Stockwatch: Short squeeze triggers recovery here

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Stockwatch: Short squeeze triggers recovery here supermarket competition
Can Morrisons (MRW) "do a WH Smith (SMWH)", or is its valuation becoming exposed as the expansion of discounters Aldi and Lidl force more price cutting?

Against declining or static revenue, WH Smith soared 176% to 1,880p in the four years to spring 2016, as its operating margin rose from 7.1% to 10.5% - significantly higher than the food retailers' (see table below). Morrisons has only recently achieved 2.6%, yet its latest results imply a quiet revolution is underway.

After the 2015 interims, I drew attention to Morrisons' director share buying. The finance director made a near-six-figure monetary purchase at 169.8p, the chief executive bought over a million pounds' worth at 205.85p and the chairman elect spent nearly £500,000 at 186.2p.

The market thumbed down the results, but bosses' buying on this scale spoke through. The chart has since been volatile, but is testing 210p for a second time this year after the latest interims to end-July.

Major improvement

Last year's 35% slump in underlying pre-tax profit corresponds to a 35% rebound in earnings per share this year and second quarter like-for-like sales ex-fuel/VAT rose 2.0%, representing a third consecutive quarter of top-line growth. It begs the question whether Aldi and Lidl's disruptive influence is peaking, given that Morrisons is fighting back to build intrinsic value.

Mind that the arch-competition continues: Morrisons has just slashed meat and poultry prices 12% in a 4,000 line price cut programme, as if tempering scope for margin recovery. I'd strip out profit from disposals to view the first-half operating margin jump 0.9% to 2.6%, helped by a 50% cut in administrative expenses.

While there is fear that weaker sterling increases food import prices, retailers could opt to absorb these in an ongoing price war. Morrisons says it imports less of the food it sells than the 40% industry average.

The CEO looks to have established a grip compared with woes under his predecessorThis affirms a "vertical integration" model where Morrisons rather uniquely owns aspects of the production line, like farming. It also has a smaller consumer goods offering compared to other supermarkets, where products which are typically imported.

The story on sales is currently bolstered by online-related initiatives, which include renegotiating a contract with Ocado (OCDO) and extending a partnership with Amazon Fresh. Morrison is also installing click-and-collect lockers in the hope Amazon (AMZN) customers will also shop for groceries.

Free cash flow jumped 16.5% to £558 million, which helped reduce net debt by £477 million - ahead of target - to £1,269 million. The interim dividend rose 5.3% to 1.58p and although the annual dividend recently de-rated (see table), it nicely rounds off a release that affirms a recovery situation.

It conveys the current chief executive having established a grip compared with the woes under his predecessor.

Morrisons the second most-shorted stock

From Short Interest Tracker you can see that 18.1% of the issued share capital is on loan, but a look at the five-year chart suggests any hedge funds short on Morrisons are seeing their profits either eroded - assuming they took positions pre-2014 - or losses extended.

These latest results imply the story is unlikely to worsen in the short term, with shorters under pressure to close. Do you recall how Home Retail Group was similarly one of the most shorted stocks, but rose substantially from 85p in June 2012 when I drew attention to this coinciding with marginally better news? Home Retail has since been acquired by Sainsbury (SBRY) for 144p equivalent, a proper denial of financial speculators.

It remains to be seen whether the Aldi/Lidl marketing mix can help them join the UK top tierThe bear case assumes the price war intensifies to such an extent that Morrisons' latest boss runs into diminishing returns; that a weaker currency and UK economy during the Brexit years undermines his progress; or that Aldi and Lidl take more share, their sales up 10.4% and 12.2% respectively in the three months to mid-August.

In November 2014, Aldi declared an intention to increase its estate from 450 stores to 1,000 by 2022, and is a fifth of the way there. Lidl is investing £1.5 billion over the next three years to build 40-50 stores annually, up from 150 as of last November. By comparison, Morrisons has 490 stores, albeit with a much bigger footprint.

The bearish scenario shorters are betting on is that the "big four" supermarkets become the "big six" and decidedly ex-growth. The stocks could then de-rate to exact a yield more attractive for income-seekers.

Yet it remains to be seen whether the Aldi/Lidl marketing mix can help the discounters join the UK top tier, given their limited product ranges, often lengthy check-out queues (with no self-service) and smaller car parks. Another risk is if Walmart puts more resources into its Asda subsidiary, helped by the sterling/dollar exchange rate. Again, this is speculation, whereas Morrisons has just dealt proof of progress.

Risk/reward weighs to the upside if Morrisons can maintain progressive updates and firm numbersAgainst these risks, Morrisons trades on 20 times forward earnings at about 210p a share, a circa-50% premium to net tangible assets and a sub-3% yield - a rating that admittedly leaves little room for disappointments resuming.

On present evidence, however, Morrisons looks a diluted version of WH Smith, the new chief executive succeeding to wrest earnings growth and establish a fresh corporate culture. Never under-estimate the pervasive long-lasting effects of a capable CEO.

So it's a close call; you can expect to see a high percentage of stock remain on loan - shorted - both for reasons of supermarkets' competition and hedge funds' conviction. Meanwhile Tullow Oil (TLW) has staged a recovery despite being in the top five for stock-on-loan, with some of the hedge funds dug in.

All considered, risk/reward weighs to the upside if Morrisons can maintain progressive updates backed with firm numbers. They raise the likelihood that a chunk of the 18.1% stock on loan will be bought back in the market - i.e. technical support to squeeze the stock higher and entice other traders to back a recovery trend.

Morrisons - financial summary Consensus estimates
year ended 31 Jan 2012 2013 2014 2015 2016 2017 2018
Turnover (£ million) 17,663 18,116 17,680 16,816 16,122    
IFRS3 pre-tax profit (£m) 947 879 -176 -792 217    
Normalised pre-tax profit (£m) 949 880 696 1,462 242 330 356
Operating margin (%) 5.6 5.2 4.4 9.2 2.1    
IFRS3 earnings/share (p) 26.0 26.6 -10.2 -32.6 9.5    
Normalised earnings/share (p) 24.5 24.9 24.3 64.0 8.7 10.0 10.6
Earnings per share growth (%) 4.5 1.7 -2.5 163 86.5 15.3 6.3
Price/earnings multiple (x)         24.1 21.0 19.8
Cash flow/share (p) 36.1 45.6 31.0 37.6 38.5    
Capex/share (p) 30.6 40.2 42.4 3.1 2.8    
Dividends per share (p) 11.5 11.0 12.2 13.2 11.1 5.3 5.6
Yield (%)         5.3 2.5 2.7
Covered by earnings (x) 2.2 2.3 2.0 4.9 0.8 1.9 1.9
Net tangible assets per share (p) 201 205 181 132 140    

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.