By Camilla Palladino
Remember the old saw about a hotshot manager taking on a company with a poor reputation? It’s generally the company that emerges from the experience with its reputation intact. That, in short, is the worry about Wm Morrison’s takeover of Safeway.
Investors love Sir Ken Morrison and what the septuagenarian boss has achieved at the north of England based supermarket chain. Before it bought Safeway, Morrison had industry-leading like-for-like growth and margins, in spite of its relatively small size. But they worry he won’t be able to replicate his success with tired old Safeway.
This has been an issue ever since the takeover – mainly because it was such a huge mouthful for Morrison. And the alarm bells have been ringing loudly
following Morrison’s warning in July that Safeway’s sales had fallen sharply since the deal went through.
It was never going to be easy for Morrison to make juicy returns from Safeway. But what hope it had of doing so hinged on its ability to increase the target’s sales per square foot, from about £16 a week to Morrison’s own £20 a week in big stores, by a mixture of rebranding and cutting prices.
This was supposed to generate £215 million ($318 million) of cost and revenue synergies in four years’ time. Added to the £400 million Safeway could earn on its own, that would give £615 million of operating profits – or £430 million after tax.
In present-value terms the Safeway estate would have net operating profits of about £300 million.
That would deliver a return of almost 8% on Morrison’s £4 billion investment, valuing the share element using the prevailing price at announcement.
No bonanza
Sure, that’s superior to the group’s weighted average cost of capital of between 7% and 7.5%. But it’s scarcely a bonanza.
The warning has now punctured even these dreams. Morrison’s price cuts at Safeway have so far failed to spur volume growth, and investors now fear that Safeway might be impossible to turn around – or that Morrison will take much longer to do it than it thinks.
That’s partly because the plans depend to some extent on taking market share. Competitors such as Tesco and Asda, however, are unlikely to let the supermarket group do so without a fight. Indeed, there has already been a spate of price cuts the length of the high street.
It is also because there are doubts about the extent to which Morrison’s brand can be transferred.
What if Safeway’s customers in the prosperous south of England are reluctant to shop at cheaper, more downmarket Morrison? Wouldn’t that mean Morrison had to lure in a new set of customers to get sales growing again?
It’s hard to know how big these obstacles are. They won’t necessarily stop Morrison reaching its goal. At the end of the day, value seems to be king in UK supermarket retailing.
Another cheap and cheerful northern chain, Asda, has been successful in expanding down south.
Morrison is certainly making reassuring noises about the situation. It suggests that the sales drop at Safeway is a temporary phenomenon and hasn’t derailed its longer-term plans.
But it might take longer than expected to deliver all the expected benefits. And each year of delay means another year of value destruction.
Following the near 30% fall in Wm Morrison’s share price since the spring, investors are now discounting a lot of integration risk. But until Morrison manages to show it can generate some sales uplift, the worry will remain that in the contest between Morrisonian virtue and Safeway sloth, it is the latter whose reputation will out.
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