Grocers minced

Grocers minced

24 Mar 2014

“FTSE 100 sees supermarket shares shelved as Morrisons wages price war.”

Last Thursday week (13 March), shares of William Morrison fell by 12% to 206p. They have fallen by 32% since their 2013 peak of 302p in September. In a show of empathy, Sainsbury’s shares were -8% and -26% from last year’s high and Tesco’s -4% and -23% respectively. The strategic announcement from Morrison has emphasised what we already knew – that discounters like Lidl and Aldi have been winning market share from the “Big 4” supermarkets (the other one, Asda, is a subsidiary of the US giant Walmart). This stock market fallout has delivered some shares that ostensibly now look cheap. As ever, the way to judge is to ask what the valuations tell us about the outlook for the businesses and to decide whether this view is realistic, optimistic or pessimistic.

But first, some background.

Due to the fact that we all go shopping, my observation is that people tend to overestimate the value of their own opinions about retailers. (This is true of many other topics: house prices, because we all live somewhere; climate chance, because we all notice the weather; healthcare, because we all get ill; bankers, because we all use banks.) On that basis, I must assume the same is true of me. So let’s get my prejudices out of the way.

First, Lidl and Aldi are private companies from Germany. In my experience, which is somewhat out of date, shopping in Germany is a grim experience, evocative of Britain in the 1970s. If German retailers compete on scale and price, it is because they have nothing else. It is still the case that the collective German psyche has a horror of inflation (I have a 50 million mark note from the 1920s on my desk) and until 10 years ago, the law regulated prices and shop opening times in a way that suggested that shoppers needed to be protected from greedy retailers.

The only Lidl outlet I know (in rural France) usually has just one member of staff on the checkout and the last time I was there (buying Chardonnay at less than €3 a bottle) the customer next to me was a bearded woman. I just went to look at an Aldi store in Catford, South East London. It was certainly cheap and popular (it was 12.45 on a Friday) but it was not in itself a pleasant visit. There were large baskets of random shoes and many of the displays looked as if they had been dumped in a hurry. The checkouts had around eight people in each queue and the car park was jammed by a delivery lorry. The only lifestyle choice here is “I love a bargain”.

French supermarkets (which I use frequently)are generally large and welcoming, benefitting from a natural supply of fresh local ingredients and offering keen prices. English people usually love French supermarkets for these reasons. The dominant chains like Leclerc, Carrefour and Auchan are able to open huge shops (there’s plenty of space in France) and seem to be content with operating margins of c.3%.

Likewise, the German Metro’s cash and carry grocery chain claims to make 3% margins (though financially this group is a mess, generating no cash flow and paying no dividend at present).

The Big 4 British supermarket chains have historically done better than that. Tesco’s operating margin hovered around 6% from 2007-12, a feat that won it many admirers, (including Warren Buffet, who has recently been cutting his stake at a loss, according to the press). Morrison also generally exceeded an operating margin of 5% and Sainsbury, though scoring consistently well on customer surveys, plugged away at c.4%.

It does not take much imagination to suspect that all the Big 4 are going to trend down towards that 3% operating margin. There are all sorts of structural developments cited in favour of this argument. Lidl and Aldi are not going away; it is widely, though wrongly, believed that the global price of food is constantly rising; online ordering and subsequent delivery are also large and expensive logistical challenges. Every talking head around states as a fact that it is the end of an era.

My uninformed bias leads me to suspect that the stock market is underestimating the cyclical effect of lower disposable incomes but no one should invest on the back of an ignorant guess like that. As ever, we should look at the numbers behind the share prices.


Tesco’s years of 6% margins ended in 2013 when its consolidated operating margin was just 3.4%. The group had to resort to the dreaded underlying operating profit to report a more modest decline to a margin of 5.5%.One of the one-off costs that were added back was a write-down of its property portfolio. And there is a key point to understanding Tesco’s finances. In recent years it became a dedicated property investor with the intention of realising £250-350 million in property profits every year. In FY 2012/13, Tesco reported £370 million in property profits but took a charge of £895 million writing down the value of its portfolio.

Some analysts and investors have admired Tesco for sweating its assets in this way. Most of Tesco’s property is either an existing store or land for potential development. When an existing store is sold the company will typically execute a sale and leaseback as a result of which the buyer will receive a lease contract that commits Tesco to paying rent for a number of years. These operating lease liabilities are not carried on the balance sheet but appear as supplementary notes to the accounts. One could argue that there is an accounting mismatch here. The cash and profit (if any) from the sale appear in full in the accounts at once but the liability pops up gradually, year by year, as an operating cost, over the lifetime of the lease. Some would say that the financial performance of the company is shown in a flattering light.

