retail

How a private equity buyer could make the most of Morrisons

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Managers at Wm Morrison have expressed relief at agreeing a takeover that respects the “fundamental character” of the UK’s fourth-largest grocer — but few think that will prevent a new owner from making big changes.

The board’s decision to recommend a £9.3bn offer from a consortium led by Fortress Capital was partly driven by the private equity group’s pledge to honour the legacy of Ken Morrison. The founder’s son committed the company to low debts, high property ownership and a vertically integrated model in which the grocer produces half the fresh food it sells.

But for all the plaudits Morrisons has won for its handling of the coronavirus pandemic, the company is forecast to make about £342m in net profit in its current financial year, almost exactly half what it made a decade ago. Its operating profit margins are little different to rivals such as J Sainsbury, despite its low rent bill and captive supply chain.

That suggests any acquirer — two other private-equity bidders have expressed interest in buying the group — would need to improve performance or release cash from the business to achieve a decent return, even if some big investors have warned about buying the company “for the wrong reasons”.

The most obvious Morrison shibboleth to revisit is the high level of property ownership. Many believe that Fortress will release cash from Morrisons’ extensive real estate even though it has ruled out “any material store sale and leasebacks”.

Ken Morrison
Ken Morrison committed the company to low debts, high property ownership and a vertically integrated model in which the grocer produces half the fresh food it sells © Shutterstock

At Majestic Wine, which Fortress acquired in December 2019, freehold assets were immediately transferred into a separate property entity also controlled by the private equity group and leased back to the wine merchant for 25 years.

“It makes sense to monetise that asset base,” said one senior private equity executive specialising in real estate. “I would expect them to at least look at an opco-propco structure”.

Simon Laffin, who was finance and property director at Safeway before its acquisition by Morrisons and later advised on a private equity bid for Sainsbury’s, said outright sales of stores were not straightforward.

“In 2004, Tesco and the others were salivating at the prospect of buying the stores we might have to sell,” he said. “Nobody is looking to open more big supermarkets now.”

He added that sale and leaseback deals risked saddling the group with rents that would reduce its profitability.

But Steve Windsor, a principal at Atrato Group, said financial buyers would pay high prices for freehold sites with Morrisons as a tenant on a 20-year lease. Atrato advises the Supermarket Income Reit, an acquirer of such freeholds.

“[Morrisons] could raise considerable cash just by reducing the freeholds to the same level as Tesco,” he said. The UK’s market leader owns just under 60 per cent of its stores.

Fortress declined to comment on its post-acquisition strategy.

Line chart of Change over year (ppts) showing UK supermaket market shares

A private equity owner could also look to sell distribution or manufacturing sites. TDR and the Issa brothers, who acquired rival supermarket Asda this year, have already sold its petrol stations and are closing in on a sale of its logistics assets.

Another alternative is to issue bonds secured against property. Iceland Foods raised more than £250m at a coupon of about 4 per cent this year. That is comparable with the yield an investor would expect on a sale-and-leaseback, but without sacrificing the flexibility of freeholds.

Debt was another of Morrison’s pet hates, but supermarkets’ cash generation allows for high leverage. Nick Coulter at Citi said raising £6bn of debt to acquire Morrisons for £9bn would equate to about five times forecast underlying earnings, a level of leverage that Iceland has lived with for almost a decade.

Although Morrisons is regarded as a well-run operation, there may still be opportunities to cut costs, by reducing ranges in the stores as Asda is doing, or by rethinking the “Market Street” format of separate counters for meat, fish and chilled produce.

Rivals have already largely abandoned counters, citing their high operating costs and changing customer behaviour. A new owner may also consider unpicking the integrated supply chain and selling some of the manufacturing operations.

Fresh fish counter in a Morrisons store
Supermarket rivals have largely abandoned separate counters for fish, meat and chilled produce © Christopher Furlong/Getty

But one former executive at Morrisons warned that the supply chain and counters were both key to the operating model.

“They did a big review of manufacturing under [former chief executive] Marc Bolland and concluded that having their own supply allowed them to match rivals on price, which as a smaller operator you would not usually be able to do,” he said.

There may also be opportunities to boost returns by marrying the core food retail operation with other businesses. Coulter at Citi thinks the fuel forecourt portfolio owned by Clayton Dubilier and Rice, another potential bidder for Morrisons, would provide a sizeable convenience store pipeline and the opportunity for efficiencies.

Morrisons’ wholesale business, which supplies convenience stores and filling stations, could also be expanded by acquisition. Its annual revenue is currently below £1bn compared with the £6bn or so that Booker generates for Tesco.

Then there is the question of an eventual exit. A sale to a rival UK supermarket is unlikely after the Competition and Markets Authority blocked the takeover of Asda by Sainsbury in 2019.

Laffin said that unless there was a re-rating of the sector, a return to the stock market would be difficult if Morrisons’ profitability was much weakened by rents or interest charges. “Its value to shareholders is driven by profits, not property.”

That leaves a “secondary buyout” by another private equity group, a sale to an overseas retailer or a combination with a non-food retailer, possibly Amazon, as other options.

Or a new owner could retain the group for an extended period. “You don’t always need an exit,” said one former supermarket chief executive, adding that if equity exposure was reduced by disposals, distributions from regular cash flow and refinancings could generate a more than adequate rate of return.

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