Confidence isn’t catching

Why aren’t investors buying Morrisons’ confidence that it can continue to grow?  The thumbs down–sending the stock progressively lower down the benchmark index on Wednesday—overrode stronger than forecast underlying 2017 profits, 5.8% revenue growth, and positive yearly and quarterly like-for-like sales trends. Most importantly, the market’s first take on the group’s 4 pence a share special dividend was also negative, seeming to disagree with the rationale offered by CEO David Potts’ that the bonus pay-out “reflects our good performance so far and confidence for the future.”

Shares drift lower, like margins

Investors might be acting on a more tempered view of the future for Britain’s No. 3 supermarket. Morrisons shares have wallowed so far this year, as have Tesco’s and Sainsbury’s, with barely a percentage point rise a piece, after losing 3%-10% in 2017. Big UK grocers are growing again: last week’s industry data showed all four—including Asda—increased market share over 12 weeks to the end of February, with help from the return of food price inflation. The problem is they are not growing as fast as upstarts Aldi and Lidl whose combined market share continues to advance, rising by almost a third over the period compared to low single-digit growth at the Big 4. Discount groceries are in demand as consumers respond to real wage declines by trading down, forcing the likes of Morrison to increase the proportion of ‘value’ brands in the mix. This pressures margins: note for instance the seven basis-point slip in Morrisons’ operating margin during the year.

Cash flow is king

Shareholders are now schooled in supermarket tactics against Aldi and Lidl and they know cash flow is key. Selective use of free cash flow for ‘investment in price’ combined with revamped efficiency and slashed costs helped put the brakes on the decline of Tesco et al during their 2014-15 crisis. Morrisons’ “confidence” may therefore have rung a little hollow on Wednesday given that free cash flow generation almost halved to £350m from 2016/17’s £670m, despite 60% less net debt and a modest dividend rise (9%). The quality of that cash flow was also questionable. Only £132m was from retail sales whilst disposal proceeds and improved working capital accounted for most of the rest.

Wiggle room and the lack thereof

Furthermore, the group cautioned that whilst revised store cash flow assumptions allowed a small “impairment reversal” of £8m, a rise in overall financing costs of as little as 1% relative to the current 9% discount rate could “result in an additional impairment charge of £96m”. Little wonder Morrisons gives itself sufficient wiggle room around the future “uses of free cash flow”. Prudently, it will be “guided each year by the principles” of its capital allocation framework “in assessing the uses of free cash flow.” But in doing so, the group will also be acknowledging that expectations still price more ‘perfection’ than can it can be certain to deliver. Morrison’s forward rating suggests it is still pricey. And at 17.19 times 2018 earnings, the stock is second only to Tesco and 5-10 points above M&S and Sainsbury’s. Wednesday’s 4% share price fall shows investors aren’t convinced it can grow much faster than these rivals.