Marks & Spencer – if it’s 400p it must be a takeover play

Marks & Spencer – if it’s 400p it must be a takeover play

29 Nov 2012

In the investment rule that I call “Competing Assets” I included four ways in which investors in a company’s equity should look to get paid out. They are 1) by the share price appreciating because the value of the company increases; 2) by the equity’s share of the company increasing relative to the share of other liability holders; 3) through direct pay outs in the form of dividends; 4) through the sale of the whole business at a premium.

M&S is obviously a very mature brand with a business model that some might unkindly label “dinosaur”. If it ever joins the e-commerce party it will be a late arrival. The chance of 1) (the value of the company increasing) looks modest. The same goes for 2); indeed, with capital expenditure growing this year and next, the opposite (the equity’s share of the company’s value declining) looks a risk.

This leaves us with 3) (dividends) and 4) (takeover).

There seems to be no serious risk to the dividend but no obvious reason why it should be increased. At present, M&S is maintaining its dividend (recent half year results). As such, we can look at the dividend yield (4.4%) and compare it to alternative investments as we wish. 4.4% is not to be sneered at but you can do better from Tesco and Sainsbury.

But as the price occasionally pushes towards 400p (389p today) there is reason to think that a small takeover premium has crept into the share price.

One of the obvious poison pills that a buyer of M&S would have to swallow is its pension liabilities. Any venerable, domestic company with a large workforce has potential problems with pension liabilities. As interest rates fall, the actuarial calculation of the present value of pension liabilities goes up. From that point of view, the current era of low rates is not good news. In addition, the actuaries have noticed that people are tending to live longer. Good luck for them but bad news for the pension liability.

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. To express the increase in terms of the equity, that’s 51p per share.

Marks and Spencer plc  i s a general partner and the Marks & Spencer UK Pension Scheme i s a limited partner of the Marks and Spencer Scottish Limited Partnership (the Partnership). As such, the Partnership is consolidated into the results of the Group.

The Partnership holds £1.5bn of properties which have been leased back to Marks and Spencer plc a t market rates. The Group retains control over these properties, including the flexibility to substitute alternative properties. The limited partnership interest (held by the Marks & Spencer UK Pension Scheme) entitles the Pension Scheme to receive an annual distribution of £71.9m from the profits of the Partnership earned from rental income.

I n 2009, it was agreed with the Trustee that this distribution was discretionary a t the instance of Marks and Spencer plc. The discretionary right was exercisable if the Group did not pay a dividend or make any other form of return to its shareholders. O n this basis, the future value of total discretionary scheduled payments was an equity instrument, disclosed within other reserves. 

O n 21 May 2012 the Group changed the terms of the Partnership to waive the Group’s limited discretionary right over the annual distributions from the Partnership to the Pension Trustee. This brought discussions with the Financial Reporting Review Panel (FRRP), that had been ongoing since February 2010, to a close.  The change has been reflected by the de-recognition of the related equity instruments and recognition of a financial liability. The financial liability has been initially measured at fair value of £606.0m, representing the present value of the remaining ten years of distributions of £71.9m per annum. The difference between the value of the derecognised equity instrument of £427.9m and the fair value of the liability has been recognised in equity in accordance with IAS 32. The change has no impact on the cash flows of the Group.

To translate as best I can, in 2009 the group tried to have its cake and eat it with regards to its pension liability. Paragraph three describes how the annual payment to the pension scheme ceased to be guaranteed but could be withheld at the discretion of the company in the event that e.g. the financial situation of the company should deteriorate to the extent that the shareholders’ dividend was scrapped. Consequently, because the liability was not guaranteed it was not required to be explicitly visible on the balance sheet. For accounting purposes, it was something less than a financial liability. It was in fact an “equity instrument”.

In May 2012, the pension trustees called time on this accounting play and reinstated the guarantee and the financial liability.

As the excerpt above states, “the change has no impact on the cash flows of the group”. In which case, one might ask what all the fuss is about. A frequent answer to questions such as this is that the company is in fact somewhat sensitive about the presentation of its financial liabilities because it is not entirely comfortable with its cash flows.

Returning to those H1 results one can see that free cash flow was the weakest since H1 2008. Free cash flow (after capital expenditure) was just £35m. Moreover, this continues a sequence of decline: 2008: £345m; 2009: £283m; 2010; £195m: 2011; £142m: 2012; £35m.

M&S needs to raise investment to compete but is doing so out of stable-but-not-growing operating cash flow. This is why the dividend for fiscal 2013 looks as if it will be unchanged on 2012 and 2011. It also explains why the reappearance of hidden financial liabilities is uncomfortable.

Yesterday the shares jumped slightly on the following press release:

Marks and Spencer Group plc (“The Company”) today announces that it has reached agreement with the Company’s Pension Scheme Trustees on the terms of the triennial actuarial valuation as at 31 March 2012.

The valuation of the Company’s UK defined benefit pension scheme (“Pension Scheme”) at 31 March 2012 has resulted in a deficit of £290m. This represents a substantial reduction in deficit from £1.3bn as at 31 March 2009.

The improvement reflects the additional contributions made to the Pension Scheme following the 2009 valuation together with strong investment growth and sound risk management. The valuation is based on the same methodology adopted for the 2009 valuation but incorporates the latest asset values and revised assumptions in relation to longevity.

The Company and the Trustees have agreed a 10 year funding plan, which includes annual cash contributions of £28m per annum from 2013/14 to 2016/17, a reduction on the previously agreed £60m per annum until 2017/18. The remaining balance is expected to be met by investment returns on the scheme’s existing assets. These contributions are in addition to the payments under the existing pension property partnership.

If I understand this correctly, this is a different pension liability from the one discussed above but what looks important is that it implies that the company and the pension trustees are resolving their differences. The stock market reacted positively because the resolution of pension uncertainty fuels belief that M&S could be a takeover target – the poison pill is being sweetened.

Is M&S a plausible takeover target? I can say with confidence that I have no clue. 

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