M&S – on the cusp of an exciting speculation

Marks & Spencer at 315p post Brexit and post Q1 Trading statement (Pre Brexit.)  How Brexit might radically change things? Earnings would seem to have to fall a long way to make these shares seem dear.

In the midst of the mountain slide of domestic UK share market capitalizations came the results from Marks & Spencer (MKS) to prove that there was at least some stability in this mad and seemingly unpredictable world. (Essentially, that once again, Marks & Spencer food sales were up and household and clothing sales down.)

And in the middle of all that, the share price of the company fell and then rose like a dangerous out of control firework, moving at speed from one spot to another, causing utter confusion.

The rocket of a share price, fell to 255p on 24^th of June, “Brexit Day”, before then jumping again like one of old Barnes Wallace’s bouncing bombs, aimed at bringing flood and devastation to the very heart of the EU (sorry, I mean the ‘Third Reich’.) Meanwhile, the bouncing bomb of a share price has now reached 315p (last seen) having risen 23.5 percent in a few short days.

The share price fall made sense given the “Doomsday” aspect of the great democratic vote that was “Brexit” (a bit like witnessing inebriates performing advanced heart surgery from a book, urged on and advised by ‘wide boy’ encyclopaedia salesmen in a “Carry On” film) but the subsequent share price bounce seems to defy reason. Why should people buy a share when the average UK shopper was suddenly about to be become mighty hard up because of the dramatic fall in the pound sterling , whilst others apply for Irish Passports ?

Being a child of a past mechanical engineering culture I have opened the bonnet to have a look at the engine, in the shape of the last set of annual accounts, to see what is happening.

I conclude that it may have been a case of the vehicle hitting fundamental value. At 255p, according to my calculations, the share was valued at just 3.25 times last year’s operating cash flow; net assets attributable to ordinary shares stood at 222p so that one was paying only 33p for earnings; about as close as you can get to giving away the company for a hand of pennies. I add that for a net 33p, an investor could take a stake in a share that represents control over a total asset, enterprise value worth on my figures about 547p a share. I add that sales revenue on that basis seems to have been worth 690p a share.

Whatever the precise reason for the bounce in the Marks & Spencer share price, it did represent remarkable equity value.

When I reviewed Marks & Spencer shares in May, I came to following conclusions about them at that stage; they were then priced at 395p. ‘In share price technicalities, Marks & Spencer shares, after the recent fall is at recent and historic lows where it has previously found support.’ I added that the biggest near term threat, to this largely domestic retailer with troubles, would be a Brexit ‘leave’ vote’, which would probably make the task of the new CEO harder if, as seems likely, economic conditions worsen. In my opinion, the ultimate buying advice was to wait until the June 23^rd referendum is out of the way before buying.

Having reached that stage now, in early July 2016, is there a bull case that can be made for Marks & Spencer shares apart from financial fundamentals, which although looking attractive, are now built on the economic quagmire 37% of the UK electorate were persuaded to vote for?

First, this is a long term business with a big chunk of the UK food retail market. It looks entirely probable that the share price would rise if, under pressure of the economic outcome of Brexit, the management decided to dispose of the cash absorbing clothing and household goods segment of the Group’s business. First, that would be greeted with a mixture of relief and celebration amongst a large section of investors.

In the circumstances of the new and suddenly much tougher conditions of UK retailing thanks to leaving the EU that will almost certainly have to be reviewed by the management.  If you share the view that this outcome is inevitable, then the shares become a Brexit ‘buy’ despite the macro economic problems it brings.

Although now significantly less certain than it was, the market consensus estimate of an annual dividend of 20p this year is worth a forecast 6.3 percent. UK retail customers will be unexpectedly much poorer this year thus upsetting the calculations but arguably the long expected restructuring of the business in a fundamental way, must be that much more likely. It is a speculation but one made attractive by the last statement of balance sheet equity assets, the total enterprise value of the company and the last annual sales revenue figure and market share it commands.

To underline those with the latest figures based on last seen share price of 315p and a last annual balance sheet net asset value of an estimated 222p means that an investor now would be paying a notional 93p for earnings only. That is a multiple of only 2.5 times the pre Brexit 36p earnings estimate for this year, as published in the month before last. Assuming that 15 times  was a reasonable price to pay post Brexit then, earnings per share could fall to 21p (40% down on the May consensus estimate) and still represent buyable, fair value.

My conclusion is that the shares bounced at 255p because they were calculated to be oversold at that point. At 315p they still look to lowly valued even in relation to a fairly steep decline in earnings this year. Chuck in a speculative change in Board policy of the kind mentioned above, and you have an exciting speculation.