The bidding war for Morrisons is expected to ratchet up this week with expectations of an imminent higher offer from CD&R putting pressure on the Fortress-led consortium and the Morrisons board.
The Morrisons board has accepted a 252p per share offer from Fortress and its backers, but a Sunday Times report suggested bids and counter bids could raise the level to 290p per share by the end of the bidding.
Even that – which would value the supermarket at just over £7bn – is short of fair value for the supermarket, according to cashflow analytics specialist Quest.
The division of Canaccord Genuity distinguishes itself from more conventional equity analysts by undertaking cashflow valuation analysis of companies for institutional investors – in effect, advising big investors on whether to accept bids for stocks they hold in their funds.
For Morrisons, it argued in a recent note that the current bid levels remain materially lower than its own current adjusted value per share of 314p based on assumed cashflow returns.
Morrisons, it argues, is just one of a plethora of stocks being fundamentally undervalued by the market, which uses different valuation metrics to those private equity investors are employing.
“Private equity investors want to know what their return is,” says Quest director Graham Simpson. “They don’t care about PE ratios, DCFs and all of the other classical conventional valuation metrics.”
Ultimately, he says, PE investors want to know: “What is my annual return over the next three years and how does that compare to the cost of debt?”
Looking at UK-listed stocks through this lens, Quest identified particular opportunities for private equity to take undervalued assets at the small end of UK plcs. Some 177 stocks with a market capitalisation below £1.5bn have an leveraged buyout free cash yield above 10% – a key metric making them very attractive to a PE acquirer.
Under-pressure retailers are among those currently most undervalued – according to Quest’s research – with names such as Topps Tiles, Smiths News, Dixons Carphone and Halfords all having an LBO free cashflow yield of between 15% and 30%.
Perhaps most notably for the grocery sector, Sainsbury’s is the most attractive food retail name, with a LBO FCF of 15.3%.
Quest’s Simpson cautions that this current Sainsbury’s level is before a bid premium that would see it fall. For example, assuming a bid came in 30% higher, this would see the Sainsbury LBO FCF yield fall to 12%.
However, this level remains “incredibly attractive”, he says.
“PE typically take a three to five-year outlook in their LBO models,” he explains. “Therefore, the return would be 12% per annum and you still own Sainsbury’s to which you can also apply typical PE levers such as improving working capital delaying paying creditors, reduce stock, strip capex down, run it lean, close stores, to extract further value.”
The big payday at the end of this process, he says, is an ultimate exit and possible IPO having recouped plenty of the PE investment already during the ownership period.
McColl’s, currently at a LBO FCF level of 12.8%, is also picked out as representing value.
Meanwhile, among food suppliers Finsbury Food Group (14.4%), Wynnstay (14.1%), Carr’s Group (10.7%) and Stock Spirits (10.6%) are above the key 10% level, while in household and personal goods Accrol (18%) also makes the cut.
“Finsbury Food is incredibly cheap on our 40-year DCF [discounted cash flow] model, which is more robust than outdated conventional valuation metrics that are point in time and look no further than the current or following year,” he explains.
He describes the current post-Covid differential between market and PE valuations as “unprecedented” and “shows the true extent of the UK plc undervaluation relative to global peers”.
“We do not see the current enhanced M&A interest in the UK plc slowing and we expect H2 2021 to be just as frenzied.”
The Morrisons bidding war may be just heating up, but it’s unlikely to be the last this year.