Mands Analysis

An analysis of the results of
For the year ended 2nd April 2006
Report devised and prepared by
Duncan Williamson
www.duncanwil.co.uk
May, June and July 2006

3rd Edition
Marks and Spencer Analysis
Introduction
This article concerns Marks and Spencer and came about following the publication of
their annual financial results.
There is nothing extraordinary about the results apart from two things!
• They were very big news in the business and ordinary press
• They have been prepared under International Financial Reporting Standards rather
than under UK Financial Reporting Standards
The second point took me a little by surprise for the simple reason that it didn’t seem to
cause a fuss. I expected a few more explanations by accountants and analysts over the
restatement of 2005’s results and the potential impact on 2005 and 2006 and beyond of
the application of IFRS. Of course, M&S published comparative figures for the IFRS
based results for the latest year and they restated the previous year as they should.
However, I seem to be the only person who is worried or concerned or bothered in the
slightest about the potential for smoke and mirrors lying behind some or all of what was
revealed.
Why am I worried? Well, M&S is still trying to work its way out of a fairly tough trading
period and coming at the end of the transition to IFRS I wanted to hear what analysts
thought about what I was worried about.
This is the second edition of this article and the final section brings us right up to date by
discussing the M&S executive bonus scheme that helps to explain why there has been no
explanation by M&S over the introduction of International Financial Reporting Standards
based accounting results.
Finally, I include a question from the AGM that reflects some of the concerns I raise
here: I also include the official M&S answer.
Background
In 1999 the stock market valuation of Marks and Spencer was £19 billion. Today, 8th
June 2006, it stands at £8.94 billion. Now, isn’t that part of the reason why Philip Green
was prepared to buy the company for around £9 billion? So much potential growth in the
company!
In 1997 profits at M&S peaked at just over £1 billion on sales of £8 billion: something
like half of the entire UK population wears M&S underwear. By 1997 half of us
shopped at M&S every week.
Analysis of Marks and Spencer Interim Unaudited Accounts for the year ended 2nd April 2006
© Duncan Williamson www.duncanwil.co.uk duncan@duncanwil.co.uk
Page 2 of 20
M&S introduced refrigerated TV dinners to the UK, they were the first to sell pre packed
sandwiches and, believe it or not, the first ever pre prepared chicken Kievs came from
M&S. Innovators or what?
Sir Richard Greenbury was the man in charge of M&S from 1991 and he oversaw the
company at its zenith and then he oversaw it slide into its darkest period ever.
The dark times, aptly named the gray times, arrived in the Autumn of 1998 when M&S
started selling things that no one wanted to buy: their gray range. Profits plummeted; they
budgeted for a 10% increase in overall sales growth but the company actually shrank in
that period.
M&S built its business on the back of high quality, British made, value for money items.
Because of the competition they faced, they began to source £2 billion of their
merchandise abroad. They did it in stages but just look at the size of that purchasing
budget: £2 billion, just from abroad!
Competition in general was hitting hard at this time but M&S were more conscious than
anyone that to convert an idea or a need into a brand new fully functioning shop was a 5
to 8 year process. Catching up and correcting was going to take a lot of time.
Rather than pulling together, the Board started to fall apart from around 1996 and
onwards.
Greenbury was due to retire in 1996 but since there was no succession strategy, they
fudged the issue and appointed four, yes four, joint Managing Directors. Given the nature
of the beast, it should have come as no surprise that at least one of these four people
would jockey for position.
The jockey turned out to be Keith Oates, the Financial Director. After a while of
jockeying, Oates made a grab for power by writing to the non executive directors on the
board saying that Greenbury should be replaced as CEO by, well, himself! Greenbury
was on board an aeroplane to India at the time. Greenbury dashed home to solve the
problem and Oates was sacked.
Peter Salisbury was appointed as CEO to Greenbury’s Chairman at the end of November
1998 and that, too, proved disastrous. Salisbury flexed his muscles. Salisbury and
Greenbury just didn’t get on.
In December 1999 M&S aired its first ever television advertisement: another disaster, As
they chose to use a slightly too large and naked women to sell the company!
Luc Van der Velde was the next manager in the hot seat: he became known as the first
man at the top who knew nothing about the merchandise that lay at the heart of the
business. It didn’t stop the company paying him a total of something like £3.2 million
over the course of his tenureship.
Page 3 of 20
Van der Velde was guilty of managing by short termism but he was credited with
introducing the Per Uno and Simply Food ranges, which were successful.
Philip Green appeared as the predator in June 2004 and this is when he made his £9
billion cash bid for the entire company. He tried and tried but failed to secure the
company.
Stuart Rose now appears: he became the latest man at the top: a retailer of several
decades’ standing, at least. Rose
• Sold the financial services subsidiary of the company

