Wm Morrison (MRW) has revealed sales were down 2.4%, excluding fuel, suggesting that the difficult economic environment and increasing competition remain near-term challenges. We don’t expect these pressures to abate over the next several quarters, but we still think the firm’s sales should accelerate once new convenience stores mature - Morrisons maintained its guidance to end 2014-15 with 100 convenience stores - and online sales start to ramp-up: Morrisons plans to begin selling food online early next year, and expects to be able to reach nearly 50% of U.K. households by the end of 2014.
We are maintaining our 285p fair value estimate and our view that Morrisons lacks an economic moat, as we think the grocery industry’s non-existent switching costs could prevent large U.K. grocers from garnering a sustainable cost advantage over competitors. Shares trade at a modest discount to our fair value estimate, but we suggest investors wait purchase Wm Morrison at a greater margin of safety, and we think Tesco (TSCO) may prove a safer bet.
Wm Morrison is the fourth-largest grocer in the United Kingdom, but in contrast to its larger peers, it operates a vertically integrated supply chain with more than 15 manufacturing facilities and more than 10 distribution centers. These capital-intensive manufacturing operations pose a barrier for new entrants to overcome and give Morrisons greater control over product quality. Morrisons attempts to differentiate itself and capture the retail and manufacturing margin by touting the quality of its fresh food offering. However, we do not assign the firm an economic moat because we don't think it commands a sustainable cost advantage or enough brand equity to sustain material price premiums over rivals' products.
The U.K. grocery industry is highly consolidated, with Tesco (share over 30%), Asda (17%), Sainsbury (SBRY) (17%), and Morrisons (12%) controlling a large portion of this £170 billion market. The industry is also very competitive, and rivalry has intensified over the past few years. Most firms spent the better part of the past decade increasing square footage to drive sales growth, but some of these investments failed to produce expected returns once the global economy began slowing and consumers started spending more money in alternative channels.
Morrisons has lost share owing to its late entry into the online and convenience store channels, but we're optimistic the firm should benefit from its convenience store rollout and its new partnership with online distributor Ocado. It has taken competitors several years to build out online capabilities, so we think this partnership makes sense for Morrisons, as it gives the firm an instant presence online while reducing the execution risk associated with building capabilities from scratch.
Although channel expansion is a plus, the threat posed by discounters Aldi and Lidl is unlikely to subside. These no-frills concepts are leveraging lackluster economic growth to expand aggressively, challenging Morrisons because it has more demographic overlap with the discounters. We expect Morrisons to compete with these firms by highlighting its in-store service, fresh food, and greater product assortment.
