Food retail fights back

As for investors, it has certainly been a rough, painful ride watching the share prices of Wm Morrison (MRW), Sainsbury and Tesco fall off a cliff edge since the autumn of 2013. Now, however, there are tentative signs that the sector might be on the cusp of a major recovery. With new chief executives at the helm of all three grocers armed with fresh strategies, the feeling is that the worst might be over. Many well-regarded City analysts and fund managers have ploughed money into the sector, most notably into Tesco. Thus far, that bet would have done well: Tesco's share price has risen 29 per cent since the start of the year. But with so much uncertainty in a still over-saturated food retail market - and dividend payments looking thin on the ground - the question is whether this is merely a false dawn, or is it time for investors tuck in?

Trolley wars

If, like most householders, you tend to buy most of your groceries at the supermarket, you'll have noticed that food doesn't seem to cost as much as it used to. In fact, food prices fell a massive 3.4 per cent in the year to February, according to the Office for National Statistics. The reason for this happy (if you're a shopper) state of affairs is that the UK's supermarkets have been locked in a bitter price war that started around this time last year. The catalyst was partly a fall in the price of certain staple commodities, such as sugar and milk, but more to do with the seemingly unstoppable rise of the so-called discounters, Aldi and Lidl, who offer cash-strapped consumers good quality products at bargain prices. Suddenly, Tesco, Sainsbury and Morrison - and to the same degree unlisted peers Asda and The Co-op - started losing shoppers. Meanwhile, posh nosh outfits Waitrose and M&S Food were stealing business from the top, creating a sort of sandwich effect for the mainstream grocers. Having spent so much time expanding their store estates, the net result was huge overcapacity in the marketplace and higher competition, all set against a backdrop of lower spending.

The big question, then, is whether the discounters still pose a big threat, or if that is now tailing off. Views are mixed, but the general consensus is that these continental retailers are still a force to be reckoned with. It's estimated that 72 per cent of UK households now shop at discount stores. That's a phenomenal figure. And Aldi and Lidl together enjoy an 8.5 per cent share of the total grocery till spend in the UK - although some analysts put this at 10 per cent - up from 7.4 per cent this time last year, according to industry research firm Kantar Worldpanel. Meanwhile, Sainsbury, Tesco and Morrison have all lost clout over the same period. Average takings per square foot per week has declined annually for five years at Tesco and Sainsbury, while Morrison has seen a fall over the past three years.

Fraser McKevitt, head of retail and consumer insight at Kantar, reckons the discounters remain a thorn in the side for supermarkets. Admittedly, their sales growth has slowed this year, after peaking in the early summer, but it's still at a healthy 18 per cent. "The fact that Aldi and Lidl are still growing in double digits while the big four are barely growing at all means they are stealing a lot of money," he points out.

Food price deflation isn't helping. In the first quarter of this year, it reached a new low of 1.6 per cent, marking the 18th successive fall and a record low since Kantar began recording grocery price inflation in October 2006. "That doesn't sound like a lot, but it equates to £400m over the past three months which has simply disappeared from the revenue pool, so it's a big problem for food retailers," adds Mr McKevitt.

What's more, Aldi and Lidl have ambitious plans to double their store estates by the early 2020s. That suggests they are effectively looking to double their market share, too, which means they could one day have a 20 per cent slice of the sector. That's why Mr McKevitt believes "we will definitely see price wars continue". However, Mike Watkins, head of retailer and business insight UK at rival research firm Nielsen, sees things differently. "I predict another couple of percentage points of market share growth for the discounters over the next three years, but not frenzied growth, and then it will start to slow," he says. "I don't see the 20 per cent market share in the time horizon I'm looking at. In France, the European country most similar to the UK in terms of trade structure, discounter growth plateaued at around 12 per cent. Accordingly, I don't see prices falling much further, but expect them to be maintained."