• They bought out the Per Uno range rather then franchising it
• Closed several of their shops
• Squeezed their suppliers on price, quality, delivery
The company is back in profit again after several very poor years. Clothing sales
recovered over the last year at the rate of around 4.5%.
What has kept M&S alive throughout these troublesome times? Customer goodwill:
M&S is seen by many as an archetypical British bastion of excellence. They have waited
for M&S to get back on an even keel. Maybe their dreams have just been realised.
Now, read on to learn a bit about some of my concerns over the accounting and reporting
at M&S!
I am grateful to Channel five television for their programme When M&S lost its Billions,
broadcast on 7th June 2006 for much of this background information.
Restated Results
Now, I don’t suspect fraud but I did want to hear that M&S needed to explain to the rest
of us why sales had been restated downwards for 2004/05: under UK GAAP sales for
2004/05 were £7,942.3 million but under IFRS the sales were stated to be £7,490.5
million for the same period. I was also interested to hear if anyone thought that the
restating of profits for the same period from £745.3 million to £505.1 million was odd or
not.
I know that in the Press Release in which they published their results, note 11 gives us
some sort of reconciliation of FRS and IFRS results but it’s a bit scant. Let’s wait for the
audited accounts to see what greater detail they might reveal.
I do think that M&S might easily have slipped in a few unorthodox numbers given the
opportunity: the AGM isn’t until July by which time anything even slightly iffy may well
go unnoticed and unpunished.
Page 4 of 20
The results that were published are the interim unaudited results for the year ended 2nd
April 2006 and they were announced at 0700 hours on 23rd May 2006.
Background to the Company
Marks & Spencer: fashion, household ware and food The UK Group, Marks & Spencer,
is the owner of shops that specialize in apparel, food and beauty products and household
items. It also provides financial services ? loans, savings and credit cards. Until a short
time ago, the Group was highly active internationally with almost 70,000 employees in
almost 40 countries. But today it is determined to adopt a new strategy, withdrawing into
itself to prepare for the future. After mature reflection, at the beginning of 2001, Marks &
Spencer took the decision to sell most of its stores abroad to other countries, including 18
stores in France (taken over by the Galeries Lafayette) and 10 in Hong Kong, plus 220
Brooks Brothers sales outlets (men's apparel) in the USA and Asia and 25 Kings Super
Market (food stores) based in New Jersey (USA). It is very active in Ireland and has 400
highly successful stores in the UK.
Source: http://uk.finance.yahoo.com/q/pr?s=mks.l 250506
Stock Market Reaction
The reaction of investors to the results are shown in the following M&S share price chart
that takes us up to the end of business on 25th May 2006. The share price climbed swiftly
immediately following the results’ announcement. It then fell back somewhat as investors
and analysts worry over where M&S’s growth prospects lie only to rally a little
yesterday.
Page 5 of 20
Source of chart and data:
http://uk.finance.yahoo.com/q/bc?s=MKS.L&t=5d&l=on&z=m&q=l&c= 260506
In terms of analyst sentiments, here are the latest feelings and those from up to three
months ago.
http://uk.finance.yahoo.com/q/ao?s=MKS.L 250506
The M&S Beta Value
The M&S Beta value is reported to be currently standing at 0.613

http://uk.finance.yahoo.com/q/tt?s=MKS.L 250506
The Capital Asset Pricing Model (CAPM) contends that shares co move with the market.
If the market moves by 1% and a share has a beta of two, then the return on the share
would move by 2%. The beta indicates the sensitivity of the return on shares with the
return on the market. Some companies' activities are more sensitive to changes in the
market, eg luxury car manufacturers, have high betas, while those relating to goods and
services likely to be in demand irrespective of the economic cycle, eg food
manufacturers, have lower betas. The beta value of 1.0 is the benchmark against which all
share betas are measured.
• Beta = 1 - neutral shares

