Private equity swoop for Morrisons shows how hot the sector is

One of America’s leading private equity firms is circling Morrisons – and it looks like becoming the most controversial takeover approach for a British company since Pfizer’s tilt at AstraZeneca seven years ago.

The Daily Mail, which has been running a campaign for a while now opposing the takeover of UK companies by private equity firms, has already given a flavour of how it will present the debate.

Alex Brummer, its influential City Editor, wrote a piece in this morning’s paper with the headline “We Can’t Let These Locusts Strip Our Economy”.

Shares of Morrisons, which on Saturday confirmed a report from Sky’s Mark Kleinman that it had received an approach from Clayton, Dubilier & Rice (CD&R), shot up by 32% at one point this morning.

Its shares hit a high of 237.5p – a very modest premium to the 230p-a-share proposal from CD&R, which has also promised that Morrisons shareholders will also still receive the 5.11p-a-share dividend announced by the company on 11 March.

That rather implies that the market thinks a deal could go through if CD&R comes up with a small “bump” to its existing offer.

It certainly doesn’t appear to suggest, at this stage, that investors have any confidence of a full-blown bidding war erupting – even though newspapers have suggested counter-bidders could include other US private equity firms, including Lone Star and Apollo Global Management, as well as Amazon, which already owns the smaller Whole Foods supermarket chain and which has a long-running grocery supply agreement with Morrisons.

There are very good reasons why CD&R is interested in Morrisons.

The first is that private equity firms are hoarding “dry powder” – money they are looking to put to work on behalf of their investors. Estimates vary as to how much dry powder is looking to be invested globally but the figure can be comfortably put at more than $2trillion.

CD&R is certainly among the most active in the space. During the first three months of this year alone, it was among the busiest private equity firm raising new money, with its Clayton Dubilier & Rice Fund XI raising $16 billion from backers.

This year it has already agreed to pay £2.6bn for UDG Healthcare, the pharmaceuticals industry services company; S&S Activewear, a US-based sportswear wholesaler and distributor and in January, it agreed to buy Wolseley UK, the builder’s merchants, for £308m.

Accordingly, while the £5.52bn it has offered for Morrisons might appear to be a lot, it is certainly a sum CD&R can afford to pay.

The second factor at play is that UK assets have been cheap for a while – which is why, at the end of last year, expectations for a rash of takeovers of UK companies were high.

The end of 2020 finally saw the end of uncertainty over whether the UK would achieve a Brexit deal with the EU and, in addition, there was pent-up demand for deal-making following the pandemic.

Moreover, with sterling’s value having fallen during 2020 against the euro and trading at a historically low level against the US dollar, buyers of British companies using those currencies were in a position to get more for their money than was once the case.

There are also specific reasons why CD&R might have alighted on Morrisons in particular.

The UK’s fourth largest supermarket chain enjoys a significant amount of asset backing, owning 85% of its 497 UK supermarkets, as well as 19 manufacturing sites and abattoirs where it processes and packages a significant proportion of the bakery products, seafood, meat, fruit and vegetables, flowers and chilled products sold in its stores – operations big enough to make it the UK’s second largest fresh food manufacturer and the biggest supermarket customer to Britain’s farmers.

These are assets that could quite easily be sold to a property company and then leased back – immediately raising a big chunk of money that could be used to repay any debts incurred during a takeover.

Alternatively, such assets could easily be mortgaged, the tactic used by brothers Mohsin and Zuber Issa and the private equity firm TDR Capital in their recent £6.8bn takeover of Asda. The buyers raised £2.75bn towards the purchase by selling a bond secured against Asda’s property assets.

It means that the buyers have put at risk just £780m of their own capital in buying Asda.

Moreover, there was huge demand from institutional investors, including pension funds, for the bond because of the quality of the assets it was secured against. It enables the Issas and TDR to borrow at an exceptionally low rate of just 3.25%.

This has, naturally raised concerns that an Asda hocked-up to its eyeballs will be a less competitive business, concerns that are now being raised over Morrisons should it have a similar fate.

