David Potts, a former Tesco director, has been appointed as the new chief executive of Morrisons (LSE: MRW), it was announced on Wednesday. This is great news for Morrisons shareholders, but whether Morrisons will deliver terrific returns to investors hinges on several other factors.
In fact, one key question now is: will Mr Potts chop the dividend?
David Potts
Virtually everybody in the retail world knew that Mr Potts was the preferred choice for Morrisons’ chairman Andrew Higginson, and it looks like he may be the right man to lead the turnaround of the fourth-largest food retailer in the UK.
A retail veteran, he previously contributed to Tesco’s success in the UK under the leadership of Terry Leahy, so he may be able to carry out a successful restructuring at Morrisons.
He’ll be faced with a few tough challenges, however.
Landscape
Of course, Mr Potts doesn’t have an easy task.
As you may know, operating and net profits are under pressure in the food retail sector, where the big four are faced with fierce competition and may have to operate at a loss to preserve their market share.
Commenting on falling sales last week, Asda CEO Andy Clarke pointed out that there was “no doubt that Q4 drove a higher level of distress in the market with a significant amount of vouchering and promotional activity,” which Mr Clarke defined as “unsustainable” over the medium term.
“You can only give away 10 pound notes for 9 pounds for so long,” yet there comes a point where “sanity takes over from vanity,” Mr Clarke added. Of course, vanity stands for revenue, while sanity stands for net profit.
Morrisons has recorded a decent performance in recent times, given that sales are declining at a lower pace, but it must grow its market share to boost its equity value, hoping its aggressive strategy works out. In mid-February it decided to cut the price of 130 shopping basket staples — branded and own-label products — by an average of 22%.
Prices will drop on such basic items such as milk, bread, butter and eggs — all products that tend to be loss leaders for food retailers. Whether the consumer will purchase more expensive items while shopping for basic groceries is another matter, however.
Valuation
The retailer’s financials are not incredibly stretched, with forward net leverage below 3x, but if a comprehensive corporate restructuring is implemented, then a 30% cut in the payout ratio is likely. Such a move would still leave the dividend cover close to the danger zone, but would signal that Morrisons is serious about becoming a stronger entity, at least financially.
The shares currently change hands at 196p. While a 250p price target is ambitious, Mr Potts’ appointment has been welcomed by investors and will likely continue to contribute to value creation for some time because investors seem willing to give credit to “restructuring stories” in the food retail sector.
Furthermore, Morrisons stock trades on a forward price to earnings ratio of 15x and 14x for 2015 and 2016, respectively. These trading multiples are much lower than those of Tesco and Sainsbury’s, so if Morrisons’ strategy is successful then I believe its shares could easily trade in the region of 250p, thus narrowing the valuation gap with its larger competitors.