It's the economy, stupid

The economy is growing and the chancellor has a spring in his step. Wages are rising faster than inflation and people should feel richer. But food retailers won't necessarily be the beneficiaries of this uptick in consumer confidence. If households feel richer, they're more likely to spend that extra cash on leisure, rather than food. The idea that consumers will suddenly change their shopping behaviour is, frankly, unrealistic. Research conducted by Nielsen suggests UK consumers, from across the wealth spectrum, still intend to buy cheaper food products, even if they feel better off. "We talk about structural change in the industry but there has been a fundamental change in shopping behaviour which is equally important to consider: shoppers are savvier and more promiscuous, more demanding," says Mr Watkins. "They check prices online before buying. That's a symptom of technology but also austerity. Put the two together and it’s a formidable combination that's not going to change."

Shoppers now also tend to make more frequent, but smaller, shops, thus avoiding waste. That's good for convenience stores, but not good for large hypermarkets. We're also buying more nosh online. "Why drive to a supermarket when you can settle down, watch Netflix and order from home?" asks Garry White, chief investment commentator at Charles Stanley. Indeed. That service is great for us, but not for the supermarkets, who don't make much money from online purchases. In fact, online sales are probably loss-making.

Every little helps...

All three supermarkets have new management teams at the helm who have unveiled big, sensible strategies, outlined in the boxes. They include slashing capital spending, halting store expansion, taking costs out of the business and pumping savings back into customer service, products and stores. All three have cut their dividend payouts to save money. That's bad for income-seeking investors, but it's vital for growth, because lower prices alone won't be enough to lure back shoppers.

Indeed, it's very hard to grow a business in a sector still held back by overcapacity. Supermarkets must, therefore, steal market share from each other through more than just discounting. "They'll have to be much cleverer," explains Julie Palmer, retail expert at Begbies Traynor. She points to Waitrose as a success story, with its essentials range. "Behind those nice wide shopping aisles people are putting higher-margin products into their trolleys, which support the discounted lower priced items. It is always a game of subterfuge with the customer."

Supermarkets must, therefore, innovate and improve their propositions if they are to get back in the game. That means refreshing store environments and extolling the benefits of the wider choice they offer. Being more competitive on proposition as well as price. If they're able to do so, they might just be able to stem those losses and give shoppers a chance to re-discover the brands they know and love. "When priced well, consumers do like brands," says Mr McKevitt. And it's worth pointing out here that the 'big four' - Asda, Tesco, Sainsbury and Morrison - still have a 75 per cent share of the market, so they're not going to disappear overnight. "It will be a hard battle for them, but if they win they will do so by exploiting what makes them different to discounters, not the same," says Mr McKevitt. "They have to shout about what they are good at: availability, wide range, in store environment, shopping experience, plentiful parking and concessions."

Things can only get better

So, despite these huge challenges, there are signs that things might be turning a corner. Sentiment is undeniably more positive - that was lacking 12 months ago. Recent trading figures and sector-wide data suggest that the supermarket price cuts initiated last year, worth hundreds of millions of pounds across thousands of lines, might be stemming the outflow of customers. Over the past two quarters, both Tesco and Morrison have reported an improvement in the rate at which like-for-like sales are declining. Sainsbury capped off a tumultuous year with much better than expected fourth-quarter results and all three had a relatively buoyant Christmas. What's more, volumes at the UK's leading supermarkets increased 1 per cent year on year in the four weeks to 28 February - the third consecutive month of growth following 17 months of decline, according to data from Nielsen.

"The fact that those volumes grew in the past few weeks is potentially a turning point in terms of being sustainable," says Mike Watkins of Nielsen. "We also believe supermarkets have started to stabilise their businesses, having re-set prices and promotions. We'll have a better feeling by the second half of the year as to how long-lived this recovery is. But what all of this suggests is that the cycle, like most things in life, seems to be changing. It has favoured discounters in the past three or four years, but may well move back to supermarkets.

