Rethink supermarkets and start with Morrisons

But we are going to make the business case for the supermarket anyway, and even after a year in which hopes of a pandemic-led surge in earnings were skittered by the extra costs of managing Covid-19. That’s because there is an increasingly strong bull case for the broader grocery sector, after years of understandable apathy from investors. Within the group, Morrisons looks to be a front runner.

We made a long-term income-themed investment case four months before the pandemic shut down the UK economy, and with the shares at 199p. Much of what we said then stands now. A deepening partnership with Amazon remains positive for sales, branding and ever-present takeover chatter. A now-profitable wholesale arm goes from strength to strength. And while the run of special dividends was ended by changing cash management priorities last year, a robust balance sheet should provide support to payouts.

Fifteen months on, we also think there is further evidence that Morrisons has the right strategy. Its operations are unencumbered by legacy bets on international markets, banking or non-grocery retail (unlike rivals Tesco (TSCO) and J Sainsbury's (SBRY)), while expansion plans do not rest on sale-and-leaseback arrangements and the issuance of billions of pounds of junk debt, (as with the private equity-backed leveraged buyout of Asda). The limited product range discounters Aldi and Lidl do remain a threat, although their deliberate under-investment in online channels now suddenly looks like a weakness.

By contrast, Morrisons has grown its market share from 9.9 per cent in late 2019 to 10.4 per cent, according to Kantar World Panel. That’s a greater rate of increase than any of the big seven UK grocers (see chart), and is due to a combination of extra in-store and online capacity, expansion of the Amazon tie-up, doorstep deliveries, a popular food box range, and a successful trial with the Amazon-backed last-mile delivery group Deliveroo.

At the same time, sales for both Morrisons and the wider sector have been juiced by grocers’ designation as essential retailers, although the return of £230m-worth of business rates relief and £280m in one-off virus-related costs in the recently completed financial year show this has been a double-edged sword. An unchanged forward price-to-sales ratio of 0.25 also suggests investors see the past year’s surge in like-for-like trading (see chart) as a one-off.

From deliveries to deliverance

Near-term pessimism isn't unfounded. The reopening of the hospitality industry might mean Morrisons’ non-fuel retail sales dip in the 12 months to January 2022. That’s not a given, however, and many people will have formed new habits that prove sticky. Equally, we think shareholders should think bigger, and longer term.

Why so bullish? Well, in less than a year the incumbent grocery sector has both improved its brand value and learned a decade’s worth of lessons about how to successfully run and scale an online shopping business.

Belated perhaps, but supermarkets now finally understand what Jack Ma meant when he told Alibaba shareholders that “the boundary between offline and online commerce disappears as we focus on the fulfilling the personalised needs of each customer”. Those comments were made in 2017, the same year Amazon surprised everyone by buying premium supermarket chain Whole Foods.

Why would the world’s most successful e-commerce company place a value on physical retail? As the Boston-based investor Gavin Baker argues persuasively, bricks-and-mortar retail operations help to lower the so-called customer acquisition cost (CAC) to online retailers, which are eternally looking (and often struggle) to improve their marketing efficiency. “In a world where ‘CAC is the new rent’…one of the best ways to lower your online rent – ie, CAC – is to pay rent offline for physical stores,” says Baker. A real world presence helps build online loyalty.

This brings other benefits. Morrisons now offers a click-and-collect service, which is only likely to grow as customers cement the habits formed in lockdown, particularly if they have found them more convenient. The past year has also forced grocers to think smartly and efficiently about meeting and anticipating shoppers’ needs. It is therefore encouraging to hear chief executive David Potts talk of a rapid and continual learning process. Partnering with Amazon, the perennial reinventor, can hardly hurt in this endeavour.

There’s another reason to believe the sector, and Morrisons in particular, looks undervalued in a post-Covid world. While there will be pockets of strong economic recovery in the UK, the return to restaurants and bars is likely to be both staggered and checked by the millions of people whose disposable incomes have been hit by job losses or financial hardship. It won’t be as binary as leisure versus food retailer stocks, but the higher valuations of the former seem like an odd premium for the market to apply compared with the latter. We now know that short of total social collapse, the supermarkets are going to stay open.

Evolution, not revolution

Naturally, investors should be ever mindful of the sector negatives. Although bets against the stock at 3.9 per cent are down from a post-Brexit vote high of almost 20 per cent, Morrisons is still the 13th-most shorted London-listed share, according to regulatory disclosures.

That means plenty of smart people remain bearish, and with foundation. For one, while it’s fair to say that the worst fears have been avoided, Brexit is throwing up all manner of complications to UK food supply chains. These aren’t merely confined to customs issues, either. Following withdrawal from the single market, the government is yet to work out a long-term solution to the question of agricultural labour, although some believe the eventual settlement could lead to high prices on supermarket shelves.

With or without a domestically sourced supply chain, the rising prospect of higher inflation in the coming years will be a challenge to a business model that keeps suppliers on a short leash while giving customers everything they want. Throw in dogged competition, and you get an average operating margin of 1.9 per cent over the past five years. The flipside of this could be increased consumer preference for the lower prices that supermarkets specialise in. Plus, Morrisons has navigated inflation for more than a century.

The current chapter of this long history sees the grocer finally start to emerge as a digitally-enabled, omnichannel business, with all the potential for productivity efficiencies this brings. A business rates regime that levels the playing field for physical retail is another potential fillip in the years to come. Property investors, which can’t pour enough money into supermarket sites, seem to recognise the sector’s renewed strength. The rest of the market could soon wake up to the shift, too. Morrisons’ full-year numbers are released on 11 March.