Blood in the aisle?

By Nathalie Olof-Ors, 14 May 2008

The evidence of food price inflation in supermarket aisles is something most shoppers are now all too familiar with. Yet few are probably aware the concept of 'differential inflation', which has been creating major concern among retail analysts lately. In plain English, differential inflation describes the gap between the actual inflation on foodstuffs and the share of inflation passed on to customers at the supermarket tills.

The latest BRC-Nielsen shop price index suggests that although food prices rose by 4.7 per cent in April, retailers have absorbed some of the actual inflation at the expense of their own margins in order to avoid passing its full force on to customers. That's because supermarket chains are grappling with a retail equation which does not yet add up.

On the one hand, food manufacturers are putting serious pressures on retailers to secure price increases in order to offset an unprecedented inflation in their own cost bases. This week dairy processor Robert Wiseman was forced to issue a flagging that its first-quarter profits will be £3m lower than expected and that full-year profits could fall by a further £2m if another round of price increases was not secured.

On the other hand, cash-strapped consumers are feeling the pinch from higher mortgage and credit card repayments and could be tempted to 'down trade' by switching from from a 'Tesco Finest' or a 'Sainsbury Taste the Difference' label to a cheaper supermarket own-brand alternative. While the latest figures released by supermarket chains show little evidence of this shopping trend, analysts are increasingly nervous about this risk and are actively looking for any signs of the trend emerging.

With these contradictory forces at work, analysts are now convinced that something will have to give. One of the scenarios envisaged by brokers is that supermarkets will eventually have to reflect the full impact of food price inflation. But many warn that this would have serious consequences for sales volumes and, more dramatically for supermarkets' profits, would accelerate the move towards less-profitable own-brand labels.

The second possibility is that supermarkets will try to compensate for a decline in food sales with their non-food businesses. Tesco has big ambitions on that front and has already delivered promising figures on its general merchandise catalogue Tesco Direct. Meanwhile, Sainsbury has significantly increased the retail space dedicated to non-food. Some analysts argue that consumers on the lookout for cheap deals will naturally turn to supermarkets which have strong value credentials on electrical goods or entertainment products.

This theory is not without its detractors, though. Others point out that this strategy only increases their exposure to the risk of weaker consumer spending. And back in March, Morgan Stanley's retail analysts also pointed out that even though non-food could generate sales of £900m next year, the big three supermarkets would still need to grow sales by at least 5.8 per cent to hit the market's forecasts.

A third scenario, which is gradually becoming more plausible, is that the current environment could lead to another price war. Yet analysts warn that this time around a price war could easily turn to a "blood bath". At broker Oriel Securities, Jonathan Pritchard points out that during the last price war Tesco, Asda and Morrisons gained market share at the expense of the weakest players, namely Sainsbury, Safeway and Somerfield. Yet he flags that there are no obvious "fall guys" today.

The big four supermarkets are now all well run and struggling M&S is too small compared with other supermarkets to make much difference in terms of market share. This means that a potential price war could well be conducted at the expense of margins rather than market share. "If a price war begins, we would be concerned for those players with shallower pockets. Tesco and Asda (via Wal-Mart) have much more potential than Morrison and Sainsbury to cut margins to ensure a stronger medium and longer-term position," he says.

Against that unpromising backdrop, analysts also point out that another part of the investment equation appears weak. Supermarket shares trade at a 60 per cent premium to general retailers, which concedes little to earnings downgrade risks. That's because supermarkets have long been considered as more defensive, but also because multiples have been distorted by property-related speculation. But with the rapidly falling property market, this support appears increasingly flimsy. So in the coming months, sales volumes at supermarkets might not be the only thing dropping.

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