How a supermarket price war will affect investors
With UK food inflation running at about 6% according to the World Development Movement, and grocery bills now making up between 10% and 25% of total monthly bills according to the Institute for Fiscal Studies, supermarket customers may enjoy some respite from the latest price-matching war. But at what cost to the food retailers and their investors?
If you don't like the answer, you shouldn't have asked the question…
The UK food retail sector is facing a perfect storm of stagflation, slowing consumer spending and falling returns.
And now there seems to be a price war brewing.
When Asda launched its Price Guarantee last year, the retailer promised that if consumers could buy their basket of comparable items cheaper at Tesco, Sainsbury's, Morrisons or Waitrose, it would give consumers a voucher for the difference plus a penny. It has now gone even further, promising to refund any shortfall if a basket of goods is not 10% cheaper than its rivals.
Tesco followed suit at the end of September with its Price Drop, cutting the cost of more than 3,000 products, including everyday essentials.
Now, after branding Tesco's strategy as "smoke and mirrors", Sainsbury's has upped its pledge two notches by introducing Brand Match, which adds a commitment to match Tesco and Asda A-brand promotions, and matching many of Tesco's Big Price Drop cuts, including fresh foods.
The impact for investors...
Interestingly, Sam Hart, retail analyst at Charles Stanley, believes that these promotions will have a neutral impact on the food retailers' gross margins for two reasons. Firstly, producers like Unilever and Reckitt Benckiser themselves are funding the promotions to keep their volumes high; and secondly, price increases in other products would offset price decreases in the discounted products.
So if the price war does not impact margins, what part does food inflation play in the margin saga?
There seems to be a misconception that food inflation is good for the food retailers, which may have been the case in 2008 when volumes were still positive and so inflation was passable.
However, in this cycle, consumers are proving to be much more prudent. Household budgets have come under considerable pressure, with higher VAT and fuel and utility bills and with consumers trading down, buying a smaller amount and wasting less. Retailers have thus been unable to pass on the higher prices to their customers, putting pressure on gross margins.
Additionally, during the last three months, consumer price inflation (CPI, an inflationary indicator that measures the change in the cost of a fixed basket of consumer products and services) has trended below producer price index (PPI, an inflationary indicator that evaluates wholesale price levels in the economy), exacerbating the gross margin pressure that the food retailers are facing.
However, there is a ray of hope as input costs start to moderate.
As a rule of thumb, costs for retailers are split roughly equally between labour, fuel (via transport) and packaging and manufacturing.
Soft commodity and fuel costs have started to calm down, which investors expect to work its way through towards the end of this year and into early next year.
But perhaps the most efficient way for retailers to improve volumes and margins is to increase emerging market exposure, something that Tesco has been doing on a consistent basis.
"[The] UK is a low-growth cash cow market that is being used to fund Tesco's emerging market growth over the next five to 10 years," confirms Hart, adding that this is the correct strategy.
'International' is expected to contribute around 40% of Tesco's pre-tax profits by 2012. With emerging markets today having the same growth opportunity that the UK markets enjoyed in the 1990s, this exposure is expected to drive more than half of the group's growth going forward.
Additionally, the new chief executive Philip Clarke seems to be taking the bull by the horns. He does not seem to be afraid to exit unprofitable markets (Japan) and make the company more global in its outlook.
The stock is trading on a 2012 price to earnings (P/E) ratio of about 12 times, and offers a free cash-flow yield of almost 7%. Shares have lost about 6% of their value year-to-date, slightly outperforming the FTSE 100.
Sainsbury's, on the other hand, has a 100% exposure to the UK market. While it has recently made some noises about expanding in China, Hart is skeptical of these plans. He notes that not only is China a concentrated market, but that the firm's attempts to expand overseas have not been fruitful.
Additionally, even with a margin that is half of Tesco's, management has a dividend payout ratio of 57%, compared to an industry average of between 40% and 45%. This dividend has either been paid out from debt, or from a rights issue (2009).
Furthermore, as discussed above, management seems to be under pressure to react aggressively to Tesco's big price drop, which has led some analysts to believe that either the dividend or margins will have to give.
However, Sainsbury's is Hart's top pick. He argues there is nothing wrong with companies paying out dividends from debt, adding that Sainsbury's balance sheet ratios were "strong".
Moreover, Hart adds that investors are not taking into consideration Sainsbury's "good" asset and freehold property backing. "It doesn't make sense that while Sainsbury's net asset value is 295p, shares are currently trading at 302p!" he says.
Sainsbury's shares have fallen 15% relative to the FTSE 100 and are currently trading on a 2012 P/E of about 10 times. Sainsbury will report its half-year results on November 9.
With no loyalty card and no price guarantee, it looks like Morrisons has fewer levers to pull when it comes to matching the price-war tactics the other supermarkets have implemented.
