Edmond Jackson's Stockwatch: Making sense of Morrisons

Is Morrisons worth the risk yet? Despite management advancing a robust message at the 11 September interims shares in the FTSE 100-listed food retailer have festered - down to about 160p, a near halving in the last 12 months.

Does this include bad sentiment likely to improve in the longer run, or is it a rational response to a major supermarket under pressure?

Dividend is axiomatic for the risk/reward profile

If the dividend is long-run sustainable over 10p/share then the shares will re-rate, but the market doubts this even after the board raised the interim payout by 5% to 4.03p and affirmed a total dividend of not less than 13.65p for the year to 3 February. Strong cash flow progress was cited, up £531 million year-on-year, and "we remain confident that we will generate £2 billion of cash and £1 billion of cost savings over three years."

Good, but this is spin - as the net cash flow position is what counts, once the effects of the supermarkets' price-war become clear, which will take a while. Sainsbury's must in due course respond to falling sales and Tesco continues to beef up its board towards better retailing.

The privately-owned Aldi and Lidl have lean structures and no need to pay dividends, a significant competitive advantage. Listed UK supermarkets often talk of "investment in the product offering" and you can see from Morrisons' five-year table how capital expenditure per share has swallowed most if not all cash flow. This is an amber light for investors, and mind it could turn red if the "investment" has to include more price cuts.

Vertical integration has mixed benefits

This is a unique aspect of Morrisons, meaning it owns aspects of the supply chain which confers quality for customers, e.g. Morrisons was not affected by the horsemeat scandal and was 2013 Fresh Produce Retailer of the Year. A fish processing plant in Grimsby means a wide range of fresh fish and a banana plant in Boston helps mature bananas more precisely.

Locally I notice a Sainsbury's store may get compromised with lots of small ripe bananas, or lack of any, whereas Morrisons are generally larger and with better scope to ripen. Its fresh produce shelves are usually well-stocked and "use-by" dates are adequate, implying investment in the supply chain which makes for a dependable customer experience.

By contrast at Lidl, while chilled produce has "use-by" dates, you are left guessing about other fruit & veg. There is anecdotal evidence in online forums, people don’t consider it lasts long enough from Aldi and Lidl - especially more perishable produce such as berries. Yet owning some key suppliers also tends to lock in costs and mean less opportunistic sourcing; what's new?

The Germans can still under-cut massively on specific items

Take apples for example. I find Morrisons the best provider of quality English apples as the season evolves, but it is hard to trust pricing. Last August, Morrisons introduced bags of Discoveries at a price over 200p/kg then discounted this to 189p/kg for loose Discoveries and put the same price label on Worcesters when they appeared in September. But when I checked out the Worcesters they were charged as "Loose English apples" at 229p/kg.

When I challenged a second store about this, they refunded me the difference, yet Morrisons head office later insisted all English apples had been priced at 229p/kg this season. Instead I recall a "Loose English apples" at 229p/kg category appearing on check-out machines alongside apple varieties at different prices. There is no need for it to exist anyway because English apple varieties are supplied with a 4-digit ID label; but it has helped establish a pricing category to exist for the legal minimum period, such that Morrisons has now put "English apples reduced 20% to 179p/kg" all over its shelves.

To me this feels like a bogus offer and Morrisons still has discrepancies at check-out: e.g. I bought Spartans priced at 179p/kg on the shelves but my 7 October receipt shows they were charged at 189p/kg. Contrast this with Lidl where Class 1 English Cox are 100p/kg; I have bought three lots in recent weeks and all lasted well. It's a big under-cutting which doesn't apply to all produce but shoppers are learning to find items significantly cheaper. On my first visit to Lidl I parked in between a large new BMW and a Porsche.

"Match & More" loyalty card looks a damp squib

This latest initiative fails to recognise shopping trends towards 1) smaller baskets as more fresh healthy food is sought, and 2) shoppers increasingly nimble between stores as to what they want. At least Morrisons has adjusted to a minimum £15 to be spent than the £35 vouchers enough people must have thrown away; but it is hard to see how effective comparisons can be made with the continental brands (of different sizing) in the German-owned stores. Lidl is already poking fun.

The best that can be said is this loyalty card being an overdue effort to monitor buying patterns like Tesco has done via Clubcard or Sainsbury's via Nectar. Not that I for one tend to act on Sainsbury's targeted vouchers, e.g. why get a few Nectar points on nuts and seeds when they are 20-30% cheaper at Lidl and good quality?

Discount to net tangible assets is no margin of safety or takeover prospect

Some investors take heart in net tangible assets per share possibly around 180p, as limiting downside risk and raising the chances of a takeover. But Morrisons' property assets are integral to the business with limited scope for sale-and-leaseback. The crux is where Morrisons ends up in terms of profit and cash, versus its rivals, in possibly 1-2 years' time.

This is currently speculative e.g. because you can't anticipate what certain rivals may do, and what becomes the "investment" response simply to stand ground. Ultimately, the dividend policy has to reconcile with this.

Only the marketing battle will decide

Management's emphasises "good early progress", six months into a three-year plan, with cost savings and cash flow targets on track. Indeed you can see improvements at individual stores and for various items Morrison is a good place to shop. But its stock is unlikely to turn positively without evidence the like-for-like sales fall is at least being mitigated - and not mainly by sporadic boosts e.g. the "£5 off" vouchers in The Sun.

Conservative investors should continue to steer clear, and more speculative operators bookmark the next update due 6 November. After the recent sell-off the stock can rise if the figures lend hope. Mind that a tough battle lies ahead, and if it ever starts to look as if the next financial year's dividend should be cut, the stock will fester again.

For more information see morrisons-corporate.com.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.