These shares are expected to follow the market.
• Beta > 1 - aggressive shares
These shares tend to go up faster then the market in a rising (bull) market and fall
more than the market in a declining (bear) market.
Page 6 of 20
• Beta < 1 - defensive shares
These shares will generally experience smaller than average gains in a rising
market and smaller than average falls in a declining market.
The beta value of a share is normally between 0 and 2.5. A risk free investment (a
treasury bill) has a β = 0 (no risk). The most risky shares like some of the more
questionable penny share investments would have a beta value closer to 2.5. Therefore, if
you calculate or find a beta value of 11 you know that you or your source has made a
mistake.
M&S is therefore seen as a neutral, market following share.
Traditional Ratio Analysis

Derived from M&S published sources
Notice the problem: the change to IFRS from FRS complicates any analysis of the
company’s results. Here are the basic ratios I have calculated from the available
information.
IFRS UK GAAP
Marks and Spencer: basic analysis 2006 2005 2005 2004
Operating Profit (%) 10.90% 7.98% 7.78% 9.92%
EBIT (%) 10.90% 7.98% 9.38% 9.42%
ROTA (EBIT) 16.32% 12.29% 17.39% 10.59%
Current Ratio 0.57 0.67 0.65 2.05
Working Capital -874.9 -405.1 -451.8 1984.8
Gearing (NCL) 176.42% 299.24% 368.18% 102.67%
Stock turnover (days) 19.7 17.9 16.9 19.4
Depreciation as % of Total Gross Assets 7.0% 6.6% 7.6% 6.8%
Income Tax as % of EBT 30.2% 29.7% 21.2% 29.3%
• Operating profitability has improved

• EBIT and ROTA based profitability have improved on an IFRS basis more
significantly than it might have done on an FRS basis
• The current ratio is currently very low and that is normal for a retailer. However,
why the massive change from 2004 to 2005? There was a very large long term
debtor in the balance sheet in 2004 relating to their Pension Fund: no longer n the
balance sheet.
• Stock turnover is worsening
• Depreciation as a percentage of total gross assets looks as if it has changed as a
result of the implementation of IFRS
• Income tax as a percentage of EBT (taxable profits) has dramatically changed: is
this a cause for concern or just a result of the change to IFRS?
Page 7 of 20
Beaver Univariate Style Analysis
William Beaver, working in the

USA in the 1960s, worked on his
univariate bankruptcy prediction
model and as part of his analysis,
he considered a total of 30 financial
ratios that he felt might have the
ability to predict the potential for
bankruptcy of an organisation.
From his list of 30 ratios, Beaver
finally settled on six ratios that he
considered to have the greatest
predictive ability:
• Cash flow to total debt

• Net income to total assets
• Total debt to total assets
• Working capital to total
assets
• Current ratio
• No credit interval
The no credit interval is measured

as defensive assets (quick assets)
minus current liabilities divided by
operating expenditures
This is called a univariate model because any single ratio (one variable, one variate) can
be used to predict collapse or going concern status.
Interpreting these results can be problematic but the following graphic helps to steer us in
the right direction: I have added the M&S values for these ratios to help to illustrate the
Beaver style view of the company. The blue data point markers illustrate the FRS based
results while the red data point markers illustrate the IFRS based results.
In addition, the solid lines reflect a non failing company whilst the broken or dotted lines
represent a failing company or a company facing potential bankruptcy.
What this analysis tells us is that, taking the Cash flow to total debt ratio as an example, a
surviving company is likely to have a reasonably constant value of around 0.4 for a five
year period ending with the latest results.
On the other hand, a company that is heading for collapse over the same five year period
is like to be suffering from a significantly falling ratio result. All failing companies suffer
the same fate for all ratios, decreasing strength, except for the total debt to total assets
Page 8 of 20
ratio which is rising as the company heads for failure. This suggests that as companies
fail, they turn to greater gearing levels or to a much lower asset bases. That is, they take
on more debt or they sell of their assets to raise cash; or even a combination of both!
If you would like to check these calculations for yourself, my results for M&S for these
ratios are in the table that follows.
IFRS UK GAAP
Beaver's Univariate Analysis 2006 2005 2005 2004
Cash flow to total debt 0.5377 0.5275 0.8206 0.2645
Net income (EBIT) to total assets 0.1431 0.1038 0.1739 0.1059
Total debt to total assets 0.3912 0.5590 0.4480 0.3415
Working capital to total assets -0.1679 -0.0832 -0.1054 0.2690
Current ratio 0.5662 0.6726 0.6496 2.0531
No credit interval -0.1798 -0.1079 -0.1081 0.2122
What conclusions can we draw about the results in the Beaver style of M&S? See the
section Beaver v Altman below for my interpretation: what do you think, before you see
what I think!
Altman’s Corporate Collapse Model
Edward Altman, also working on corporate collapse and also in the 1960s in the USA,
created a multivariate model, known as a Z score model. What this means is that a
number of ratios are combined in a formula or equation to give a value, the Z score, that
will indicate whether the company is likely to collapse or remain as a going concern.
The model is, for non manufacturing companies:
Z = 6.56X1 + 3.26X2 + 6.72 X3 + 1.05X4
Where
X1 = (Current Assets – Current Liabilities)/Total Assets

