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After a 50% gain in 2016, can WM Morrison Supermarkets plc keep rising?

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Wm Morrison Supermarkets (LSE: MRW) reported its fourth consecutive quarter of like-for-like sales growth this morning. This strong performance against tough competition is one of the reasons why Morrison’s shares have risen by 51% so far in 2016.

Chief executive David Potts has cut debt and stabilised sales more quickly than many investors expected. But such rapid improvements can’t continue indefinitely.

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Forecasts gathered from 19 analysts by Reuters show that nine rate the stock as a sell, with the remaining 10 judging Morrisons to be a hold. These experts’ average target price is 191p, 14% below the current share price of 225p.

If these forecasts are right, now could be a good time to take profits. But many top investors believe you shouldn’t sell a winning stock while the investment story is still positive. Who’s right?

Strong trading

Today’s figures show that like-for-like sales excluding fuel rose by 1.6% during the third quarter. Although that’s slightly less than the 2% LFL gain in Q2, it’s still a very solid result. Busier stores are generally more profitable.

The patterns seen over the last year appear to have continued during the third quarter. Like-for-like transaction numbers rose by 4.1%, while the average number of items per basket fell by 5.5%. Customers appear to be making more trips to the supermarket, but buying fewer items each time.

I’d guess that’s good news, as it provides the supermarket with more chances to sell additional items to each customer. For example, Morrisons said today that seasonal sales have improved, with Halloween-related sales up 20% on last year.

What about profit?

It might be selling more from each store, but are profits rising?

As today’s statement was a trading update, there was no news on profit. But the group’s interim results in September showed that pre-tax profit rose by 13.5% to £143m during the first half of the year. The group’s underlying operating margin rose by 0.26% to 2.6%, and underlying earnings rose by 35% to 5.04p per share. This suggests that full-year forecasts for earnings of 10.6p per share are realistic.

However, these numbers also mean that the firm trades on a rather high forecast P/E of 21. Even if earnings per share rise by another 50% to 15p over the next few years, Morrisons would still have a P/E of 15 at the current share price of 225p. On this basis, I’d describe the stock as fully valued.

This is why I’m still interested

Despite this, I’ve no plans to sell just yet. What interests me is Morrisons’ impressive cash generation. Free cash flow was £558m during the first half of the year — more than three times pre-tax profit.

Admittedly, £318m of this came from “working capital improvements.” This basically means demanding longer credit terms from suppliers. But that still leaves £240m of apparently sustainable free cash flow.

If we assume that second-half performance will be similar, then the shares could be trading on about 11 times forecast free cash flow. That looks very cheap to me, and suggests future dividend growth could be strong. It also suggests that Morrisons could become a takeover target for private equity groups.

There’s obviously a risk that this level of free cash flow won’t be sustainable, but for now, I remain a holder.

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

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