Stockwatch: Multiple reasons to consider this share

Is Morrisons slumping on despair or fair judgment? Should you take more notice of directors' buying? Sentiment has once again turned against the supermarket chain following interim results, yet finance director Trevor Strain has made a near six-figure monetary purchase, buying 58,453 shares at 169.8p.

He was promptly about 10% down as the price slumped to 153p, currently 158p. This follows the new chief executive David Potts buying over £1 million worth – 508,000 shares at 205.85p – last March after chairman-elect Andrew Higginson bought nearly £500,000 worth, 266,209 shares at 186.22p, in January.The chief executive's buy already looks complacent versus the extent of challenges facing Morrisons; which is not hindsight because I noted his buying and, like many watching Morrisons, I felt it better to wait. He now admits what one suspected, that the supermarket chain faces "a long journey" to improve its fortunes. With interim pre-tax profit nearly halved, it's all a caution for investing in highly-competitive sectors. Yet finance directors tend to be cautious, hence it worth considering what his "marker for value" suggests.

Positives vs negatives   

Net asset value is currently about 178p a share due to Morrisons' longstanding "vertical integration" to own farms and factories, which helps assure quality and efficiencies. This translates into a strong cash flow profile (see table) in support of dividends, although note high capital expenditure also. The interims verify this with free cash flow up 13.2% to £479 million. Mind how management is diverting somewhat from this strategy by engaging sale-and-leaseback of properties - Morrisons has become the largest constituent (11%) in the Tritax Big Box real estate investment trust portfolio.

Bid speculation has involved a sense that private equity might strip the asset base, yet bidders haven't appeared – most likely because they realise the assets are integral to the business, and sale-and-leaseback can have limits. The snag for relying on assets as a valuation prop is that unless a business is liquidated they are only worth what they can earn, which leads us to marketing.

Ultimately the marketing battle will decide

Morrisons' dilemma is occupying a no-man's land between low prices at Aldi/Lidl and a sense of better quality available at Sainsbury/Waitrose. The last chief executive tried to respond, belatedly, with a price-matching loyalty card – Match & More - but this involves points collecting than straightforward lowest prices.

Aldi/Lidl's set-up is more efficient: smaller stores offering essential produce, i.e. Morrisons would likely tip into losses if taking the discounters head-on. Logically, management needs to refresh and keep refreshing the retail experience to tempt back shoppers as they tire of a limited range at Aldi/Lidl, offering quality at good prices. It's a tough challenge and only time will tell. Yet location is also an important factor; bear in mind how Morrisons is well-positioned in many towns.

Online development may be tricky. Previous management cut an exclusive 25-year deal with Ocado which has sounded off defensively over the 23 years left, saying Morrisons cannot do its own thing.

Morrisons' dilemma is occupying a no-man's land between low prices at Aldi/Lidl and a sense of better quality available at Sainsbury/WaitroseBesides all this making earnings tricky to project, the price/earnings ratio (PE) can justifiably vary also. High PE's typify turnaround situations where investors believe in recovery, but confidence took a knock when the latest results showed ex-fuel sales down 2.7% and total turnover down 5.1% - as if Morrisons may be losing business both to discounters and higher quality grocers.

The latest balance sheet had net debt down by £254 million to £2,086 million, for near 60% gearing which meant a net £47 million interest charge. That's not excessive debt, but is still likely to limit the PE multiple in anticipation of recovery.  

With both the outcome and what rating to apply remaining largely guesswork, brokers' price targets range from about 150p to well over 200p.

Higher-end values typically take a cash flow approach, with some £866 million free cash generated in the last 12 months, or £437 million excluding disposals, this gives a cash flow yield over 20% or 11%. Such levels may be sustainable as operational savings fund value and service improvements – so Morrison's broker argues. That likely reflects guidance management has provided, i.e. also implies the finance director's logic for buying shares. 

Fears that second-half guidance won't be met

What initially struck me about the latest income statement was that Morrisons is barely profitable without booking asset sales above the line. The 26 weeks to 2 August showed £126 million pre-tax profit with £96 million from disposals also £34 million "other operating income". Supermarkets do argue property disposals are part of normal operations, although investors may see the crux as selling groceries.

The stock trades at a discount to assets and is relatively attractive on a cash flow basis

Furthermore – and it takes some reading through the accounts to note 8 – the depreciation charge is 12.3% lower at £143 million, which will also have helped profit. So there are questions whether the £300-400 million annual pre-tax profit forecasts can be achieved, also how intrinsic they are.

And with £181 million investment within various costs, it's necessary to consider what extent this is vital merely to stem the sales decline, and whether more may be needed to generate growth. "Investment" is a familiar theme from supermarket bosses, although price cuts aren't every investor's sense of what it entails. Morrisons is at last replacing its delinquent self-scan checkout machines that have frustrated customers for years.

The chief industry risk is a "zero-sum game" with growth only from taking rivals' business; Morrisons being unable to claw back sales as Aldi/Lidl consolidate their positions and Sainsbury/Tesco equally fight for share.

The case for buying now

With the stock at a discount to assets and relatively attractive on a cash flow basis, if the new chief executive can progress a turnaround then the risk/reward profile is attractive. Any signs of progress – or simply declines being arrested - at this chart level will attract buyers. You do however need to believe Morrisons can stabilise and regain some share otherwise the stock's fate is to stay in a low range, the market exacting a yield appropriate to perceived risks. 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.