X2 = Retained Earnings/Total Assets
X3 = Earnings Before Interest and Tax/ Total Assets
X4 = Market Value of Total Shares/Book Value of Liabilities
There is a separate but similar model for manufacturing companies.
I have calculated the Altman results for M&S as follows, using the value of long term
liabilities in the ratio X4
Page 9 of 20
IFRS UK GAAP
Altman's Non Manufacturing
Bankruptcy Prediction Model 2006 2005 2005 2004
X1 = (CA-CL)/TA -1.101 -0.692 1.765
X2 = RE/TA 0.172 0.324 0.142
X3 = EBIT/TA 0.962 1.169 0.712
X4 = MV Stock/BV Liabilities 4.636 3.091 2.563
Z 4.668 3.892 5.182
The question is, how do we interpret a Z score of 4.668 for 2006? Altman tells us that
• If Z < 1.1 indicates a bankruptcy candidate

• If Z > 2.6 indicates financial health
Since Z = 4.668 for 2006 then Altman is saying that M&S is likely to survive for the
foreseeable future.
Note there is no value for 2005 for the IFRS basis because the interim results have not
indicated a value for retained earnings, therefore I couldn’t complete the calculation of
the Z score for 2005 under IFRS.
Beaver v Altman
We would hope that the Beaver and Altman models agree with each other. If they don’t
we would then hope that we can explain any difference!
The Beaver style analysis suggests
• Cash flow to total debt: no problems

• Net income to total assets: potential problems
• Total debt to total assets: possible problems?
• Working capital to total assets: potential problems
• Current ratio: potential problems
• No credit interval: possible problems?
Please note: we really need to take into account the industry/sector we are considering
here. This is especially true as far as the working capital position is concerned. M&S is a
cash based retailer and such businesses often manage their working capital extremely
efficiently. We would expect these ratios to be low. Consequently, we shouldn’t worry
too much about the two working capital based ratios here.
However, all ratios apart from cash flow to total debt suggest a problem for M&S!
For all three periods, Altman suggests M&S as a going concern.

Page 10 of 20
The Business Aspects of this Case
M&S is a company in transition: it has had corporate governance problems with

internecine fighting in the Board Room. It is obvious from even just a cursory visit to an
M&S shop that they had become relatively tatty and that as staffing levels fell so did
levels of service. The range and variety of clothes at M&S had become rather bland.
Stuart Rose’s job, therefore, as CEO was to get to the bottom of all of this and make the
company a star again.
Here are a couple of extracts from an interview with Rose that I took from the M&S web
site:
Q. These results show that M&S is making progress. Are you pleased?
A. Yes, naturally I'm pleased. I mean the metrics themselves speak for what's been done
last year and the EBIT margins in double-digits in terms of percentage, that's an
acceptable number. We've seen a cash flow being very strong in the business. We've seen
more customers coming in, some 350,000 more customers a week come into the business.
We've seen the conversion numbers going up in the business. We've seen market share
going up in all areas other than the children’s wear: children’s wear has actually flattened
for the first time in a while. We've seen volume market share going up.
I think we can be pretty pleased that we've ticked quite a few boxes this year. What we
have to do now is consolidate on that and make sure that we don't slip backwards so this
time next I can tell you we've improved again.
Q. So what's left to do?
A. The biggest single thing at the present time is to make sure that we absolutely nail
down the things that we have been doing. So the first thing is to work on product. And
the second thing is to work on environment. And the third thing is to work on service.
Now on product, I am very satisfied that we have absolutely re-established our

