs Average. This is one company that is not going to be caught out on fashion changes."

Gong. They got it horribly wrong and paid the penalty. Fashion retailing, even for M&S, is a notoriously difficult business to get right.

I also said:

"The beauty of an investment in Marks & Spencer is that you don't really have to go into too much detail when looking at the numbers. Because we know they are well managed, we can therefore assume that they've got their eagle eyes on important things like stock, debtor and cash levels."

Gong. Rising debtor and stock levels could have been the warning signs that things weren't quite as they seemed.

You never stop learning in this investment game, and you always learn the most from your mistakes. Never again will I invest in a company on trust, especially if the numbers are trying to tell me something different. The 1500p price tag I've put on Glaxo Wellcome (LSE: GLXO) is an example of the numbers telling you something different from the head.

I've spent a large part of this morning going back and retrospectively doing my numbers homework on M&S. It's obviously just completed a poor year, and that is reflected in some of the ratios. The company will improve on that in the coming years, but by just how much remains uncertain. That's one of the things that's lacking about M&S -- certainty of earnings. Are profits going to be materially higher in 5 years? One would hope so, but can one be certain? And in 5 years, it could be that profits are only just recovering to their 1998 levels. That's 5 wasted and backward years. Although we are long-term investors, if a company goes nowhere in 5 years, we're looking at below average returns.

Back to ratios, valuations and my exciting morning with the M&S annual report. Here's some of the salient facts:

The 1999 return on invested capital (ROIC) was 7%. The company's weighted average cost of capital (WACC) is 10.6%. In 1999, the company destroyed shareholder value. The ROIC in 1998 was 14.7%.

The company is continuing to invest capital in the business. If they were to get back to the 1998 ROIC of 14.7%, profits in 2000 would have to grow by 129%. I wish them luck. The reason such a big jump is required is that M&S has invested considerably more into the business, so the ROIC we're looking at would need to come from a much higher base.

(I know all this ROIC and WACC stuff is new to most Fools. I'll explain more about these concepts in the coming weeks. They are fairly logical. Click here for other stuff on How to Value Shares, referred to below.)

A 10-year earnings per share (EPS) growth rate projection has the shares returning a compound annual growth rate (CAGR) of 9.3%. This is based on some fairly optimistic EPS growth rates. This is below our 15% CAGR hurdle but above the building society rate of return.

1999 free cash flow was negative. It's not going to get too much better in 2000. A discounted cash flow projection gives M&S an intrinsic value of £3.5 billion versus its current capitalisation of £11.4 billion.

I can't see the dividend being lifted by more than 5% per annum for the next 10 years. It will take that long for the dividend cover get close to 2, the level it was in the years before 1999.

In short, on the numbers front, there's not a lot of good news. I firmly believe that over time, valuation matters. There is a chance that the share price moves sharply higher or lower in the short term, but eventually a company's share price reflects its true valuation.

M&S was a good company -- a great company. It is not one right now. It retains its brand name, but it is being diminished through its well-publicised problems. The competition has caught up to M&S, especially with regards to foods. Retailing is a tough business, even for the best, as M&S has found. On the flip side, Next (LSE: NXT) has bounced back from its 1998 profit warning and looks to be going from strength to strength. M&S could do a Next, but is obviously a lot bigger, and therefore this would be a more difficult task.

Investment decisions are emotional, whether we like it or not. However, I'm trying to take emotion out of the question by concentrating on the M&S numbers. What I see, I don't like.

The Sale

In the next 5 trading days, under the Fool's trading rules, the Qualiport will be selling 368 shares in Marks & Spencer. We wanted to hang onto them for 5 or 10 or more years, but in my mind this is not the company we first invested in. Also, if I had run the numbers before buying the shares, there's a very good chance we'd have never have bought them in the first place. I made a mistake, and so did they. Two wrongs don't make a right.

I hope M&S does recover its former glories. If that happens, the share price will also track higher. However, on what I'm looking at now, I can't see it happening anytime soon.

Comments encouraged to the Qualiport either/and/or M&S message boards. Rob is back on Friday.

Company  Change    Bid
DELL   -$1.60   $34.40
EMA     +0.06    13.04
IIG     +0.02     2.87
MKS     +0.05     3.87
MSY     -0.07     5.31
PIZ     -0.10     9.45
RTO      0.00     2.48
ULVR    -0.15     5.47