A US firm wants to buy the UK supermarket, giving shareholders and potential investors a problem. Here’s what our companies analyst thinks.
After soaring to over 240p this week in response to a potential 230p a share cash offer from US private equity, the mid-cap UK grocer Morrisons (LSE:MRW) has eased to 234p. It’s a reality check versus initial hysteria.
The City and media love takeovers: quick profits, advisory fees and attention-grabbing headlines. Consensus reckons this is just an opening offer - Clayton, Dubilier & Rice (CDR) have done their sums and can pay in the region of 275p a share to still make a handsome return.
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Food retailing becomes ever more competitive
CDR may be overlooking realities of the sector since it bought 60% of B&M European Value Retail (LSE:BME) as a private company in 2012, floated the discount retailer in 2014 and sold its final shares in early 2018, making a total £1.5 billion profit.
Aldi doubled its UK market share to 8% from around 2013 to 2020 and intends to invest £1.3 billion in the UK over the next three years. Lidl is investing the same amount but over two years and aims to raise its stores from 860 to 1,000 by end-2023.
That is tough competition for Morrisons and Sainsbury’s (LSE:SBRY) in the middle ground, where Sainsbury’s already shows sensitivity by way of “Aldi price match” tags. Yes, they offer a wide range of products, convenient locations and expansive car parks, but they are overall undercut on price by the discounters, which will become more significant as living costs rise.
Competition is broadly why supermarket stocks de-rated after Morrisons enjoyed annual average historic price/earnings (PE) multiples of 21x in 2016 to 29x in 2018. Equilibrium was only reached when income investors recognised a circa 5% prospective dividend yield. Stocks enjoyed a flurry in spring 2020 when supermarkets benefited from more eating and drinking at home, but higher costs of coping with Covid hit profits.
Potential buyer seeks to exploit asset value/interest rate arbitrage
Morrisons’ de-rating to net asset value (with scant intangibles) has also coincided with very low interest rates and soaring asset prices. The Issa brothers recently bought Asda from Walmart for £6.8 billion and are said already recouping their outlay with asset disposals. Spreadsheet conjurers will see scope to squeeze cash from Morrisons’ £7 billion property portfolio – 85% of 497 stores are owned freehold - with sale-and-leaseback tricks.
Yet Morrisons’ vertical integration (owning stores and farms) is integral to its competitive pitch and in support of margins. There is no scope to raise food prices versus rivals, and for private equity’s game plan to succeed the business must also be fit in five years’ time – either to re-float or sell on. Investors are nowadays wise to the long-term consequences having seen how Debenhams and other retailers were mutilated.
Yes, Pets at Home (LSE:PETS), once private equity-owned, has lately been a success, but its stock slumped from 300p to 115p over five years after listing, and I drew attention as a ‘buy’ initially at 125p in August 2018 when insiders were piling in versus a big short position. A new CEO has also recently honed that business well, hence the rise over 450p.
Who am I to doubt CDR’s game plan when it is advised by former Tesco (LSE:TSCO) boss Sir Terry Leahy – who also gave council on buying into B&M. Well, I am not sure he left Tesco in such a great state, although he did blame his successor for troubles arising.
Has Morrisons signalled an improving trend?
Its narrative says so, yet comparisons are confused by Covid. Annual results to 31 January were themed as “building on momentum,” with like-for-like sales ex-fuel up 8.6% and the fourth quarter up 9% - versus 2019 figures down 0.8% and 2.1% respectively. But it does not square with me how fuel was stripped out when people were driving far less, to focus on food and drink while pubs, cafes and restaurants were shut. Total revenue was broadly flat and profit/cash flow were hit hard.
Despite a stressful year and showing how Clayton senses ability to extract cash, Morrisons was respectfully able to raise its total dividend by 27% to 11.15p. A 4p special dividend was also paid in January 2021, albeit deferred from the second half the January 2020 year.
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Free cash flow (FCF) and debt are targeted to improve significantly – music to a private equity buyer – but so it should after a £450 million annual FCF outflow versus a prior £238 million inflow.
