It hasn’t popped up on the radar for a while, but this year the Opco Propco is back - thanks to the flurry of activist investors sniffing around Morrisons. Their pitch is simple: Morrisons should put some of its property portfolio into a separate vehicle - possibly a real estate investment trust (REIT) - and sell this off to investors, thus releasing a healthy windfall to shareholders.
Morrisons isn’t the only retailer that would benefit from exploring the Opco Propco route, they add. It is high time Sainsbury’s and Tesco graduated from crude sale and leasebacks and replicated the REIT model adopted by Canadian chain Loblaw last year.
Opco Propco vs sale and leaseback
Under an OpCo Propco, a subsidiary owns the property instead of the operating company. The subsidiary leases the property back to the operating company, which can then spin off the subsidiary as a real estate investment trust (REIT), allowing the company to avoid the double taxation on its income distributions.
Under a sale and leaseback, a company sells a property and then leases it back for an agreed term. The company has use of the asset but no capital tied up in it and does not have to list the debt it owes on the lease on its balance sheet. It is a good way to raise short term finance, but the seller loses the flexibility associated with property ownership.
As well as allowing retailers to lease their property from a subsidiary rather than an unrelated entity (as in a sale and leaseback), Opco Propcos would enable them to raise hundreds of millions of pounds. According to one City source, the combined value of the three grocery retailers’ property holdings is around £60bn, whereas their collective market cap hovers around the £40bn mark. What’s not to like?
Yet while the activist investors are very much in favour of Opco Propcos, others are vehemently against. Some Morrisons shareholders go so far as to describe the idea as “incredibly dangerous” - and analysts agree. So what’s the truth of the matter? Could an Opco Propco model work in the UK? What are the potential pitfalls? And, if not via an Opco Propco, how else can the supermarkets sweat their property assets?
The last time the debate was fully aired in the UK was 2007 when property tycoon Robert Tchenguiz launched an ultimately doomed attempt to buy Sainsbury’s. To Tchenguiz, the main attraction of the supermarket group wasn’t the sales ringing through its tills, but the value of its store portfolio. He viewed the business as a “real estate company with a retail business on the side”.
Although the Opco Propco focus is on Morrisons at the moment, Richard Bernstein, director at Guernsey-based activist investor Crystal Amber, thinks Sainsbury’s still looks “the most compelling” contender. “In 2011, I was approached by a large Middle Eastern sovereign wealth fund on Sainsbury’s,” he recalls. “There was a strong financial case for separating out the property assets and returning £4bn to shareholders.”
There’s evidence to suggest such a model could be successfully adopted by a supermarket chain. It certainly appears to have worked for Loblaw. When it announced plans to go down this route last July, its share price soared 24% and the company has raised $400m from the REIT.
“There was a strong financial case for separating out Sainsbury’s property assets and returning £4bn to shareholders”
Richard Bernstein, Crystal Amber
It’s these sorts of eyewatering figures that Morrisons’ activist investor shareholders Sandell Asset Management and Elliott Asset Management are hoping to achieve if they can force the retailer to follow Loblaw’s lead - Elliott is also understood to have small shareholdings in Tesco and Sainsbury’s.
Neither party replied to requests for an interview, but according to Bloomberg, Elliott believes that if Morrisons placed 75% of its freehold properties into a standalone property company and then floated 25% of this company on the stock market, it could boost its share price by 45%. Of the three retailers that might potentially explore this avenue (Asda wouldn’t because it is owned by Walmart), Morrisons would appear to have the most to gain as it owns the freehold to around 85%-90% of its stores versus the 70% held by Tesco and 65% by Sainsbury’s, according to sources.
David McElhannan, director of retail development at real estate agency DTZ and former development executive at Sainbury’s, believes that in theory an Opco Propco structure might work. However, he rules it out for the time being at least - and not just for Morrisons.
“The issue is that it would conflict with the supermarkets’ operating business strategy and remove the ability to control their property portfolios, something that is key to all of them as it allows operational flexibility,” he says. “Given the possible future challenges the operators are facing, the ability to retain flexibility and react to change within their stores will be key to success.”
Shore Capital head of research Clive Black agrees. Although such a move might be a worthwhile enterprise in the short term, giving cash back to shareholders, he questions how it will play out in the longer term. “UK food retailing is a low-margin industry, with operating margins somewhere between 3.5%-5.5%. Companies tend to have a degree of debt so they have to pay financing costs on top of that operating profit and they also have to pay tax,” he points out.
“So when it comes to their business models, if you take out the properties from these businesses and then you have to apply a rent to the ongoing operating company, it’s probable that these businesses will only be making a 1%-2% margin, and at that point that gives them an awful lot of inflexibility to cope with any competitive issues.”
