Clayton Dubilier & Rice has form in UK retail. Is its bid likely to succeed, and what would the implications be for Morrisons and the sector?
News of an unsolicited £5.5bn private equity approach for Morrisons sent shockwaves through the industry. Shares in Morrisons spiked 34% on as the London Stock Exchange opened on Monday, with Sainsbury’s and Tesco also carried higher as public markets suddenly woke up to the fact the listed grocers may have been undervalued for quite some time.
After turning down its offer, the Morrisons board – and the City – now await the next move by US PE giant Clayton Dubilier & Rice (CD&R), which has until 17 July to table a sweetened offer or walk away. Here’s what we know as things stand.
Why do CD&R want to buy Morrisons and how much might they pay?
Corporate raider CD&R has form in UK retail following its investment in discounter B&M, which it spun off via a stock market listing in 2014. Its ranks include former Tesco chief Terry Leahy, a senior advisor since 2011, who was put in place as chairman at B&M until CD&R’s exit in 2018. Leahy is also on the board of CD&R-owned forecourt operator Motor Fuel Group, which raises a possible strategy of introducing a Morrisons offer to its 900 sites, similar to potential plans for Asda under the Issa brothers with their EG network.
The investment firm will now be weighing up whether to come back with a higher price, taking into account the potential actions of MPs in Westminster, the unions, public sentiment, Morrisons shareholders and, not least, the supermarket’s board.
With Morrisons shares leaping 34% to 239p on the news – 9p more per share than the rejected 230p offer – markets feel there is room to go further.
Retail analyst Nick Bubb reckons a deal can be done in the 250-260p range, valuing the chain at up to £6.3bn.
Analysts at Barclays say the rejected offer is unlikely to have been pitched at the maximum CD&R could theoretically justify paying. The investment bank adds Morrison’s management may struggle to explain what it can do differently as an independent company to keep the share price at 230p or better. “On this logic, we tend to think that the story is unlikely to have ended with Morrisons’s rejection of the conditional proposal,” it says.
However, Andrew Porteous of HSBC points out PE is constrained by the lack of big synergies it can bring to the party, though freeholds, logistics and the vertically integrated supply base at Morrisons all present opportunities for a higher price.
Factoring in Morrisons’ £2.3bn of debt and £1.3bn of lease liabilities, its enterprise value is £7.9bn, which is only slightly lower than the £7.4bn of property and assets on its balance sheet. AJ Bell investment director Russ Mould says this is “prime private equity territory”.
Other PE firms may have spotted the same opportunity, Barclays notes.
Rival PE giants Apollo and Lone Star have done their homework on the sector with their failed pursuit of Asda, while KKR and private consortia are also “lurking in the shadows”, creating the possibility of a bidding war, a City source adds.
What could a takeover mean for Morrisons’ stores?
Even for Leahy it’s going to be tough to find low-hanging fruit at a retailer that under fellow former Tesco man David Potts has been one of the sector’s star performers of late.
Morrisons has been arguably the most fleet of foot supermarket through the pandemic, with Q1 sales up nearly 9% and online sales tripling in 12 months. The management team, also boasting respected COO Trevor Strain and chairman Andy Higginson, has honed an operation seen not so long ago as a laggard, lacking c-stores and online strength.
Now, as well as its much-touted vertical supply chain, Morrisons can claim to be far more competitive on price, with a major range reset well underway. Yet it has managed to hold on to another key point of difference in its in-store Market Street counters.
“This is where the alarm bells start ringing for me,” says Retail Mind CEO Ged Futter. “If there is one thing private equity doesn’t want it’s a price war.
“But if they put prices up then Morrisons will be surrendering the price war, which suggests they may instead look at taking out costs. That means colleagues in factories and stores.
“It’s not like when CD&R took over B&M, when the job was to basically professionalise that business from a £1bn to £3bn company.”
Bryan Roberts, founder of Shopfloor Insights, adds: “The big question is what do they think they can do better than the existing management to change Morrisons’ trajectory?
“It would be a huge shame if they followed everyone else and started closing counters.”
Debenhams serves as a reminder of how disastrous asset-stripping can be and the likelihood is Leahy and co will focus on the real estate side.