Due to the high levels of involvement Morrisons has in communities where it operates, this is likely to be a key area of discussion.

Morrisons enjoys a good reputation as a paternalistic employer partly because, for decades, it was a family business. Founded in 1899 by William Morrison from a Bradford market stall, it was run from 1956 onwards by his son Ken, only floating on the stock market in 1967.

It was Sir Ken who propelled it into the top rank of Britain’s supermarkets, who came up with the strategy of owning much of its food and packaging operations and who came up with the “market street” concept, still present in stores today, which showcases the company’s strong fresh food offering.

Sir Ken, who died in 2017, revelled in his image as a penny-pinching Yorkshireman – but he cared deeply about his employees.

Banks and other finance providers also like lending money against supermarkets. These are businesses that enjoy predictable cash flows and make them less of a risk.

It is why the Issa brothers had no shortage of backers for their tilt at Asda and why, earlier this year, Couche-Tard, a Canadian petrol station operator that few in Europe had heard of, was able to contemplate a bid for the significantly bigger Carrefour, the continent’s biggest supermarket operator.

Another factor why Morrisons has attracted interest is its share price performance of late. All of the big grocery multiples had a good 2020 as shoppers flocked to their stores when the lockdowns began, as “non-essential” retail was closed, but they also distinguished themselves with excellent execution, in the jargon, ensuring they always had plenty of goods on the shelves when shoppers needed them.

Their supply chains were tested under fire and came through the experience.

In the case of Morrisons, it was the continuation of a trend that had been under way for a while, culminating in a solid Christmas trading performance. Yet none of this has been reflected in the Morrisons share price which, before today, had fallen by 23% over the previous three years amid nagging concerns among investors about competition from the German hard discounters Aldi and Lidl, the fact that Morrisons was later than its competitors to online grocery delivery and the fact that, unlike Tesco and Sainsbury’s in particular, it has little presence in the fast-growing convenience sector.

There are also concerns at the extent to which a new generation of “fast track” grocery delivery players, such as Getir, Weezy, Gorillas and Dija, may eat into the market share of the big multiples.

These are already commanding high valuations. Getir, founded in Istanbul, was valued at its latest fund-raising earlier this month at an astounding $7.5bn – making it more valuable than Morrisons – even though it is just seven years old and has a fraction of the latter’s sales, profits or physical assets.

Those concerns were still evident today as analysts at the broker JP Morgan Cazenove told clients: “We would not chase Morrisons shares, as we continue to struggle to see the path for Morrisons to unlock value via execution, whilst the strategic and financial rationale for CD&R or others does not seem obvious to us either.”

Nonetheless, the interest in Morrisons has also sparked a rally in shares of its rivals Tesco and Sainsbury’s today.

Clive Black, the analyst at broker Shore Capital (the house broker to Morrisons) and one of the City’s most respected watchers of the sector, told clients today: “It is the fundamental improvement in the industry’s economics…that is key to us.”

He said both were now more competitive with the likes of Aldi and Lidl than they were previously and said their online operations were no longer the “millstone” they once were.

Yet to express an opinion is Stephen Butt, the multi-millionaire hedge fund manager, whose company Silchester is the biggest single shareholder in Morrisons. Mr Butt, a generous donor to the arts and to the Royal Ballet School in particular, is a long-term investor in the company who has taken Silchester’s stake to 13%.

His is likely to be a decisive voice in a takeover situation that has the potential to touch an awful lot of lives in this country, not least those of 117,000 Morrisons employees and the millions of people who enter its stores each week.

It also promises to be an intensely personal affair. Sir Terry Leahy, the former chief executive of Tesco, is now a leading advisor to CD&R. Andy Higginson, the Morrisons chairman, was Tesco’s finance director under Sir Terry while its chief executive David Potts, who has earned plaudits for the turnaround he has overseen at Morrisons, was in charge of Tesco’s overseas operations under Sir Terry.

The leading players in this saga know each other well. And the prospect of reuniting under CD&R’s ownership – the private equity firm is reportedly keen to keep the current Morrisons management on board – may well prove irresistible if the price is right for shareholders.

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