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Bottom Marks

Created:

29 July 2008

Written by:

Mr Bearbull

What is it about Marks and Spencer (M&S)? How is it that a company can transform itself from being the greatest British business ever created (I hardly exaggerate) to a corporate stooge - a company that somehow always manages to mess up no matter how promising its plans appear?

There is little doubt that over the past 10 years or so this transformation has occurred. Until the mid 1990s M&S was THE special British business. None other quite matched its commitment to quality, its relentless progress, or its place in the hearts and wallets of the British people. Since the mid-1990s, however, it has lurched from one minor crisis to another as a succession of bosses has struggled and failed to keep it looking like western Europe's most successful retailer.

Sure, M&S's past was not so wonderful as nostalgia would have us believe. Even under the control of the Marks and Sieff families, the firm was quite capable of making errors - witness its persistent mistakes in north America. However, these never knocked it off course. It continued to give the impression of having a clear business plan - even if none was formally set - and generated the results to prove it. But since the mid 1990s - and the second half of Richard Greenbury's time as boss - it has appeared more off course than on - with, once more, the results to prove it.

I won't pretend to analyse this decline in the short space available here - though, if I did, I suspect the juxtaposition of the words 'bosses' and 'hubris' might occur more than once. But it is noticeable how successive Marks's bosses have been their own worst enemy, making decisions that looked questionable even before events exposed their shortcomings. And the latest such error that may yet return to haunt the current boss, Sir Stuart Rose, is the company's dividend policy.

A basic primer on dividend policy would state that any payout plan that a company adopts should be clear and sustainable. It is also important to understand that the dividend policy includes both the cash dividends that a company disburses to all its shareholders and the one-off payments that it may make to a few shareholders to buy in shares. Tax considerations aside, these two types of transaction should have the same effect on shareholder wealth.

Buybacks and investment

Marks's problem is that it has embarked on an aggressive share buy-back plan at the same time as it is picking up the pace of capital spending. The effect of this is that in 2007-08 M&S had a cash outflow of £1,825m on dividends and capital expenditure - items that the year before had cost it £992m. Capital spending rose £221m to £925m, but the major new outflow was the £556m spent on buying in 7.4 per cent of the company's shares at an average cost of 441p per share. In aggregate, these items far exceeded M&S's operating cash flow. As a result, its net debt rose by almost £1bn to £2.5bn.

But it gets worse. Marks is committed to buying in another 41m shares this year. Even at the current depressed share price - 259p - that would cost £106m, although management has already bought in some more shares at levels far higher than that. In addition, Marks's bosses plan further heavy capital spending - possibly £900m, almost the same as last year. Then there is the cash dividend. If 2007-08's payout - 22.5p per share - is maintained, that would cost £346m. In total, these items may mean a £1,350m cash outflow this year - an amount that will almost certainly dwarf the group's operating cash inflow, in the process pushing net debt clear of £3bn. That would raise the real possibility that in 2009-10, Stuart Rose's leadership of the company would end with the humiliation of a cut in the dividend - something that has not happened in the 82 years that the company's shares have been listed.

Management would move mountains to avoid this, which is why it remains odds against. After all, capital spending can be scaled back. And, more controversially, the remainder of the buy-back programme can be scrapped - more controversial, because, if M&S's bosses thought the shares were good value to buy in at around 441p, they have to be screamingly cheap at current levels.

Quite likely, however, thought processes were in short supply when M&S's bosses and their advisers decided on the share buy-back programme. Perhaps they were transfixed by the possibilities that an aggressive buy-back scheme offered. After all, what stronger signal could there be that the group's prospects positively glowed and that the shares were laughably cheap than buying in 10 per cent of the company's shares in little more than a year? Besides, every other company was doing buy-backs, so why shouldn't Marks?

While M&S was generating comfortably over 40p of earnings per share, the logic of buying in shares for about 440p each was sound - effectively Marks's outlay was yielding a return higher than its cost of capital. Now that earnings are set to fall below 40p - possibly well below for the next couple of years - the logic looks fuzzier. And the stock market's response has been nothing short of contemptuous. True, that might also have something to do with Marks's decision to defy conventional corporate governance and make Sir Stuart the executive chairman. Still, the effect is that M&S's shares are now 65 per cent below last year's all-time high and the buy-back programme has been worse than useless.

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