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THE DIVIDEND HUNTER | Is M&S's near-6% dividend yield big enough? by John Kingham

Cover of The Defensive Value Investor by John Kingham Marks & Spencer is one of the most obvious dividend-paying stocks in the UK market. With so much attention from investors a company like this should be priced correctly (or so the theory goes), with shares that have no chance of generating market-beating returns other than by pure luck. That may or may not be true, but what I do know is over the last 15 years investors would have done very well buying M&S shares when the price fell below 300p and then selling within a few years for a gain of anything between 50% and 100%.

Of course there is far more to investing than simply buying at some historically successful price, but with a current price of 333p and a dividend yield of 5.6% I do think Marks & Spencer is worth looking at in some detail.

A cyclical company with a track record of highs and lows

I mentioned above that M&S shares have fallen below 300p more than once over the last 15 years and then subsequently performed well each time. In fact the shares have traded in a range between about 300p and 600p for more than two decades. This rejects two features of the business: first, that there is no strong growth trend; and second, that the company is cyclical. The lack of a strong growth trend is not all that surprising. The company started out in the 19th century and is about as mature a business as you'll find anywhere. The UK has been well and truly saturated with M&S stores for a long time and so the company's miniscule long-term growth has come mostly from inflation, real wage growth and an increasing UK population.

I've included a chart which shows Marks & Spencer's financial results over the last few years and it more or less covers one business cycle. The chart starts o with a recession around 2008-2010 and with M&S cutting its dividend. After 2010 (or thereabouts) the economy stabilised and the dividend was increased, then held for a few years and then increased again. So the chart shows an economic bust and a slow recovery, but that recovery has yet to turn into a boom.

The company's share price reacted to these events as you might expect. During the bust of 2009 it fell as low as 200p and was below 300p for about a year. The dividend yield was over 6% for much of that time which must have been very attractive for those who know that recessions do not last forever. During the recovery investors were much more optimistic and in 2015 Marks & Spencer shares were selling for more than 500p. In fact at one point that year someone paid almost 600p per share.

Boom, bust, repeat

This is a story that M&S investors have heard before, such as during the 1990s boom when M&S more than doubled its dividend and then cut it by almost 40% when the inevitable bust arrived in 2000. Or during the mid-2000s boom that followed, when M&S again doubled its dividend and then cut it by a third in the 2009/2010 recession. Over those 20 or so years M&S has been unable to sustain its dividend for long once its ten-year dividend cover (the ratio between the company's cur- rent dividend and its ten-year average earnings) falls below 1.5.

For example, after a long run of progressive dividend growth the dividend reached 14.5p in 1999. At the time the company's ten-year average earnings were 20.2p giving it a ten-year dividend cover ratio of 1.4. The next year the company's results sagged and the dividend was cut back to 9p, increasing its ten-year dividend cover to a more reasonable 2.2. The same thing occurred in 2008 when the dividend was pushed up an almost laughably optimistic 23% in a single year to 22.5p. At the time the company's ten-year average earnings were just 23.9p giving it a ten-year dividend cover ratio of 1.1. Over the next two years the dividend was rebased to 15p as the post-2009 recession hit, giving the company a much more sustainable ten-year dividend cover ratio of 1.8.To some extent these recurring dividend cuts are understandable as M&S operates in the cyclical high street retailer sector. I still think it's slightly disappointing though. I don't think it would be too hard for M&S to have a truly progressive and cautious dividend strategy simply by keeping its ten-year dividend cover ratio closer to two at all times. I think this would be much better than its historic strategy of raising the dividend too quickly, only to cut it back during the next inevitable recession.

Is a dividend cut on the cards?

Currently the company's ten-year aver- age earnings are 35.8p and its dividend is 18.7p. This gives the company a ten-year dividend cover ratio of 1.9, which is well above the historically dangerous zone of 1.5 or less, so I don't think a dividend cut is very likely anytime soon. I think M&S has this fairly cautious dividend cover because we haven't had a boom period to follow the 2009 bust, and so management have yet to become overly optimistic about the company's future. Start to worry when you see several years of dou- ble-digit dividend growth and exces- sive exuberance from the CEO.
Slow growth fails to keep up with in ation
So the company is cyclical and has a somewhat bumpy track record, but I also mentioned that it has no strong growth trend. You can see this in the most recent cycle (the period covered by the chart) where M&S managed an overall growth rate (a combination of revenue, pro t and dividend growth over ten years) of just 0.3% per year. That, of course, is not exactly electri- fying. Over the same period the FTSE 100 managed to grow, using the same measure, by 2% per year. Clearly then, M&S is a slow growth company which isn't keeping up with in ation or the UK stock market as a whole.
However, just looking at overall growth misses an interesting aspect of M&S, which is that it is e ectively two highly integrated but quite di erent busi- nesses, one which sells clothing and homewares and another which sells food. Not only are these two busi- nesses di erent in nature, they've also had very di erent results since the turn of the millennium.
M&S's future may lie primarily in food
If you dig into the archive of M&S annual reports you'll see that clothing and household revenues were around £4 billion in 2000 while food revenues were less than £3 billion. Lay out the annual reports for the following 16 years and you'll see two completely di erent stories. In clothing and home- wares (i.e. non-food) you'll nd a total lack of sustainable growth, leaving non-food revenues in 2016 at around £4 billion, pretty much where they were in 2000. In food you'll nd reve- nue growth in almost every single year, leaving 2016 food revenues at £5.5 bil- lion, almost exactly double their 2000 level.
So what's going on here? I'm sure an entire book could be written about M&S's trials and tribulations over the
last couple of decades, but here's my very much condensed version:
Marks & Spencer clothes are gradually falling out of the mainstream because they are failing to attract su cient numbers of younger people to replace their traditional older customers as those customers depart this mortal world. There have been innumerable e orts to turn this situation around but none have succeeded in any mean- ingful or sustainable way, other than perhaps to slow the decline.
In food the picture is very di erent. Following a run of success from the food business, M&S decided to start opening food-only stores, smaller Sim- ply Food stores and "food on the go" railway concessions in 2002. In that year there were only a handful of each, but the programme worked and rapid expansion followed. Today there are over 222 Simply Food stores owned by M&S in the UK and over 349 operated by franchisees, an amazing 62% of the company's entire fleet of 914 UK stores. Yes, the Simply Food stores are typically smaller than the company's combined clothing and food stores, but their sheer number negates that and they are the major reason why 58% of Marks and Spencer's revenues now come from its food business.