This is the main problem facing Morrisons. With disappointing sales, it is under increasing pressure to do something with its estimated £9bn property estate and is currently undertaking a property review, the findings of which are due to be announced on 13 March. Property experts think the likeliest outcome of the review is not a REIT or any other Opco Propco model, but a controlled release of sale-and-leaseback properties.
“We’d expect them to potentially sell freeholds to some manufacturing and maybe some distribution units,” says Black. “There may also be the sale of shopping centres where there are some non-trading Morrisons units and possibly some stores as well, but the extent to which Morrisons engages in wholesale property activity is questionable, particularly with its margins contracting at pace at the moment.”
“The ability to retain flexibility and react to change within their stores will be key to supermarkets’ success”
David McElhannan, DTZ
Property sources believe that, over the next few years, Morrisons will reduce its freehold ownership by 10%, retaining 75%-80% of freeholds (according to one source the majority of the 10% of properties that Morrisons doesn’t hold on a freehold basis are former Safeway stores). Black reckons the property strategy will be “reasonably measured”, achieving something in the region of £500m to £1.5bn - small fry when you consider that Tesco completed one sale-and-leaseback deal last year for more than £490m.
Although Morrisons’ trading performance hasn’t been very impressive of late, investor appetite for sale-and-leaseback properties from the retailer is strong, says Chris Keen, director of the supermarket landlord advisory team at CBRE.
“The people who buy these sale and leasebacks are typically annuity funds and they’re all full of Tesco and Sainsbury’s at the moment,” he says. “Even though Morrisons is a weaker retailer and a weaker covenant than Tesco or Sainsbury’s, when investors see a new investment opportunity like Morrisons come on the market it can achieve a keener price because of the scarcity value. It would be an easy win for Morrisons if it did want to sell some of its properties off.”
In terms of the yield such a package might command, Keen anticipates Morrisons could achieve in the region of 4.25%. To put that into context, Sainsbury’s, which is considered a triple A covenant, currently achieves around 4.1%, whereas one supermarket investment source reckons The Co-op would achieve around the 6% mark due to concerns about its covenant.
Supermarket property freeholdings
Although Morrisons might be pleased with this projection, it’s dependent on a number of different factors, one of which is making sure the stores are sold in a controlled manner, says Tom Edson, head of food stores at property consultant Jones Lang LaSalle (JLL).
“If Morrisons suddenly brings a high volume of food stores to the market, it will be very mindful that could have a negative impact on the valuation of not only its estate but the wider food store market,” says Edson.
It’s a view shared by Keen, who cautions: “What some people fail to realise is that although Morrisons might achieve a yield of 4.25% on the first lot of sale-and-leaseback deals, when it has sold off, say 10% of its freehold property and all the annuity funds are overweight in Morrisons like they are in Sainsbury’s and Tesco, the next 10% or so won’t be worth the same because everyone will be full. It has to make sure it doesn’t make the mistake of oversupplying it.”
Rival grocery retailers have already reined in their sale-and-leaseback activity over the last couple of years for fear of downgrading the value of their property, according to investment sources. They will also be wary of the fact that although it tends to work well in the short term, providing an injection of funds, in the longer term it can have an adverse effect, adds Black.
“Tesco and Sainsbury’s have done sale and leaseback to the point where they are not going to do a lot more because of the issue of negative operational gearing,” he explains. “We’re seeing the margins of Tesco compressed now. If Tesco hadn’t sold all its properties some time ago, it wouldn’t be paying the rent it is now and its margins might be higher.”
Investor interest grows
Keen says these concerns will also be at the forefront of the minds of Morrisons’ senior management, who will be taking a step into the unknown if they embark on a property disposal through sale-and-leaseback deals.
“We know what profit Morrisons makes with 90% freehold property portfolio, but once it has sold off 10% and it is around 80% freehold and paying rent on 20% of its stores, suddenly their profitability as a company is going to be less than it is at the moment - they might not even be making a profit,” says Keen.
In short, it might make more sense for the retailer to embrace the Opco Propco model. Calls for Morrisons to embrace this idea are only likely to get stronger in the coming weeks. In addition to Elliott and Sandell, who own a stake in the retailer, one property investment source says he’s been incredibly busy fielding requests for information about Morrisons from other activist investor groups who are weighing up investing in the company ahead of the findings of the property review.
As he points out: “The fact that Morrisons is likely to announce that it intends to raise some money against its property is probably going to be enough to push up the share price and deliver a quick return for these high-risk investors.”
That said, the jury is still out on whether it or any of the other UK supermarkets will do an Opco Propco. “It’s going to be a brave shout by the party in the UK who goes down this route first and it will completely change the pattern of how we think,” says JLL’s Edson. “However, it could work.”
And if one retailer does make the leap, you can be sure others will follow.