While Morrisons is relatively under-geared, it has a 100% exposure to the declining UK grocery market. Shares in Morrisons have increased by 12% year-to-date and are trading on a 2012 P/E ratio of about nine times.
Dave McCarthy of Evolution Securities is very optimistic on the stock. "Sustained sales growth outperformance, a self-help programme that supports the margin outlook and the ongoing share buyback programme should drive attractive earnings growth," he says. Morrisons is McCarthy's preferred stock of what he calls the "troubled" UK food retailers.
"The upside for Morrison revolves around it expanding its online, non-food and convenience businesses, to which is currently has a limited exposure," comments Hart.
In fact, Hart believes that non-food is an area of "significant" potential. Currently, the food retailers account for only between 10% and 15% of the UK non-food market.
However, this is to be taken with a pinch of salt. Not only is non-food is a lower-margin business than food, but sales are also more volatile and vulnerable to discretionary spending.
"It is this exposure to non-food that is the reason for the lagging like-for-like sales at Tesco," notes Hart. Of the three, Tesco has the highest exposure to non-food, accounting for approximately 30% of total sales. In Sainsbury's and Morrisons, non-food accounts for about 15% and 7% of total sales.
Looking forward to 2012, the main worry on investors' minds is the 'space race'; that is, while the retailers may individually be operating in a 'rational' matter with regards to new space openings, they are collectively creating an oversupply of space, implying downward pressure on like-for-like sales growth and returns.
However, analysts are not worried. They say that at the current rates of construction, it will take about 15 years for the pipeline to be brought to life, during which time volume growth should outpace new supply growth.
"Concerns about new space in the industry are more than discounted in current valuations," says Hart. "This, along with depressed sentiment towards the food retailers, makes their valuations attractive," he adds. Hart has all three stocks on an 'accumulate' recommendation.
This article was written for our sister website Interactive Investor
A way a company can raise capital by creating new shares and invite existing shareholders in the company to buy these additional shares in proportion to their existing holding to avoid a dilution of value, which means keeping a proportionate ownership in the expanded company, so that (for example) a 10% stake before the rights issue remains a 10% stake after it. As an added incentive, the new shares are usually offered below the market price of the existing shares, which are normally a tradeable security (a type of short-dated warrant) and this allows shareholders who do not wish to purchase new shares to sell the rights to someone who does.
Payment protection insurance is designed to cover you should you fall ill, have an accident or lose your job and can’t make repayments on loans or credit cards. However, research by consumer watchdogs found the cover to be overpriced, filled with exclusions (policies exclude self-employment, contract employees and pre-existing medical conditions) and were often mis-sold because the exclusions were never fully explained. In May 2011, the High Court ruled banks had knowingly mis-sold PPI and ordered them to compensate around two million consumers.
Invented by a Frenchman in 1954 and ironically introduced in the UK on 1 April 1973, VAT is an indirect tax levied on the value added in the production of goods and services, from primary production to final consumption and is paid by the buyer. Its levying is complex, with a number of exemptions and exclusions. For example, in the UK, VAT is payable on chocolate-covered biscuits, but not on chocolate-covered cakes and the non-VAT status of McVitie’s Jaffa Cakes was challenged in a UK court case to determine whether Jaffa Cake was a cake or a biscuit. The judge ruled that the Jaffa Cake is a cake, McVitie’s won the case and VAT is not paid on Jaffa Cakes in the UK.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
Net asset value
A company’s net asset value (NAV) is the total value of its assets minus the total value of its liabilities. NAV is most closely associated with investment trusts and is useful for valuing shares in investment trust companies where the value of the company comes from the assets it holds rather than the profit stream generated by the business. Frequently, the NAV is divided by the number of shares in issue to give the net asset value per share.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
If you own shares in a company, you’re entitled to a slice of the profits and these are paid as dividends on top of any capital growth in the shares’ value. The amount of the dividend is down to the board of directors (who can decide not to pay a dividend and reinvest any profits in the company) and they will be paid twice yearly (announced at the AGM and six months later as an interim). Dividends are always declared as a sum of money rather than a percentage of the share’s price. Although dividends automatically receive a 10% tax credit from HM Revenue & Customs (HMRC), which takes the company having already paid corporation tax on its profits into account. Dividends are classed as income and, as such, are liable for personal taxation and so shareholders have to declare them to HMRC.
Generic, loosely-defined term for markets in a newly industrialised or Third World country that is in the process of moving from a closed economy to an open market economy while building accountability within the system. The World Bank recognises 28 countries as emerging markets, including Argentina, Brazil, China, Czech Republic, Egypt, India, Israel, Morocco, Russia and Venezuela. Because these countries carry additional political, economic and currency risks, investors in emerging markets should accept volatile returns. There is potential to make large profit at the risk of large losses.
Permanent and absolute ownership and tenure of a property (residential or commercial) and/or land with freedom to dispose of it at will but with no time limit as to how long the property/land can be held (in perpetuity). Freehold is the opposite of leasehold.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).