Helped by the pandemic, online sales tripled, and their capacity rose five-fold, although this was probably needed to be competitive nowadays anyway.
Scope in the figures for jam tomorrow
In terms of “something new”, yes, a supply arrangement with Amazon is underway and wholesale has also been rolled out to 236 McColl’s (LSE:MCLS) stores, with conversion of 300 to a Morrisons Daily format targeted over the next three years.
There is speculation of Amazon (NASDAQ:AMZN) becoming a “white knight” buyer in a bidding contest ahead for Morrisons, but that would radically alter its partnering strategy with retailers.
February to April trading saw life-for-like sales up 2.7% ex-fuel and up 4.7% including fuel, with “encouraging signs both of significantly lower direct Covid-19 costs and recovery of profit lost during the pandemic…we now expect meaningful profit growth in the January 2023 year.”
It sounds like the Morrisons’ Finest brand of jam could be served tomorrow – so to speak.
|Morrisons - financial summary|
|Year end 31 January||2016||2017||2018||2019||2020||2021|
|Turnover (£ million)||16,122||16,317||17,262||17,735||17,536||17,598|
|Operating margin (%)||1.95||2.6||2.6||2.4||3.1||1.5|
|Operating profit (£m)||314||420||451||417||540||270|
|Net profit (£m)||222||305||311||233||348||96|
|Return on cap employed (%)||4.8||6.6||6.1||5.7||7.2||3.4|
|Reported earnings/share (p)||9.5||13.0||13.0||9.7||14.4||4.0|
|Normalised earnings/share (p)||9.2||11.6||12.9||14.5||13.6||19.7|
|Operating cashflow/share (p)||37.8||41.5||31.2||32.4||34.3||3.7|
|Capital expenditure/share (p)||15.6||17.8||20.9||19.0||21.2||22.2|
|Free cashflow/share (p)||22.2||23.7||10.3||13.4||13.1||-18.5|
|Ordinary dividend/share (p)||5.0||5.4||6.1||6.6||6.8||7.1|
|Covered by earnings (x)||1.9||2.4||2.1||1.5||2.1||2.8|
|Net Debt (£m)||1,716||1,224||2,403||2,424||2,416||3,171|
|Net assets per share (p)||161||174||180||183||189||175|
|Source: historic Company REFS and company accounts|
Scant margin of safety for Clayton’s game-plan
They likely calculate that the board would have to recommend terms of a higher offer if enough institutions say they will accept it amid behind-the-scenes haggling.
But this approach is symptomatic of gung-ho takeovers on the back of monetary stimulus raising risk appetite – to play a high-wire debt act of selling assets and squeezing out cash.
Even when fronted by a big cheese like Sir Terry, these financiers have nothing to offer by way of food retailing. They may end up disappointed in the hope B&M can be repeated a decade later, in a different landscape.
If wise grey hairs exist in Clayton’s boardroom, they will demand its young Turks explain how Morrisons is to be re-sold – and demonstrate a margin of safety in the game-plan.
This opening shot is at least shrewd to test public opinion for any takeover to succeed. Opposition MP’s have been critical, but it is unclear quite whether the government or any regulator would intervene – as a change in ownership to private equity would not significantly alter competition.
But I think Clayton could walk away if there are more institutions like Legal & General, owning 2.7%, and which has criticised sale-and-leaseback here as short-termism. They appear content to back Morrisons’ management.
A case to trim according to risk appetite
Earnings per share (EPS) is a crude benchmark but if bid hopes fade, then Morrisons looks quite exposed on 17x EPS expectations of 14p for the current year – versus Sainsbury’s on 13x.
The stock is well-supported by tangible assets, cash flow strengths and a useful yield, so I respect an overall ‘hold’ stance. At a premium only to a potential offer price however, investors alert to capital protection might want to consider selling say half (with due regard to tax liabilities if not held in an ISA or SIPP).
Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.
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