But Porteous argues there are also more creative ways PE can look at Morrisons other than selling store freeholds.
“A sale and leaseback of the warehouses or distribution centres is less of a risk than on a store as it isn’t a strategic asset in the same way,” he adds.
Morrisons, unlike rivals, also owns 18 manufacturing sites, making it one of the largest fresh food suppliers in the country, producing freshly baked bread, seafood, fresh produce, chilled foods and meat products.
“Although it is true that Morrisons contains a very sizeable food manufacturing business as well as its retail operations, we have always been sceptical that these operations could be easily hived off given its near-total dependence on one customer,” adds Barclays. “Beyond ‘optimising’ Morrison’s real estate ownership, we do not see further obvious structural changes.”
What does a PE owner mean for the Amazon partnership, and could the e-commerce behemoth mount its own bid?
The long-running and ever-expanding Amazon contract has been a growth engine for Morrisons. Despite being a late adopter on home delivery, and its handing back of CFC space to Ocado in 2019, the supermarket was a clear 2020 Christmas winner among its peers, with online growth of 190% in December, according to Kantar. Morrisons also acts as a wholesaler for Amazon, supplying goods for Prime, as well as its new till-free Fresh stores in London.
So, will Amazon be spurred into action and gatecrash CD&R’s party? Bubb thinks it is unlikely: “If Amazon was ever going to bid for Morrisons, to build a bigger physical presence in the UK grocery market, it would have done it by now.”
Barclays argues without Amazon’s existing relationship, Morrisons is not the perfect partner given its geographic weighting, less affluent customer base and limited convenience exposure.
“A PE owner of Morrisons would likely be keen to continue the relationship with Amazon, so we doubt Amazon would feel the need to get involved from a defensive viewpoint,” the investment bank adds.
Bryan Roberts points out Amazon’s ownership Whole Foods has been “a mixed experience” and it is likely to put all its energy into expanding the Fresh stores concept.
What does the CD&R bid mean for the sector as a whole?
Porteous expects the offer to act as a long-needed catalyst for revaluations in the sector, which despite soaring sales throughout the pandemic has remained unloved by investors.
“In David Potts, you have one of, if not the, best retailers in the UK,” he says. “The management team have done a really good job, and there is a lot more to go for, but that has clearly not been rewarded in the share price.
“There is a gap between the perception and the reality that is being exploited [by PE] at the moment.”
Morrisons was, before CD&R’s approach became public, worth less at £4.3bn than rapid delivery startup Getir, valued in a funding round this month at $7.5bn (£5.4bn).
Porteous thinks the markets have overlooked the sustainability of the hundreds of millions of pounds of free cashflow generated by the supermarkets. He estimates Morrisons should be able to throw off around £400m a year in the near term, Sainsbury’s £500m and Tesco should be aiming towards £2bn of free cashflow.
“The sector remains tarnished by previous mismanagement, but there has been a paradigm shift over the past five years for the better, in particular through increased focus on free cashflow, which remains underappreciated in most analysis and is more sustainable than many appreciate,” he says.
Clive Black of Shore Capital argues there has also been a fundamental improvement in the industry’s economics to go alongside the “honey pot” of free cashflow yields.
He argues inflationary pressure could also be a tailwind for grocers; the price gap to the discounters has been structurally narrowed; and the online channel has moved from being an unprofitable millstone to one of share gain, bigger baskets and improved operational metrics.
Black adds if a PE company is interested in Morrisons, Tesco and Sainsbury’s could also be in play. “The odds are not especially in the outer solar system that the three listed supermarkets may be off the public market in the foreseeable future.”
Czech billionaire Daniel Kretinsky has built a 10% stake in Sainsbury’s, leading to speculation about the retailer’s future as a listed business.
Porteous notes a Tesco valuation similar to the Morrisons bid would imply a share price well above 300p (it is currently languishing at 225p, giving Tesco a market cap of £17.4bn).
“Tesco offers the most compelling opportunity from here,” he says. “Its valuation is at historic lows; it should have the best long-term value creation opportunity; and its highly competent new management team are only just getting started in setting out their plans.”