credentials with our customers as being a retail shop that offers fantastic value across our
price architecture. Whether it be foods, whether it be lingerie, whether it be women’s
wear, men’s wear, children’s wear or home and we've done that. But we mustn't get
complacent because, remember, we were complacent once before. So that's my day job.
The second thing we have to do, and this is an extremely important year for us, is to
absolutely carry on with our programme of refurbishment. We've got the biggest
refurbishment programme of any retail company in the UK. We'll spend close on £600m
this year. We've got some 60 stores currently under work. We'll have something like a
third of our portfolio being developed this year. And that will be, if you like, the tipping
point as far as the customer is concerned, in terms of them all being able to see a new
Page 11 of 20
look Marks & Spencer.
Then the last bit is continuing to make sure that when customers come in and find that
product, see those nice exciting new stores, that they get fabulous service when they do
come in.
Concluding Remark
I will return to this case study once M&S has held its AGM in July and it has published
its full and audited annual report and accounts.
If there is nothing to report along the lines of my current concerns, I will say so.
Otherwise I will flag for you what the concerns are and why I am worried by them!
New Information for the Second Edition

Why they kept quiet about the restating of their results
In the original version of this article I said that I didn’t believe that there had been
chicanery at Marks and Spencer but that I did think that there may be more to their
accounts than meets the eye. I was right and this section reveals why.
I wanted a bit more explanation from the company about the implications of having
started using International Financial Reporting Standards (IFRS) as opposed to Financial
Reporting Standards (FRS). They have done that because European Union and UK law
have said they must. However, I thought the management would have tried to help their
shareholders at least a little by pointing out why, for example, the FRS based profit of
£7,942.3 million had been restated as £7,490.5 million under IFRS.
Of course, having restated the figures by way of restating their profit and loss account,
balance sheet and so on, they don’t have to explain anything. But let me persist: if I were
a shareholder then I would want to know answers to the following issues.
It seems to me extremely convenient that
• Senior executive managements’ bonuses are based on accounting profits

• Profits and profitability appear to be higher under IFRS than they are under FRS
Take a look at the following table to see why I say that:
The changes from IFRS 05 to IFRS 06 are much higher than the changes from FRS 05 to
IFRS 06. Given that the sole reason for the differences are due to accounting, I find it
worrying that executive bonuses are based on accounting measures.
You could tell me that there is a full and perfect reconciliation between FRS and IFRS
and you would be right. However, there are significant and underlying differences
Page 12 of 20
between the treatment of many measures under FRS vis a vis IFRS. If nothing else, isn’t
that cause for concern for M&S’s shareholders?
M&S Accounts IFRS UK GAAP Rates of Change

IFRS 05 - FRS 2005 -
2004 - 2006 2006 2005 2005 2004 IFRS 06 IFRS 2006
Sales 7,797.7 7,490.5 7,942.3 8,301.5 4.10% -1.82%
Operating Profit 850.1 598.1 618.0 823.9 42.13% 37.56%
EBIT 850.1 598.1 745.3 781.6 42.13% 14.06%
Retained Earnings 247.0 n/a 383.7 289.1 n/a -35.63%
Depreciation for the year 274.0 255.0 250.4 238.9 7.45% 9.42%
EBT 745.7 505.1 745.3 781.6 47.63% 0.05%
Income Tax 225.1 150.1 158.3 229.3 49.97% 42.20%
EPS 31.4 29.1 29.1 24.2 7.90% 7.90%
Total Assets 5,210.5 4,867.3 4,285.0 7,377.1 7.05% 21.60%

