Selling assets may generate easy wins for private equity owners but turning supermarkets into more valuable businesses is no easy task.
Unless another bidder comes along it seems that CD&R has won the battle for Morrisons with a 287p per share bid. Attention has now turned to which supermarket will be taken over next with Sainsbury’s being touted as the most likely target. It’s easy to see why people might think this but there are good grounds for thinking that it won’t happen as well.
The bull case for Sainsbury’s is that like Morrisons it has substantial freehold property assets that can be sold off. Its shares are also seen as being cheap with some commentators pointing to a forecast EV/EBITDA multiple of 5.4 times for Sainsbury’s compared with slightly over 9 times being paid for Morrisons.
This logic may turn out to be true given how desperate private equity groups are to spend the mountains of cash they are sitting on and the financial engineering opportunities that freehold property assets present.
That said, as Next rightly said in its half year results statement last week, EBITDA is a flawed measure for valuing a retail business (or arguably any business), especially one with a meaningful rent bill (EBITDA is stated before rents) but also one that needs to replace in-store assets on a regular basis.
Making Morrisons work out is far from easy for CD&R in my view. The fact that it barely increased its offer in the final auction is a sign that it was very close to the limits it was prepared to pay. That Amazon -long touted as a potential suitor – did not enter the bidding war may also be very telling.
Of the c£10 billion CD&R is paying for Morrisons’ assets, around £6.6 billion of it will initially be financed with debt. This would give the new Morrisons a net debt to EBITDA ratio of 5.9 times which is the kind of level that makes lenders nervous.
CD&R will need to pay down debt quickly and the obvious candidates are to sell off stores, petrol stations or warehouses.
Swapping freehold stores for rented ones in a sale and leaseback transaction raises cash but does little to reduce the gearing in a business as rents are then payable when previously they were not.
Selling off petrol stations would bring in some cash whilst not sacrificing much in profits due to the much lower margins on fuel sales and it would not be surprising if this is done very quickly.
The success of CD&R’s ownership of Morrison and the returns it will ultimately achieve on its c£3.4bn equity investment in the business will come down to how much it ends up selling it for.
To make it work it is going to have to create value from growing Morrisons’ sales and profits. At the time of writing, City analysts expect sales growth of just 1.5 per cent a year for Morrisons next year and the year after.
How is CD&R going to do better than this?
The company itself makes much of its success with its involvement in B&M Stores which continues to perform well. The trouble is Morrisons is not the same business as B&M.
B&M is a discount retailer which has adopted a different business model. It generally operates out of smaller stores, concentrates its buying into many fewer products and offers great prices to its customers by passing on its lower costs. By selling lots of volume it makes the kind of returns on investment that the big supermarkets can only dream of.
In fact, it is very similar to the business model of Aldi and Lidl who have inflicted so much damage on the big supermarkets and may continue to do so.
I’ve walked around Tesco and Sainsbury’s recently and both make much of their price matching with Aldi. This is a sign of their comparative competitive weakness. That Aldi leads on price – and has done for a while – should send shivers down the spines of investors in the big supermarkets – even more so if they are loaded up with debt. This is because it makes it difficult to win new customers.
Despite their bigger scale and the buying benefits that come with it, the big supermarkets’ chief problem is that they are too big. Their stores are too big with too many overheads and they sell too much stuff. This is simplistic, but it is why the discounters such as Aldi can outcompete them and why it is opening so many new stores.
The discounters are also not burdened with internet delivery businesses that suck up a lot of resources but generate little in the way of profits.
It’s going to be very interesting to see how CD&R gets on with trying to accelerate Morrisons’ growth rate against such a tough backdrop and how it can then persuade someone else to buy the business from it in five years’ time for more than it paid for it.
It may well succeed and open our eyes as to where current supermarket management teams have been going wrong. If it doesn’t, its investors will not be happy.
However, it may succeed by financial engineering and cashing in on property sales and then cash out by putting Morrisons back on the stock market.
A similar opportunity potentially exists with Sainsbury’s but investors should not see it as a certainty.