The battle for Britain’s fourth-largest supermarket, Morrisons, appears to be over. It was intense – like watching two shoppers grappling over the last toilet roll on the shelf at the start of the Covid crisis.
Perhaps appropriately, Clayton, Dubilier & Rice (CD&R) triumphed by being willing to spend a penny more than its opponent – another American private equity business, Fortress.
CD&R’s winning bid of 287p was at a 60% premium to the price Morrisons’ shares were trading at before the takeover saga began four months ago.
The deal raises a number of questions about UK equity markets. Are British stocks too cheap? How can private equity businesses pay so much? And are other British companies holding similar unlocked value?
First, valuations. The UK market has risen sharply since its Covid nadir in March last year, but remains at a significant discount to its global peers. In aggregate UK companies have recovered the earnings lost from Covid. However, unlike other global equity markets the UK has not benefitted from the multiple expansion seen elsewhere. On our preferred valuation measure of free cash yield the UK remains at a significant discount to global peers.
Over the next 12 month we expect earnings to continue to recover. Having managed cash flow prudently through the crisis, the majority of UK plc is emerging with balance sheets in a good place, allowing the strong free cash flow yield to translate into a sharp recovery in dividend yields, with many companies supplementing these returns with special dividends and share buybacks.
UK consumers today have just over £200bn more in their bank accounts on aggregate than they had when we went into Covid. Amid restrictions on travel and with supply chain bottlenecks slowing new house and car purchases, the consumer is still saving today. The UK economy is very heavily driven by the UK consumer, so I think we will see strong growth this year and right through to 2023 as consumers have more confidence to spend, and more ability to spend as travel restrictions ease, and supply chains for big ticket items such as cars and building materials ease.
The combination of low valuations and favourable economic outlook keeps us feeling very positive about UK markets. Against this backdrop it is not surprising we are seeing so many bids for British companies. But the premium on Morrisons will still surprise many. How is this affordable?
Private equity has raised hundreds of billions of dollars this year. The bond markets are currently lending the money for negative real yield. That money must be invested – private equity managers don’t get paid unless they spend.
Morrisons offered an outstanding arbitrage opportunity because of the property it owns. Many of us expect its new owners to release cash through property sales and leasebacks. In a world of low interest rates and rising inflation, everyone is hunting for yield. There are many buyers who would pay a high price for property with a secure tenant like Morrisons on a long lease.
With cost of capital so low, Morrisons offered an attractive target – an 8% free cash yield and the chance for new owners to leverage that return on their equity, by funding the majority of the transaction at much lower rates in the corporate bond and commercial property markets.
The defeated Fortress group, like its peers, will be looking for similar opportunities elsewhere, and property is not the only arbitrage available.
A number of conglomerate-type businesses are susceptible to attack. Investors today don't want unfocused companies. At various times through history different assets and their associated cash flows can attract different valuations. A wall of money is looking to invest in real-returning infrastructure assets with low volatility now. That creates an opportunity for companies you might consider to be conglomerates to divest and refocus – or be takeover targets if they don’t.
Many companies own assets that fit into a popular thematic. SSE, for example, could split off its gas infrastructure network business from its renewable energy assets. If it weren’t for the drag of its pension commitments, BT could easily spin off its Openreach network, which would be valued more highly by infrastructure funds than the market values telecoms generally. It may still do so. It is interesting to see strategic investors appearing on the shareholders register, suggesting some have their eye on that opportunity.
Different groupings of assets attract different valuations over time. We are seeing environmental, social and governance (ESG) and sustainability creating some interesting opportunities in the market. If you look at Anglo American, for example, about 3% of its business was in thermal coal, which is a cash-generative business. Ironically, the move to renewables and resultant power shortages when these intermittent supply sources are curtailed has seen gas and coal prices rally strongly. Anglo American has demerged its coal business, which has allowed it to re-rate upwards as its ESG profile improved.
Interestingly the thermal coal business, Thungela, has now tripled since the demerger, as the free cash yield on the shares has more than offset the ESG concerns for some investors. Similarly, Glencore has interesting positions in copper, nickel and cobalt, which are all essential for electric vehicles. Pure copper companies are valued very highly, so splitting this part of the business from Glencore’s thermal coal business could also be advantageous.
Post Brexit there was a massive flight of capital from the UK. Foreign buyers have returned. Expect more big private equity deals to follow.
Ed Legget is co-manager of the Artemis UK Select fund. The views expressed above are his own and should not be taken as investment advice.