Cube Report (21 June 2021) – Morrisons goes on sale

Cube Report (21 June 2021) – Morrisons goes on sale

Good morning, it’s Roland here with today’s Cube Report.

A couple of interesting stories have caught my eye this morning:

  • Morrisons (MRW) – the UK’s third-largest supermarket is in bid talks with private equity firm CD & R
  • Capita (CPI) – outsourcer Capita says trading is in line with expectations for a return to growth and announces a disposal

Wm Morrison Supermarkets

  • Stock data should display here.
Market cap £4.3bn
RNS Statement re Possible Offer
Writer disclosure No position

Private equity group Clayton, Dubilier & Rice has made a cash offer of 230p per share for FTSE 250 supermarket group Morrisons. The company’s management say that the bid was rejected as it “significantly undervalued Morrisons and its future prospects”.

I’d certainly agree with that view. Deal talks remain and I’d guess that a higher offer will appear — either from CD & R (which is advised by former Tesco boss Sir Terry Leahy), or perhaps from Amazon, which sources groceries for its UK food business from Morrisons.

I’m a fan of Morrisons. I admire the group’s mostly estate of freehold property and strong cash generation. I also like its unusual vertically-integrated business model, which makes Morrisons one of the UK’s largest food producers. This capability is supporting a capex-light expansion into the wholesale market — Morrisons now supplies most McColl’s convenience stores, plus a growing number of garage forecourt shops.

What are Morrisons shares worth? Ahead of the bid news, Morrisons shares offered a 5% dividend yield and were trading close to their net asset value of £4.2bn (c.175p). I don’t think it’s hard to see the attraction for potential bidders. Here are a couple of numbers that might support a higher bid:

  • Freehold land & property (FY21): £5.8bn
  • Free cash flow per share, (FY20): 12.2p per share

(I’ve used FY20 free cash flow (y/e 31 Jan ’20) above because cash flow last year (FY21) was affected by working capital outflows linked to the operating conditions created by Covid-19 and lockdown. I believe these effects should reverse, so I’ve used FY20 free cash flow to provide a more reasonable estimate of what shareholders might expect in a normal year.)

In the unlikely event that a private equity buyer used no additional leverage and made no changes to Morrison’s capital structure, I think that a bid of c.245p would generate a free cash flow yield of around 5%. I would view this as a minimum valuation for a serious offer.

More likely in my view is that CD & R would use similar financial engineering strategies to those being used by the garage chain owner EG Group, which is buying Asda.

I’d guess that sale-and-leaseback deals on some property — and perhaps a spin-out of Morrison’s food production business — would generate most of the cash needed to to fund a successful bid for the group. In other words, by asset stripping monetising Morrison’s assets, CD & R might get the main supermarket operating business (almost) for free.

My view

Morrison’s shares are trading at around 235p as I write, above CD & R’s rejected offer of 230p. This suggests that the market expects a higher bid.

The supermarket’s current management team are said to share late founder Ken Morrison’s belief in the benefits of a strong balance sheet and a vertically-integrated business. But everything has its price. I’d guess that an offer north of 260p might generate enough shareholder support to seal the deal.


  • Stock data should display here.
Market cap £635m
RNS Market update

Agreement to sell stake in AXELOS

Writer disclosure No position

Trading update: Outsourcing group Capita says that it’s seen “an improving trend in our trading performance” during the first half of 2021, in line with expectations. The company expects to report revenue growth in 2021, for the first time in six years.

Recent contract wins include Royal Navy Training (£925m) and the extension of a European telecoms client (£528m) with which Capita has worked for more than 20 years.

Progress on cost-cutting is expected to deliver operating leverage benefits. What this means is that by cutting fixed costs, revenue growth should translate into stronger profit growth.

Capita had £689m of available liquidity on 17 June, ahead of a £160m debt repayment in July. That seems comfortable to me.

Disposal: The company is also continuing to make progress with the sale of non-core assets. Capita has today announced a £380m deal to sell its stake in AXELOS, a joint venture with the Cabinet Office. AXELOS appears to be a project management/IT service management training provider. The deal values the business being acquired at 11.5x 2020 EBITDA and will result in Capita receiving cash proceeds of £172.5m for its 51% stake.

My view

Capita is one of several such companies to have fallen from grace in recent years. Unlike some rivals, the company’s valuation has yet to recover from dilutive fundraising and a collapse in profitability.

However, Capita shares currently trade on less than six times forecast earnings. Is this a potential value opportunity?

I’m not convinced, for a couple of reasons.

Net debt: Net borrowings were reported at £1.1bn at the end of 2020. That’s equivalent to 3x FY21 forecast EBITDA, which is higher than I’d like to see. Disposal proceeds might reduce this, but I have some concerns about underlying free cash flow.

Free cash flow: Capita reported adjusted free cash flow of £238m in 2020. If sustainable, this would give the business an enterprise value/free cash flow multiple of just 7.7 — cheap. Unfortunately, last year’s free cash flow appears to have been driven by cost-cutting, delayed capex and cash preservation measures such as VAT deferral.

Consensus forecasts I can see show a free cash outflow of £255m this year, presumably as these savings are unwound. Broker estimates then suggest positive free cash flow of £51m in 2022 and £70m in 2023. Based on these estimates, I’d suggest this business is probably fully valued.

An additional concern is that Capita hasn’t felt able to pay a dividend since 2017.

Conclusion: Capita has destroyed a lot of shareholder value in recent years. CEO Jon Lewis now seems to have steadied the ship, but as far as I can tell Capita is still a low-margin business with too much debt.

I’d imagine that continued progress with the group’s turnaround plan could support a higher rating for the stock, especially if Mr Lewis manages to reduce debt levels. Shareholders whose timing is good may be able to benefit from a revaluation gain.

However, I’m not convinced Capita is likely to start generating the kind of reliable, above-average returns on equity I look for in potential investments. So it’s not something I’d buy.

That’s all for today — thanks for reading. As always, all feedback through the channels below will be much appreciated.




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