Hidden charms of Mrs M&S

5 Jun 2016

Back in November one of my first ever blogs was about M&S. The shares were trading at 389p and I wrote that only takeover interest could justify a higher price but I thought that the pension liabilities made that a very unlikely prospect. For reasons which were and remain unclear to me the shares touched 600p last year but M&S has not yet been taken over and they have now tumbled all the way back to 355p.

A battered low-end competitor BHS has just been closed with 11,000 jobs lost and 164 stores closed. It is no surprise that it was the pension liabilities that provoked the final bullet to the head. In addition, Austen Reed is closing 120 outlets at the cost of 1000 jobs and Matalan is reportedly struggling under its debt burden. (Matalan’s founder loaded it with extra debt in order to pay himself a dividend – sound familiar?)

A hard-headed analysis might suggest that the closure of a competitor is good news for the other clothing retailers but on 25 May M&S shares were hammered following publication of its 2015/16 results. Excluding last week’s ex-dividend adjustment they are down 17% (from 445p).

For the nth year, M&S is having trouble with its Clothing business. The CEO was ridiculed for referring to the core customer as “Mrs M&S” though the results presentation offered the slightly surprising observation that 42% of its 32 million customers are men.

I seriously doubt if there is any company on which more people have an opinion than M&S. There are millions of experts out there. I can read in the presentation what customers are complaining about. There is too much choice, too much fashion at the expense of style, too many sizes out of stock and not enough consistency about price and value.

As someone burdened by little interest in shopping or retailing I must say that none of that looks impossible to fix. You can also shop at M&S online though I don’t know how well it works or whether that would appeal to the 78% of customers who are 35 or over (still reading the presentation).

Following the rather negative publicity and the share price fall, I looked at the 2015/16 financial results and found that, according to what matters to me, they were rather good.

Let’s start with the pension. Back in November 2012 I wrote as follows.

The M&S half year results (published on 1 November) were interesting reading in this respect, once you made your way to Note 10 on page 26 (of 28). This explained why a special pension liability of £541m had appeared on the balance sheet, thereby helping to take net debt, including net pension liabilities, from £1738m in March to £2557m in September.

Imagine my surprise now to see that there is a pension surplus and the net debt including pension liabilities is more than £1 billion lower, at £1418m. On the face of it, that takeover speculation could return. The pensions “poison pill” has gone.

In 2012 I wrote that there seemed no reason to cut the dividend (then 17p). In 2014/15 it was raised to 18p and in 2015/16 to 18.7p. This is more than twice covered by free cash flow.

M&S may be something of a high street dinosaur but it is a sturdy work horse when it comes to cash flow. Net operating cash flow is after tax has been paid. Capex is all investment in fixed and intangible assets (like software). Free cash flow (Ent FCF) is what is left after the latter has been subtracted from the former.   

The chart shows that annual net operating cash flow has traded consistently around £1200m. This is despite the fact that operating profit has roughly halved over the period (from £1050m to £584m) and the operating margin has fallen from 12.2% to 5.5%.

This is a good illustration of why investors should as a rule focus more on cash flow than on accounting (or adjusted) profits, even though it involves doing some work.

In 2007/8 Marks &Spencers’ sales were split 50/50 between food and general merchandise (aka “clothing and home”).  The gross margin of food is typically just above 30% but much higher in general merchandise (55% last year). The revenue split of M&S is now 58/42 in favour of food for the obvious reason that clothing sales have constantly and notoriously misfired and food has not only done well in the main stores but is being aggressively expanded through the smaller Simply Food outlets. That must partly explain the fall in average group operating margins.

The other major pressure on operating profit is higher charges for depreciation, amortisation and impairment of past investments. The red line on the chart shows that in 2007 and 2008 M&S was investing merrily in capex. This burdens future operating profits with higher depreciation costs but it does not affect cash flow because these are just book-keeping charges.

Cash flow does not care that the company is expanding into lower margin areas. It also doesn’t mind that mistaken past investments have to be written down against today’s profits. Ol’ man cash flow just keeps rolling on.

In common with most other companies M&S is now cutting capex. In 2016/17 it plans to reduce capex further (from £550m to £450m.) The green line on the chart is enterprise free cash flow – that is operating cash flow minus tax and minus capex. After a peak of sorts in capex in 2012/13 (new store format, apparently), the subsequent discipline has allowed free cash flow to grow very nicely. This has allowed M&S to raise dividends and to reduce debt.

What’s not to like? The answer to that is £150m pissed away (excuse my language) on stupid share buybacks last year which were doubtless executed at prices that look embarrassing now. How many times do I have to make this point?

Finally, I did some due diligence yesterday morning and went into M&S in Lewisham. It was about 09.15 and not very crowded but it looked fine to me. I even bought some T shirts (plain, £6) which were largely properly marked and I didn’t have to queue to pay for them. The staff members I saw were helpful and not pushy though I’m not sure how I feel about being addressed as “dear” by a woman twenty years my junior. Had she known that I am a shareholder I’m sure that she would have called me “sir”.