Tangible Gross Assets 3,904.9 3,871.5 3,316.1 3,497.6 0.86% 17.76%
Current Assets 1,142.1 832.3 837.5 3,869.5 37.22% 36.37%
Current Liabilities 2,017.0 1,237.4 1,289.3 1,884.7 63.00% 56.44%
Stocks 374.3 338.9 339.7 398.0 10.45% 10.19%
Non Current Liabilities 2,038.2 2,720.7 1,919.7 2,519.6 -25.09% 6.17%
Shareholders' Funds 1,155.3 909.2 521.4 2,454.0 27.07% 121.58%
Executive Bonus Detail from the M&S Annual Review 2006
To ensure that the Group has a highly capable executive team, our remuneration
packages need to be competitive. We are recommending changes to the Annual Bonus
Plan and Performance Share Plan, which I ask you to support.
Bonus targets remain extremely demanding. Over half of any bonus awarded would be
paid in shares, which must be held for three years. We are committed to rewarding
success, not failure and directors’ contracts are subject to a clear obligation to mitigate
cost to M&S.
These changes continue to align directors’ rewards with the long term interests of
shareholders.
Annual Review Page 2
Annual Bonus Scheme The Annual Bonus Scheme is designed to focus and reward
executives for specific operational improvements which will drive the Company’s
recovery. The 2005/06 bonus for directors started at 60% of salary for on target
performance rising to a maximum of 150% for exceeding targets.
The targets for the Company are determined annually by the [Remuneration] Committee
and for 2005/06 incorporated a mixture of corporate profit before tax and business unit
sales and profit. The targets for the executive directors were entirely based on the
Page 13 of 20
delivery of corporate profit before tax. The Committee assesses the achievement of
targets for all executive directors and senior management prior to any bonus awards
being made.
The executive directors are required to defer 50% of the bonus paid into shares which
will be held for three years.
For 2006/07, the Committee intends to increase the bonus potential for executive
directors to a maximum of 250% for exceeding targets. The level for on target
performance will remain at 60%. The level of deferred shares will increase from
50% of any bonus earned to 60%. Bonus potential is being raised to this maximum level
for the three executive directors to help incentivise and secure further significant growth
in corporate profits.
Long term Incentive Schemes: Performance Share Plan The Performance Share Plan is
the primary form of long term incentive for the top 100 senior management. Under the
plan, annual awards of up to 200% of salary may be offered based on performance and
potential, with the exception of a 300% limit in the year of recruitment.
Performance targets are based on Adjusted Earnings per Share (EPS) growth. The
Remuneration Committee considers this target to be the key measure of management
performance to generate significant increases in profits and increase shareholder
value. The Committee regularly reviews the level of targets to ensure they are demanding
in the context of the Company’s circumstances and projected performance.
Executive Share Option Scheme Executive Share Option Schemes have operated for
over 20 years and in recent years have been open to approximately 400 senior managers.
Although a new Executive Share Option Scheme was adopted at the 2005 AGM, the
Committee does not intend to use this Scheme on a regular basis. However, it does wish
to have the flexibility to make grants from time to time if it considers it appropriate to do
so in the future. No grants have been made under this Scheme in the year under review.
The performance targets in this Scheme will be based on EPS growth and the same
target range will apply to any grants in the future as applies to the Performance Share
Plan. There are options outstanding for management, including executive directors,
under a number of previous schemes which will vest, subject to the delivery of the
performance conditions, in 2006, 2007 and 2008.
Performance targets are assessed over an initial three year period from the date of grant.
There is no ability to retest any grants made since 2004/05, which includes all grants
made to the executive directors.
Pages 28 – 29
Let’s assume for the sake of argument that in spite of what I have said about the
reconciliation of FRS and IFRS outputs, there are no problems with them as far as this
discussion is concerned. Let’s take a look at what others have said about executive bonus
schemes.
Page 14 of 20
Share Options: where’s the incentive?
In terms of the efficacy of share options, consider the two diagrams that compare the
Marks and Spencer share price over the last two years and five years respectively with the
FTSE 250. Notice that in general the M&S share price is well correlated with the FTSE
250 meaning that the general trend of the share price is upwards. The recent M&S poor
performance period is included in the two diagrams that follow so any director receiving
share options that he had to hang on to for three years or more would hardly have
suffered would he?
Where, then, is the incentive effect in share options?
http://uk.finance.yahoo.com/q/bc?t=2y&s=MKS.L&l=on&z=m&q=l&c=&c=%5EFTMC
210606
http://uk.finance.yahoo.com/q/bc?t=5y&s=MKS.L&l=on&z=m&q=l&c=&c=%5EFTMC
210606
Page 15 of 20
Perhaps one surprising note here is that the M&S share price mirrored that of the market
yet everyone was blaming poor management for that. In reality, it may be that the market
didn’t think there was that much wrong at M&S.
Alfred Rappaport, the Leonard Spacek Professor Emeritus at JLKellogg Graduate School
of Management, Northwestern University writes:
The problem lies in the way conventional stock options are structured. The exercise price
is established at the market price on the day the options are granted and stays fixed over
the entire option period, usually ten years. If the share price rises above the exercise
price, the option holder can cash in on the gains. Therefore, fixed price options reward
executives for any increase in share price even if the increase is well below that realized
by competitors or by the market as a whole.
Consider the following example. A CEO is granted options exercisable over the next ten
years on 1 million shares at the current share price of $100. If the share price rises by
5% a year to $163 at the end of the period, the CEO will take home a gain of $63 million.
But if the share prices of competitors grow at 15% a year during the same period, a
convincing argument can be made that the CEO does not deserve to cash in the options.
No reasonable board of directors would knowingly approve a plan that offers high
rewards for such poor long term performance.
Rappaport goes on to say
Stock option plans don't have to be blunt instruments. By tying a plan's exercise price to a
selected index, boards can increase the pay of superior performers while appropriately
penalizing poor ones. Let's assume the exercise price of a CEO's options are reset each
year to reflect changes in a benchmarked index. If the index increases by 15% during the
first year, the exercise price of the option would also increase by that amount. The option
would then be worth exercising only if the company's shares had gone up by more than
15%. The CEO, therefore, is rewarded only if his or her company outperforms the index.
In selecting an index, companies can choose either an index of their competitors or a

