Supermarkets on special offer

Sector Focus

A profit warning from Carrefour. Lowered guidance from Ahold. An orderly retreat from Japan for Tesco. And another downgrade from the increasingly accident-prone Ocado. These last few months have been difficult for anyone in the congested business of selling food, anywhere in the world.

For UK grocers, the true impact of the latest bout of runaway food inflation, promotional madness and consumer weakness has yet to be seen, but the half-yearly results of the first company to report, Morrison, provide a glimpse of what to expect from Tesco and Sainsbury when they provide trading news next week.

Price hikes bite hard

High inflation, particularly at the petrol pumps, continues to eat away at spending power. Dalton Philips, chief executive of the UK's fourth-largest supermarket group Morrison, called it the worst squeeze on consumer spending in a generation, pointing out that spending power over the past three years has dropped at the fastest rate since the early 1980s.

The upshot is that while food sales continue to climb, underlying sales volumes are in fact down, with the top-line performance being distorted by high food price inflation. Recent figures from research group Nielsen show that food volumes fell by 0.9 per cent in July, even though top-line sales were up 3.4 per cent. Morrison's Mr Philips says that this represents a social shift in the way people shop - shoppers now spend to a set budget rather than piling up the trolley with whatever takes their fancy, and are fastidiously using the internet to make sure they're getting the best prices on every item in their basket.

Loyalty evaporates

Rising prices are also prompting a return to the kind of trading down to more low-end retailers last seen at the height of the credit crisis in 2009, despite efforts of both supermarkets and branded manufacturers to protect market share with investment in promotional activity, which remains close to record highs at 37 per cent of total sales.

As analyst Dave McCarthy at broker Evolution points out, hanging on to customers is becoming increasingly difficult."There is less loyalty in this industry than ever, with market share following who has the best promotion in a given week,", he says. "Tesco and Sainsbury continue to pour money into their loyalty schemes, but this environment is about low prices, not marketing ploys."

That trend is showing up clearly in trade figures. Recent surveys from the British Retail Consortium, Nielsen and Kantar all show that the big-four chains are once again losing share to hard discounters such as Lidl and Aldi. Tesco, which has had the weakest growth of the big four supermarkets despite its generous loyalty-card scheme, has launched a major price 'war' to regain its lost trading momentum, with accompanying worries that this will put a dent in returns across the whole industry. Its 'Big Price Drop' will see prices cut on 3,000 lines at a cost of £500m, although some of that will be funded by reducing other promotional initiatives such as fresh food multi-buys and ending its double Clubcard points initiative.

Source: Datastream & Nielsen

Light at the end of the aisle?

A price war is also seen by many as a signal that there are already too many stores chasing too few customers, and that the massive expansion in capacity will further exacerbate the industry's problems. Evolution's Mr McCarthy describes the 41m sq ft of new space in the pipeline as "a new Tesco in the planning".

However, much of this is being given over to non-food and convenience which means that, according to Dalton Philips at Morrison, real industry space growth is closer to 1 per cent, in line with population growth and food demand. Critics of expansion still suggest that supermarket forays into convenience retailing will cannibalise sales from larger stores. But as Mr Philips points out, supermarket share of the convenience market is a mere 5 per cent, which suggests there's plenty of opportunity to steal share from smaller rivals, who are currently enjoying the increasing propensity of households to shop more frequently to help budget more effectively by reducing food waste.

Philip Drogan also believes that while a price war may not be good for grocery share prices in the short term, it will ultimately cement the position of stronger players at the expense of marginal players such as Ocado that lack the scale to absorb the impact. "While price wars - real and imagined - are generally not taken well by investors, the fact that Tesco looks set to move onto the front foot in the UK for the first time in 10 years will be good news for the shares in the long run," he says. Clive Black at Shore Capital is even more sanguine. "The quantum of 'The Drop' is substantial but not one that causes us to wince. Largely self-funded, the initiative should at least be neutral for earnings to our minds, and if it does build volume and share, it could be more than self-financing."

IC VIEW:

Overall, we still believe supermarkets are better positioned than most consumer-facing businesses. They may not be immune from the decline in household spending power, and food retail is highly competitive, but supermarkets still offer defensive qualities that provide some safe haven in these turbulent times. People need to eat, even if they are cutting back on some of those little luxuries in life. And the sheer scale of large grocers means they will emerge from the consumer slump stronger than ever, as smaller rivals fall by the wayside. In the meantime, share price falls mean the sector is attractively rated on a forecast PE ratio of 11, giving investors the opportunity to pick up what we think should be core holdings in any portfolio on the cheap.

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