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Why I’d buy FTSE 100 flyer Morrisons and sell this 50% faller

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Internet shopping is the big story in retail at the moment. But online sales don’t always translate into big profits. To make money as investors, I believe we need to focus on companies that can deliver profitable growth, wherever it comes from.

One retailer whose success has surprised many investors over the last couple of years is supermarket group Wm Morrison Supermarkets (LSE: MRW). By signing wholesale supply deals with convenience store group McColl’s and Amazon, Morrison’s has been able to boost volumes and improve the profitability of its in-house food production business.

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These changes have been combined with long-overdue IT upgrades, tighter control of working capital and price cuts in-store. The overall result has been very impressive, in my view. Like-for-like sales excluding fuel and VAT rose by 2.8% last year, while total revenue was 5.8% higher, at £17.3bn. Pre-tax profit rose by 16.9% to £380m and the ordinary dividend was lifted 12% to 6.1p per share.

Is the price still right?

The Morrisons share price has risen by 14% so far in 2018. The stock now trades on 19 times 2018/19 forecast earnings, with a forward dividend yield of 2.9%. This isn’t cheap, but I think the firm’s triple role as a food producer, wholesaler and retailer should help it stay competitive against larger rivals Tesco and Sainsbury.

City analysts seem to agree. Broker consensus forecasts suggest an 8% rise in earnings per share for 2019/20. I continue to rate this stock as a buy.

Sales are rising, but so are losses

Sales at online-only electrical retailer AO World (LSE: AO) have tripled from £275m in 2013, to £796m for the year ending 31 March 2018. Total revenue rose by 13.6% last year, but figures published today show that AO made an increased loss of £16.2m during the year, compared to a loss of £12m in 2016/17.

There are a couple of reasons for this. The first is that AO is still investing in its unprofitable European business. Today’s results show that Europe revenue rose by 54.8% to €131.2m, but the division’s operating loss was unchanged at just under £28m.

The second reason is that profit margins collapsed in the UK. Higher spending on marketing and a “competitive pricing environment” meant that although UK sales rose by 8.1% to £680.8m, operating profit in the firm’s home market fell from £15.6m to just £11.6m. This reduced the group’s UK operating margin from 2.5% to 1.7%.

Just not big enough

AO’s revenue of £796m represents just 7.5% of the £10.5bn reported by UK rival Dixons Carphone last year. This gives the larger group valuable economies of scale.

Although AO is still expanding, last year’s UK sales increase of 8% suggests to me that growth in its home market is slowing. Meanwhile total sales of €131.2m in Germany and the Netherlands indicate that the company is still a minnow on the Continent.

In my experience, AO provides a good service to its customers. But it’s been a terrible investment. It’s racked up a loss every year and was forced to raise cash from shareholders in April through a £50m placing.

Electrical products are highly commoditised and price competition is intense. AO is expected to report another loss next year. These shares still look too expensive to me.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Roland Head owns shares of Dixons Carphone. The Motley Fool UK owns shares of and has recommended Amazon. The Motley Fool UK has recommended McColl's Retail. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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