broader market index such as the Standard & Poor's 500. The choice requires trade offs.
Stock options indexed to the market are easily measured and tracked. A market index,
however, ignores the special factors that affect the company's industry.
Rappaport also helps by saying this:
Whatever index is selected, indexed options have clear advantages over fixed price
options. Indexed options do not reward underperforming executives simply because the
market is rising. Nor do they penalize superior performers because the market is
declining.
Alfred Rappaport (1999) How to Link Executive Pay with Performance Harvard Business
Review March-April 1999
Page 16 of 20
Furthermore, Jeffrey Pfeffer says:
Individual incentive pay, in reality, undermines performance: of both the individual and
the organization. Many studies strongly suggest that this form of reward undermines
teamwork, encourages a short term focus, and leads people to believe that pay is not
related to performance at all but to having the "right" relationships and an ingratiating
personality
Jeffrey Pfeffer (1998) Six Myths About Pay Harvard Business Review May-June
An Alternative Approach
All is not well with the M&S approach: using accounting measures as the basis of the
award of a bonus. What should be done, therefore, to overcome this problem? What many
other companies do is to assess their most important Key Performance Indicators (KPI’s)
I have seen a suggestion that M&S is using the Balanced Scorecard approach for at least
some aspects of its work. The BSC is a rigorous approach to management and
improvement and it uses a very wide series of KPIs throughout an organisation to ensure
(and I use that word advisedly in this context) the level of Return on Capital Employed
(ROCE) that management and shareholders are looking for.
Before anyone tells me that the M&S ROCE results are excellent, they do appear high, I
need to point out that whilst sales have grown modestly by any measure over the last year
or so, the accounting profits have risen dramatically and as a shareholder I would want
firm assurances that this represents a real increase and not an artificial one. The following
expands on the basis for true performance assessment as opposed to one based merely on
accounting profits.
The basic BSC is structured in this way although many companies have amended their
own scheme as their understanding of the approach evolves:
Page 17 of 20
The inventors of the BSC approach, Robert S Kaplan and David P Norton, say that its
proper application leads from learning and growth to financial success, along these lines:
That is, if employment skills are appropriate and maintained and process quality and
cycles times are properly cared for and if delivery is on time and customers are loyal then
ROCE will be what you want it to be. It’s a an approach based on cause and effect. What
sorts of measures, KPIs, are we talking about here then? The answer to this question
depends on the industry, the sector and the company we are reviewing. Here are a few
examples:
Financial performance profitability

