No taste for food retailers

The general consensus, certainly, is that things are likely to get much worse before they get better. Food price deflation will persist, due in part to heavy discounting as the big supermarkets try to prise shoppers away, not just from each other, but from the budget retailers, too. The latter, meanwhile, notably Aldi and Lidl, continue to grow sales and steal market share, threatening the dominance of the 'big three'. Worryingly, their rise has come despite enormous capital spending programmes at Tesco, Morrisons and Sainsbury's. Now, all are scaling back new store openings and using the money to bankroll store refits and price cuts, instead.

An apparent changing of the guard at the top only compounds the problems. Justin King will end his decade-long reign at Sainsbury's this summer. Tesco boss Philip Clarke is under intense pressure following a string of awful results (finance director Laurie McIlwee has already resigned), and Morrisons' chief Dalton Philips is treading on thin ice with investors (chairman Ian Gibson has resigned). So, with the sector in turmoil, investors risk being dazzled by big dividend yields and more reasonable ratings. We think the investment case is not quite that straightforward.

Tesco

We believe sales will keep falling at Tesco this year, leading to further downgrades. How significant they will be is, however, difficult given a lack of any margin guidance and unreliable management forecasts. The new strategy to win back shoppers involves at least £200m of price cuts on core products, while reducing promotional activity. Spending will be reined in and space growth curtailed. Consequently, sales will fall in the near term and margins will suffer. We think Tesco stands a chance of success, but it will be a long, hard slog, given that Aldi and Lidl have captured the imaginations of cost-conscious consumers. We're also unconvinced that Tesco's price cuts will compete with Sainsbury's and Asda. Tesco will have to go further on price, while also sprucing up its product offering and refurbishing drab stores.

Debt levels also remain high and the overseas business is weak. In fact, the catastrophic error of taking success in the UK for granted, while focusing on ultimately unsuccessful overseas growth, actually caused Tesco's problems. Currency depreciation in key international markets is now hitting the business even harder. Julie Palmer, a retail expert at Begbies Traynor, says what is most worrying is that Mr Clarke lacks a clear turnaround strategy. "With Tesco's depleted management lurching from crisis to crisis trying to correct past mistakes on the international front, they continue to underdeliver in their core UK grocery business which is by far their most appealing asset," says Ms Palmer. "I expect Mr Clarke has at most 12 months to prove his worth before investors demand more drastic measures." We upgraded Tesco to a 'hold' following well-timed sell advice in October, but emphasised that this was a 'neutral hold'. Nothing has changed since.

Morrisons

Sir Ken Morrison, former chairman of the supermarket that bears his name, launched a visceral attack on the company's management team at last week's AGM. He blames them for steering the business his father founded into the rocks, and with some justification. Morrisons plunged into a loss last year and strategy has changed far too many times for our liking. Just a few years ago, Mr Philips firmly opposed loyalty cards - now Morrisons is adopting one. Similarly, the fresh format strategy to spruce up shops went down like a lead balloon, alienating core shoppers. In a volte-face, Morrison has pledged to spend hundreds of millions of pounds cutting prices, funded by £1bn of cost savings and selling freehold property.

But it's difficult to see where Morrisons' long-term growth will come from. Core shoppers have defected to Lidl, Aldi and Asda and we don't think price cuts will be meaningful enough to win them back. Instead, they'll simply erode gross margin. Management seems unable to grasp the nature of the market and to understand who its customers are. These are basic failings. It's telling that Mr Gibson is stepping down, and also worth noting that 27 per cent of shareholders voted against the board's remuneration policy last week, 12 per cent voted against the re-election of Mr Gibson and 15 per cent opposed the re-election of Mr Philips. That level of anger should make him nervous. As for rumours that Morrisons will spin out its property portfolio, we think this is unlikely given that Morrisons could not sustain rent roll on those stores. The likelihood of a private equity takeover is also low. The share price has fallen below the net asset value, but any acquirer would have to be certain of recovering margins and volume growth against a backdrop of food price deflation, intense competition and the prospect of dishing out funds to protect core channels, while investing in online and convenience (Morrisons is still incurring massive costs associated with launching convenience and online so late in the day).

Granted, Morrisons is arguably on a better footing now, but it has taken a beating and there's more to come. Its shares are trading on a punchy forward PE ratio of 15, expensive for the sector, but offer a 7 per cent yield. If that seems attractive, do bear in mind that further deterioration in the underlying performance could threaten the dividend. We exited our well-timed sell recommendation at 198p last month, but, as with Tesco, we're neutral on Morrisons.

Sainsbury's

Sainsbury's is a well-run, cash-generative business, but it isn't immune to the themes affecting its peers. Indeed, the fourth quarter of its last financial year ended a streak of 36 consecutive quarters of like-for-like sales growth. We think this could be a turning point and fully expect sales to continue to fall this year as it loses market share. It could face bigger problems if Tesco cleans up its act. And, like Tesco, Sainsbury's hasn't given any margin guidance for this financial year, either, amid uncertainty over pricing. To address the challenges, management will open fewer stores, cut spending and divert money to store refits. Short term, this means the outlook for profits isn't great. However, Sainsbury's does offer a well-covered dividend, with the shares yielding 5 per cent, so they could make a reasonable income play for long-term investors. Hold.

Source: S&P Capial IQ

IC VIEW:

The supermarket industry is entering a new era of constrained profit growth as the discounters are driving margins down, forcing the established players into a price war. The next six months will determine where the sector is headed and offer clarity on how real these price cuts actually are. We'll be watching how Aldi, Lidl and Asda respond. Eventually, the sector will undergo a rebasing and ratings will improve. Capacity has been cut, too, and the economy is growing strongly, but uncertainty persists and the situation is unlikely to change any time soon. Until it does, we would advise steering clear of the sector.