He remains cautious, though. "The caveat, of course, is that it's still early days. Clearly we need to see sustained periods of volume growth at all three grocers before being able to say that the recovery is in full swing, because what has become clear is that volume is key in this no-growth deflationary market. Higher volumes at lower margins equals higher profit," says Mr Watkins. "Food retail is best served in that model, as opposed to when it was sustaining 5 to 6 per cent margins and people had more money and the market was growing."

Is it time to invest?

For years supermarkets have enjoyed rising prices and ever beefier margins. That's clearly not realistic now and margins are certain to re-base. But the trouble with the sector - whether or not you believe the time is right for a sustainable recovery - is that any profit or margin forecasts out there are pie in the sky. That's according to Garry White of Charles Stanley. "We don't know where margins will settle after the price war, so analysts making predictions for future earnings are essentially just making their best guess. We know margins will be lower than before, Aldi and Lidl aren't going away, but the financial crisis has changed everything," he says.

So, while the supermarkets are recovering, we just don't know how long that recovery will take, and how volatile the journey will be. "There are arguments for a recovery, but you need certainty when investing and what the sector doesn’t offer is certainty," says Mr White. "The margin range estimates are wide and that, to me, is a red flag."

The general consensus appears to be that margins will settle around 3 per cent mark, but the wide range of profit forecasts makes it difficult to value the shares using the traditional price-to-earnings metric. After all, if you don't know how much profit they will make on that pint of milk, you can't go about valuing them. Tesco's shares, for instance, trade on a PE ratio of 23 times consensus forward earnings, while Morrison is on 16. That compares with a historic PE ratio of around 11.

Ken Perkins, a retail analyst at Morningstar, believes a recovery is coming, but like everyone else, warns it's still early days. "Discounters will continue to take market share for some time, but with efforts to cut prices and lower margins, at some point that market share loss will stop as well. Like-for-like sales are trending in a better direction, so 2015 is looking more positive."

In terms of the individual stocks, Mr Perkins isn't keen on Morrison, but prefers Sainsbury and Tesco as possible recovery plays. "Tesco probably has the biggest opportunity for recovery if it can sort out its sales growth, but Sainsbury is better insulated against discounter threats," he says.

Mr White remains bearish on the sector. "I look for companies with high and growing yield. There is possibility that the Sainsbury dividend might fall again next year as they rebased, so clouds of uncertainty remain. The share price drive in recent months has been sentiment driven. People are betting," he says.

Ms Palmer, however, sees the sector as a "real mixed bag". On Morrison, she questions whether things can get any worse: "They've been such awful performers. If the new CEO has an ounce of imagination in terms of a viable turnaround plan, Morrison might stop being a whipping boy. But the winners will continue to be Aldi and Lidl. They are appealing to a wide range of people and play into our new shopping habits. If they are successful in doubling their market share to 20 per cent, that poses a challenge." She adds that she can't see any of the supermarkets failing. "They might be making a lot less profit but they remain extremely profitable organisations."

The real tabasco - our verdict:

Shares in Wm Morrison, Tesco and Sainsbury have bounced back since the start of the year, driven by better than expected sales figures and the possibility that this could be the start of a major recovery. And there is reason to believe that with new leadership, fresh ideas and an improving economy the tide is turning for the supermarkets. Price cuts are certainly a way to win shoppers back and if the supermarkets can give people a better reason to shop with them, in addition to lower prices, than the discounters, it could be a winning formula. As for Aldi and Lidl, they're here to stay, but it does look as if the threat here might ease off.

So what should investors do? Well, long-term, population dynamics favour the food retail sector, but at the moment, the recovery is fragile and any hint of a slow-down in like-for-like sales will send share price tumbling again - particularly given the lack of dividend support. In the long run, there will be a point at which trends move in the right direction, but investors in this sector should expect short-term volatility. Perhaps, then, it's better to remain on the sidelines until sales and volumes head in the right direction. In the end, it's a question of how much you can stomach to lose before things get genuinely better.