According to its latest annual report, Tesco’s aggregate operating lease liabilities are £17.3 billion. These materially exceed its net debt of £7.1 billion and its pension liabilities of £3 billion. According to the press, some analysts and investors have been urging Tesco to declare the mother of all price wars on the grounds that financially it can outlast its smaller rivals. In my view, this would be a great act of folly, because the group’s operational gearing needs to be supported by strong cash flow. And there is another point. In the last seven years, Tesco has generated strong free cash flow once: £2.4 billion in 2010, which was partly the result of a 33% cut in capital expenditure following the economic freefall that began towards the end of 2008. In the year to February 2013 it generated just £300m, covering just 25% of its dividend. Gross property proceeds (which are not included in operating cash flow) of £1350 million slightly more than covered the dividend payment of £1184 million.

At 293p, Tesco shares yield 5%. Last year I wrote this about shares that yield 5%.

The market does not like these companies. They are seen as unreliable. This may be because there are external threats that are beyond the power of management to prevent or mitigate or it may be that management is simply mistrusted. It might also be the case that they are mature businesses that are, rightly or wrongly, thought to be approaching the end of their life-cycle.

Well, yes, quite. In the case of Tesco I would add that dividends paid by disposing of operating assets are not to my taste at all. I think that the future for Tesco could yet fall short of what is implied by its apparently lowly share price.


At a price of 307p, Sainsbury shares yield 5.5% implying that the company is liked or trusted less than Tesco. Given that Sainsbury gets a much better press concerning its quality and its perceived ability to defend its revenues from discounters, I imagine that this is due to its history of lower operating margins. Another factor is that the highly respected CEO Justin King is retiring in July.

Financially, Sainsbury is comparable to Tesco but somewhat less aggressively geared. Net debt including pension liabilities amounts to 48% of its equity: for Tesco this figure is 61%. Off-balance sheet operating lease liabilities are also quite punchy, at £8.6 billion. As with Tesco, there is very little free cash flow left after capital expenditure. Yet, the Sainsbury dividend looks more comfortable. Last year, net cash flow before capex was 3.6x the sum needed to pay dividend. The ratio at Tesco was 2.8x. Sainsbury intends to raise its dividend for the ninth year in succession. Tesco’s dividend has been unchanged for three years.

If we believe that supermarket operating margins are trending down towards 3%, the fact that Sainsbury is already at 3.8% should give us some comfort. Overall, I much prefer Sainsbury to Tesco at present.


At 206p, Morrison’s shares yield 6.3% – moreover, the company has said that it will raise the dividend by 5% this year, implying a 6.6% yield. Here is what I previously wrote about companies with 6% yields:

The market does not trust the dividend. It expects it to be cut (or “rebased”, in modern corporate terminology).

That certainly applies in this case. Interestingly, in the conference call after its recent results and strategic rethink, the management went to some trouble to refute claims that it will have to cut or rebase its dividend. Net cash flow in 2013 was 2.6x the sum needed to pay the proposed increased dividend. On the face of it, that looks ambitious. To make matters worse, the name of the Finance Director is Mr Trevor Strain. Ouch. Worse still, investors are not keen on the CEO, Dalton Philips. Philips took over in January 2010 and there is frequent press speculation that a series of poor results have left his position under threat. There is general agreement that his office is now doubling up as the last chance saloon.

The company says that it will release £2 billion of free cash flow over the next three years. Given that the cost of the dividend is £318 million, one might say that this is a strong argument in favour of the company’s defence of its pay-out. Closer examination reveals that this £2 billion includes £1 billion released from Morrison’s property freeholds. So this is not operating cash flow. But the good news is that Morrison owns most of its sites. Unlike Tesco and Sainsburys, it does not have vast operating lease liabilities (they are just £1 billion compared to £17.3 billion and £8.6 billion respectively) and it aims to maintain 80% freehold ownership of its core operating sites (currently c.90%).

So, monetizing part of its property portfolio seems to be a reasonable strategy, albeit one embarked upon as a result of stress (or Strain).

Morrison will also be boosting its free cash flow by a significant cut in capital expenditure: from £1000 million last year to £550 million this year, to £400 million in the next two years. The effect of this plus the planned property disposals more than account for the entire £2 billion of extra free cash flow. In other words, Morrison is not really committing itself to an improvement in the underlying business, which is effectively going to be half as profitable as it used to be. The move down to a 3% operating margin (it was 5.9% in 2010), like Metro, like Carrefour, has been signposted.

So what is the share price of Morrison telling us? It implies that the dividend is unsustainable. It implies that the company’s strategy is unconvincing. The only point on which the market appears to trust the management is its forecast of halved operating margins.

With this as the starting point, I am prepared to invest. At least the company now has a strategy that can largely be understood. There is no doubt that Q1 trading statement on 8 May will be a time of nervousness. But it is also true that another profit warning would probably be the end for the CEO and, sadly for him, that is likely to boost the shares. It is also the case, in my view, that Morrison is the only listed supermarket that could be taken over. There were press reports in February that a private equity consortium might be looking at it. On that point, the minimal pension liabilities and the high freehold ownership are crucial.

When we add operating lease liabilities to net debt and pension liabilities, the three supermarkets trade on the following enterprise value to sales multiples:

Tesco:  0.79x

Sainsbury:  0.74x

Morrison:  0.48x

Were Morrison to trade on the same multiple as Sainsbury, its shares would be at 400p. This is not a forecast, merely an observation.

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