Wm Morrison (MRW) 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 centres. 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 possesses a sustainable cost advantage or enough brand equity to sustain material price premiums.
The U.K. grocery industry is highly consolidated, with Tesco (TSCO) with a 30% market share, Asda at 17%, Sainsbury (SBRY) also 17%, and Morrisons with 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 lacklustre 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.
Morrisons' returns on invested capital have averaged around 10% over the past three years, slightly above our high-single-digit cost of capital estimate, but we do not assign the firm an economic moat (sustainable competitive advantage) because we don't think it commands a sustainable cost advantage or enough brand equity to sustain material price premiums. Morrisons has a national distribution system in the U.K., but it is a food-focused company that lacks the purchasing scale its competitors possess in non-food categories. Selling higher-margin general merchandise items can allow Morrisons’ competitors to sell food at little to no margin, making it difficult for the firm to develop a clear cost advantage overall.
Morrisons differentiates itself by focusing on its fresh food offering, much of which is manufactured in the company's facilities. Morrisons benefits from better control over its supply chain and the potential opportunity to capture both the retail and manufacturing margin on the sale of company-produced goods. However, switching costs are virtually non-existent in the grocery industry, and we don’t think Morrisons' points of differentiation (vertical integration and fresh food) are strong enough to ensure that the firm can sustain a materially higher price point or develop a sustainable cost advantage. Finally, while we think a prolonged price war is unlikely, we believe Morrisons' margins would deteriorate faster than those of market leaders if this scenario were to occur.
