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At What Price Would Wm. Morrison Supermarkets plc Be A Bargain Buy?

morrisonsPatience is one of the key attributes of a successful investor. The likes of US master Warren Buffett have been known to wait years for the right company at the right price.

Now, while buying stocks at a fair price will tend to pay off over the long term, we all love to bag a real bargain.

Today, I’m going to tell you why I believe Wm. Morrison Supermarkets (LSE: MRW) could be one of the biggest bargains in the market today.

Sector turmoil

No industry ever stands still, but some periods of change can be more tumultuous than others. The supermarket sector is currently going through a major structural shift.

The ‘Big Four’ — Tesco, Asda, Sainsbury’s and Morrisons — are being squeezed by hard discounters, such as Aldi and Lidl, and by posh nosh purveyors, such as Waitrose and Marks & Spencer. Giant out-of-town stores are no longer pulling in shoppers at the rate of old, and online and convenience are becoming more important.

When industry dynamics are changing radically, valuing companies becomes more problematic.

A 9% dividend yield

Ahead of Morrisons’ half-year results last month, I argued that, contrary to almost universal belief, there were good reasons for thinking the company might not cut its dividend. Indeed, I suggested Morrisons could be just about the biggest income bargain in the market.

For the year ending February 2014, the company paid a dividend of 13.0p. At the time, the Board said that for the current year it anticipated making a payout of “not less that 13.65p”. In last month’s half-year results, management lifted the interim dividend to 4.03p from 3.84p and confirmed its commitment to the full-year payout.

A 13.65p dividend would give a whopping 9% yield at a recent 52-week low share price of 152p.

Dividend conundrum

When a company is on as high a yield as Morrisons, only two things can happen: either the shares rise massively to bring the yield down to a more normal level, or a more normal level is reached by the dividend being cut.

Market commentators are expecting the latter. They point to the dividend being uncovered by forecast earnings per share (EPS), and the recent precedent of Tesco cutting its payout.

But as I said ahead of the half-year results, forget about EPS and so-called “safety levels” of EPS cover. Dividends aren’t paid from accounting earnings, but from free cash flow.

Morrisons has a credible strategy to generate £2bn of free cash flow over the next three years. A 13.65p dividend this year, followed by modest increases (per management’s stated policy) would cost the company about £1bn. So, Morrisons has some leeway to fulfil its dividend commitment, even if trading falls short of the Board’s targets.

Of course, there’s a risk the company will seriously undershoot on its strategy. In which case, we’d almost certainly see current chief executive Dalton Philips depart and a re-basing of the dividend.

However, if Dalton delivers — and, as I said earlier, his strategy seems credible to me — Morrisons will prove to be one of the biggest bargains in the market today at a price of around 150p.

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G A Chester has no position in any shares mentioned. The Motley Fool UK owns shares in Tesco. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.