This distinction between the food and non-food businesses is important because it may be a glimpse into the longer-term future of M&S. The clothing business may be in terminal decline, or at least terminal stagnation. The food business on the other hand may be able to continue growing at the almost 5% per year it's achieved over the past 16 years. Once the UK is saturated with Simply Food stores M&S may be able to roll the idea out internationally to drive longer-term growth. This process has already started with some franchised Simply Food stores in France, but I must admit that M&S does not have a good track record of international expansion.

Of course this is pure speculation, but I wouldn't be in the least bit surprised to see more than 70% of M&S's revenues coming from food within the next ten years. And this isn't simply idle spec- ulation because I, like most potential M&S investors, want to know whether long-term dividend growth is a realistic possibility for this company or simply wishful thinking.

Prospects for dividend growth have a massive impact on what sort of share price and dividend yield make sense today, but before I talk about the share price I'd like to mention one of the enduring risks to this business, which is its considerable nancial obligations.

Large debts and pension liabilities make M&S riskier

For some reason or other M&S has traditionally chosen to carry a heavy debt load relative to many other high street retailers. Larger debts can boost pro ts during good times, but they can also increase the damage done during downturns and I think that Marks & Spencer's habit of cutting its dividend during a recession exists in no small part because of its heavy debt load.

Its current total borrowings of £2.2 billion are exactly four-times the company's five-year average normalised post-tax pro ts of £0.55 billion. This ratio of debts to average pro ts is my primary measure of financial lever- age and a ratio of four is interesting because that is exactly my preferred upper limit for cyclical companies. In other words, M&S has about as much debt as I'd be willing to stomach from a cyclical company. Admittedly, M&S is relatively defensive for a cyclical company, but I would still prefer to see those debts come down by perhaps 50%, and I would much rather see that happen during the next boom than an overoptimistic and probably short-term increase in dividends.

The other major financial obligation I look at is defined benefit pension liabilities. I'm looking to avoid pension liabilities that are more than ten-times the company's recent average pro ts, which as we just saw are £0.55 bilion for M&S. Unfortunately M&S fails this test as its pension liabilities are a whopping £8.1 billion, some 14.6-times its average pro ts. The scheme is currently in surplus, but if that were to change then a deficit of £1 billion or more could easily be on the cards, and M&S would be legally obliged to remove that deficit by diverting cash away from shareholders and towards the pension fund (the company is already paying almost £30 million a year into the fund to defend the surplus). One positive point is that the scheme has stopped accruing future benefits for current members in order to reduce risk, although of course this is not such a positive point for the affected employees.
Normally this massive pension would be a deal breaker for me, but perhaps if I was in a good mood then I might still consider an investment in M&S because I do think the business is fundamentally sound. But what price is the right price to pay?

333p could be good, but 300p would be better

At its current price of 333p and with a dividend yield of 5.6% I think M&S shares are quite attractively priced. Each week I build a stock screen of dividend-paying companies and M&S currently ranks 85th out of 230, so it's just outside the top quartile. Generally I like to stick to buying companies that are in the top 50 and to join that club M&S would have to drop below 300p, at which point it would have a nice 6.2% yield as well.

If I did invest in M&S there are a few things I might suggest to its management. These are: 1) Pay down debts before increasing the dividend; 2) Reduce those pension liabilities through a deal with an insurance company; 3) Institute a cautious and progressive dividend policy to avoid future dividend cuts; 4) Continue the shift towards food and find ways to repeat food's UK success overseas.

If M&S followed those four actions then I think inflation-beating dividend growth could be sustainable over the longer-term.

About John
John Kingham is the managing editor of UK Value Investor, the investment newsletter for defensive value inves- tors which he began publishing in 2011. With a professional background in insurance software analysis, John's approach to high yield, low risk investing is based on the Benjamin Graham tradition of being systematic and fact- based, rather than speculative.

John is also the author of The Defensive Value Investor: A Complete Step-By-Step Guide to Building a High Yield, Low Risk Share Portfolio.

His website can be found at: www.ukvalueinvestor.com.
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