How a supermarket price war will affect investors

15 November 2011

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.

Non-food potential

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

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