Marks and Spencer’s shares may disappoint investors

Marks and Spencer is currently focused on international expansion and transforming itself into a true multi-channel retailer, but will that drive enough growth to offset its relatively weak dividend yield?

It’s an interesting question because, after looking at the company’s history, I think it would take a giant leap of faith to assume it can produce any kind of sustainable growth.

A low dividend yield means investors must be expecting market beating dividend growth

With Marks and Spencer’s shares currently trading at 565p, the company’s dividend yield is just 3.2%. That’s slightly below the 3.6% yield which is available from the FTSE 100 (with the large-cap index at 6,800 points).

To justify that lower dividend yield, investors must be expecting Marks and Spencer’s dividend to grow faster than “average”, i.e. faster than the FTSE 100’s dividend.

Over the long-term, the UK stock market has grown its dividend at around 2% after inflation, or a nominal 4% per year if we assume the Bank of England maintains inflation at 2%.

If the market keeps up that rate of growth then Marks and Spencer will have to grow its dividend faster than 4% a year, for many years, in order to justify its current low dividend yield.

To me it doesn’t look as if that’s the most likely outcome.

Marks and Spencer is not a high growth company

The chart below shows just how flat results have been at Marks and Spencer in recent years.

Revenues have been climbing, but the per-share earnings and dividend figures have gone less than nowhere.

And it doesn’t look any better if I convert that chart into numbers:

• 10-Yr Growth Rate of minus 0.8% – Which is negative (obviously) and below the very weak 1% earnings and dividend growth rate achieved by the FTSE 100 over the same period
• 10-Yr Growth Quality (i.e. consistency) of 67% – Slightly better than the very inconsistent 54% achieved by the FTSE 100

Although Marks and Spencer has produced a profitable dividend in every year, its results are nothing to shout about.

Of course, it does have various strategies to drive growth, such as international expansion, its transformation into a true multi-channel retailer (combining online and offline shopping channels), investing for efficiency and so on.

But its competitors all have their own strategies for growth, and while Marks and Spencer could turn things around and start producing consistent growth, I see no obvious reason why that will be the case.

A company with a history of negative growth is obviously not the most attractive investment on earth, and that’s one reason why the shares need a higher dividend yield in order to be attractive (at least to me).

Also, I have a couple of rules of thumb relating to growth:

• Only invest in a company if its 10-year Growth Rate is above 2% (i.e. keeping pace with inflation)
• Only invest in a company if its 10-year Growth Quality is above 50%

Clearly Marks and Spencer fails the first test. That means I would only invest if the shares were significantly cheaper than they are today, in order to offset the risk that the company is in permanent decline.

There are no signs of a competitive advantage

To be able to grow consistently faster than average, companies typically require some sort of competitive advantage. I like to look for competitive advantages primarily through the return a company can get on the capital employed within the business (ROCE).

If a company can generate above average returns on its capital assets such as shops, factories and equipment, there is a good chance it has some sort of competitive advantage.

Of the 230 or so stocks I track on my stock screen, the median 10-year post-tax return on capital employed is 10.7%, which I usually round down to 10% and use as my definition of “average profitability”.

So how does Marks and Spencer stack up? The answer is – extremely averagely.

Up to the 2015 annual results, Marks and Spencer had a median return on capital employed of 10.8%, which is slightly above my ballpark “average profitability” of 10% and just 0.1% above the actual median of those 230 companies.

Admittedly, those 230 companies are a solid bunch to start with as they all have a 10-year unbroken record of dividend payments. However, among that group, Marks and Spencer does not stand out at all as being especially profitable.

I also have a rule of thumb for profitability, which is:

• Only invest in a company if its 10-year median net ROCE is above 7%

M&S beats my relatively low hurdle for profitability, but it is still no better than average (although at the right price, average can be good enough).

It requires significant capital investment to drive growth

Some companies can get by with a few desks, some telephones and little else. This makes growth easy because all they have to do is buy a few more desks and install a few more phones. I imagine this is what it’s like to run a recruitment company.

But that isn’t true of Marks and Spencer. M&S has to fit out a new store with (probably) millions of pounds worth of shelves, checkouts, cash vaults and facilities for staff.

Even its transition into a multi-channel retailer has required the construction and fit-out of a highly automated distribution centre at Castle Donington, costing many millions of pounds.

Because it’s easier for capital-light companies to grow, I always check how much a company spends on capital expenses (capex) as part of my “value trap” analysis.

In Marks and Spencer’s case, over the last decade it has invested more than £6bn into capital assets, which is more than it earned in pre-tax profits.

That makes it a relatively capital intensive business, where growth and even survival requires large amounts of investment.

That’s fine, but sustaining growth in those sorts of companies, especially those that generate “average” rates of return on capital employed, can be a hard slog.

It has relatively high debts and a massive pension scheme

Currently Marks and Spencer has just over £2bn of interest-bearing debt. That is approximately 3.7-times its average post-tax profit over the past 5 years, where that average is £550m.

I call that ratio between debts and earnings the Debt Ratio, and for cyclical sector companies (Marks and Spencer operates in the General Retailer sector, which is cyclical according to the Capita Dividend Monitor) I have the following rule of thumb:

• Only invest in a cyclical company if its Debt Ratio is below 4

M&S does pass this test, but a Debt Ratio of 3.7 is not a million miles away from 4, so by that measure the company has fairly substantial debts.

That might have been okay on its own, but Marks and Spencer also has another, far larger financial obligation in the shape of its defined benefit pension scheme.

The pension scheme’s liabilities are currently just over £8.1bn, which is almost 15-times greater than the company’s average earnings over the last 5 years (of £550m).

Although the scheme is currently in surplus (i.e. its assets, at £8.6bn, are greater than its liabilities) it still represents a significant risk.

If the value of the assets, which are primarily government bonds, were to fall (i.e. if interest rates rise) then the fund could easily end up with a small deficit.

But with an £8bn pension fund even a 10% deficit would mean an £800m black hole into which the company would have to funnel cash.

Again, I have a rule of thumb for this, which is:

• Only invest in a company if its pension liabilities are less than 10-times its 5-year average post-tax profits

Because of this large pension scheme, I would only consider investing in Marks and Spencer at the moment if its shares were outrageously cheap.

My “fair value” for Marks and Spencer is about 450p

By adjusting a company’s share price until it ranks in the middle of my stock screen, I can estimate their “fair value”, and at the moment fair value for Marks and Spencer appears to be around 450p.

At 450p, Marks and Spencer would have a 4% dividend yield, which is slightly better than the FTSE 100’s 3.6% (with the large-cap index at 6,800).

I think that would be a fair dividend yield for a company that shows no obvious signs of having market-beating growth potential.

However, in order to beat the market you have to buy shares below their fair value, otherwise all you’re likely to get is the market rate of return, and you can get that with a passive index tracker.

So for Marks and Spencer, my “buy price” for now would be around 300p.

That would make it a top 50 stock on my screen and would also give it a dividend yield of 6%.

That may sound like an excessively high yield, but it’s the sort of compensation I would need before investing in such a low growth company.