Morrisons (LSE: MRW) seems to have confounded the doom-mongers who were out in force in the weekend press.
Many had expected the supermarket chain's profits to drop during the first half. Instead they rose slightly, which is probably why the City seems to be pretty pleased with the figures.
The reasons for pessimism were well-founded. Morrisons has been losing market share to its rivals for months, according to industry sales data. During the last recession in 2008, the company did very well as value conscious shoppers flocked to its stores. Morrisons seems to have failed to connect with this type of customer in the current downturn.
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So how did Morrisons manage to grow profits? Well, today's results are quite revealing. It seems that Morrisons has put profits before sales.
There's nothing wrong with that - at least in the short term. But if the management team is going to convince investors to buy its shares, it needs more people to shop in its stores. In short, it needs to grow its sales.
Cost cutting is a limited strategy
Morrisons has maintained profits growth by avoiding being sucked into a price war. While Tesco, Asda and Sainsbury's have wooed shoppers with lots of coupons, Morrisons has refused to play this game.
That's helped to keep profits healthy. Trading profits are up slightly to £475m from £458m. The company has also cut waste and become more efficient. Lower taxes and buying back lots of shares has seen underlying earnings per share (EPS) increase by 10%. Dividends have increased by 10% too. That should keep most shareholders happy for a while.
But its refusal to chase unprofitable sales has cost Morrisons customers. Like-for-like customer numbers are down by 1.8%, while like-for-like sales are down by 0.9%. How is Morrisons going to get these customers to come back?
The trouble is, there are just too many supermarkets in the UK, chasing too few customers. The fact that many of these customers are short of money just makes things worse. The last thing you want to do is to build more stores in this kind of environment.
The good news for Morrisons shareholders is that management seems to have seen sense on this point. It is cutting back its expansion plans. It has cut the amount of new space it wanted to open by 500,000 square feet, which will save £200m from the capital expenditure budget over the next two years.
So how are sales and profits going to grow? Morrisons has spent quite a lot of money on online baby store Kiddicare, and is looking to open ten stores in out-of-town retail parks. But even though Morrisons has probably secured these stores at favourable rents, we're not sure that they are going to make a big difference to shareholder returns.
One potential source of encouragement is convenience stores. If the sales growth of Sainsbury's Local is anything to go by, it seems that customers like them. And Morrisons' trial of its "M Local" concept has performed a lot better than it initially thought.
It's trying to do something different to the competition by charging the same prices as it does in its bigger stores (others typically charge more) and supplying them from its supermarkets nearby.
The chain is going to open more convenience stores in and around London, where it doesn't have a big presence. This could work well, but in other areas we're not so sure. Opening convenience stores, like offering online shopping, is a defensive strategy - if you don't offer it, customers will go elsewhere.
But at the same time, it doesn't do much for your underlying business. By doing smaller top-up shops in convenience stores, it probably means that people will spend less at bigger stores.
I can see how Tesco and Sainsbury's might make more money from its convenience stores by charging different prices for the same goods, but will Morrisons make more money if the prices are the same?
Stop building, stop buying back shares and boost dividends
As you've probably gathered, we're not upbeat on the growth prospects for Morrisons and the other quoted supermarket companies. But we are concerned that supermarket management teams don't appreciate this, and so are actively damaging the wealth of their shareholders.
Building new stores does not generate acceptable returns. Instead it seems to make most supermarkets worse off. There is only a finite amount of money to spend in supermarkets every week.
Building a new supermarket in a town can mean that the other local supermarkets lose sales, while the new supermarket may not have enough customers to justify building it in the first place. Effectively, the UK is so supermarket-saturated that they're all cannibalising each other. Focusing on existing stores and saving cash seems to be a better strategy.
Then we get on to the thorny subject of share buybacks. Corporate finance textbooks go on about efficient balance sheets. By this, they tend to mean that having some debt is good for a company.
Because interest on debt is a tax-deductible expense - dividends to shareholders are not - then swapping equity for debt lowers the cost of financing for a firm by saving tax and should make it more valuable.
This all sounds fine in theory. But Morrisons is an example of what happens all too often in practice. It has spent £628m buying back 218 million shares at an average price of 288p. This has helped to boost earnings per share - by 4% - and the bonuses of the management, but has done little for shareholders.
Morrisons' shares have gone nowhere for the last year. Yes, you can argue that increased earnings have allowed it to pay bigger dividends. But Morrisons was already increasing the proportion of its profits that it paid out in dividends. I'm struggling to see what the buyback has done for shareholders.
It's tough for supermarkets at the moment. But they could make themselves more attractive to investors. Morrisons' 4% dividend yield is OK, and it's well covered - but why not pay out more? By stopping dubious buybacks and cutting back on new stores, they would arguably serve their customers and shareholders better.
Disclaimer: Phil Oakley owns shares in Morrisons