liquidity
capital structure
Page 18 of 20
market ratios
Competitiveness relative market share and position
Sales growth
measures of the customer base
Resource utilisation productivity (input: output)
efficiency (resources planned: consumed)
utilisation (resources available: consumed)
Quality of service overall service indicators
measures of the twelve determinants of
service quality:
reliability, responsiveness, aesthetics,
cleanliness, comfort, friendliness,
communication, courtesy, competence,
access, availability, security
Innovation proportion of new to old products and services
new product and service sales levels
Flexibility product/service introduction flexibility
product/service mix flexibility
volume flexibility
delivery flexibility
Don’t take these examples as cast in stone, they are examples only. That’s not to say that
they are useless for M&S since some of them couple be used by them.
Just carrying out a simple search on the internet revealed the following examples of the
kinds of metrics that M&S might use as at least some aspect of a more realistic bonus
scheme.
Sales per Square Foot: Actual sales £ for a given period (usually a month or a year)
divided by the total floor area (in ft2) of the store. There are variants of this indicator in
terms of sales per square foot of merchandisable area of choice (like walls and display
units.)
Wage Cost: Actual wage £ paid for a given period divided by actual sales £ achieved for
the same period
http://www.dmsretail.com/kpi's.htm 210606
At the store level, the following five Store and Individual Staff KPIs might be
considered appropriate:
1 Sales per Hour: the fiscal value of the individual's and stores hourly sales.
2 Items Per Sale: the number of items sold by individual compared to the store average.
3 Average Sale: the average fiscal value of each individual sale compared to the store
average.
4 Conversion Rate: the number of walk-ins that can be converted to sales.
5 Sales per Wages Spent: the fiscal contribution each salesperson makes, or how much is
spent on wages compared to how much they sold.
Page 19 of 20
Smart Retailers Dramatically Improve Sales Performance Using Key Performance
Indicators http://www.hashemian.com/articles/2006/06/19/smart-retailers-dramatically-
improve-sales-performance-using-key-performance.htm 210606
Take the examples from the Balanced Scorecard and the above list and I am sure that
M&S can come up with something much better than relying something as flawed as a
financial accounting measure such as profits before or after tax.
From the AGM
Reflecting some of the concerns you have read above, perhaps, the following is a
question that was submitted to the Board of M&S in readiness for the AGM. The
question is included in the document whose URL is given below but it was not posed at
the AGM itself.
Q Remuneration for Executive Directors is already excessive: there is no case for

increase the bonus potential to 250% for exceeding their targets. I note that the
CEO has already enjoyed an increase in salary well beyond the rate of inflation.
How can this be justified?
A The remuneration strategy is continually reviewed to ensure it will enable the

recruitment and retention of highly skilled individuals who are key to the recovery and
future success of M&S. The Remuneration Committee carefully considers the levels of
remuneration for the Executive Directors in light of both the market and their individual
contribution to the Company. The CEO has made an outstanding contribution to the
performance of the Company since he was appointed in June 2004 and his contribution
has been acknowledged externally and is demonstrated in the greatly improved profits
which have given the shareholders both a greater dividend and increased share price. The
Remuneration Committee is clear that the CEO is vital to the continuing growth and
success of the Company and as such his reward should reflect this.
http://www2.marksandspencer.com/thecompany/investorrelations/shareholderinformation
/2006/agm_qa.pdf pages 1 and 2
Devised and Prepared by

© Duncan Williamson
May, June and July 2006
Page 20 of 20

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An analysis of the results of

For the year ended 2nd April 2006

Report devised and prepared by

May, June and July 2006

• Sold the financial services subsidiary of the company

Background to the Company

Stock Market Reaction

The M&S Beta Value

The M&S Beta value is reported to be currently standing at 0.613

• Beta = 1 - neutral shares

M&S is therefore seen as a neutral, market following share.

Traditional Ratio Analysis

• Operating profitability has improved

William Beaver, working in the

• Cash flow to total debt

The no credit interval is measured

Altman’s Corporate Collapse Model

The model is, for non manufacturing companies:

Z = 6.56X1 + 3.26X2 + 6.72 X3 + 1.05X4

X1 = (Current Assets – Current Liabilities)/Total Assets

There is a separate but similar model for manufacturing companies.

• If Z < 1.1 indicates a bankruptcy candidate

The Beaver style analysis suggests

• Cash flow to total debt: no problems

For all three periods, Altman suggests M&S as a going concern.

M&S is a company in transition: it has had corporate governance problems with

Q. So what's left to do?

Now on product, I am very satisfied that we have absolutely re-established our

New Information for the Second Edition

It seems to me extremely convenient that

• Senior executive managements’ bonuses are based on accounting profits

Take a look at the following table to see why I say that:

M&S Accounts IFRS UK GAAP Rates of Change

EPS 31.4 29.1 29.1 24.2 7.90% 7.90%

Total Assets 5,210.5 4,867.3 4,285.0 7,377.1 7.05% 21.60%

Executive Bonus Detail from the M&S Annual Review 2006

Where, then, is the incentive effect in share options?

Rappaport goes on to say

In selecting an index, companies can choose either an index of their competitors or a

Rappaport also helps by saying this:

Financial performance profitability

From the AGM

Q Remuneration for Executive Directors is already excessive: there is no case for

A The remuneration strategy is continually reviewed to ensure it will enable the

Devised and Prepared by

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