Get to grips with grocery retail

This, of course, begs the question: have the bad times passed and are the shares now good investments? To try to answer this question, it helps to understand why the supermarkets got into such a mess in the first place.

By analysing the financial performance of the companies concerned, it is possible to gain an insight into what has gone on in the past and what the future might bring. You can then look at what share prices might be implying about future profits and see if the odds are in your favour or not.

In this article, we are going to scrutinise the financial performances of the bricks and mortar supermarket companies - Tesco, Sainsbury's and Morrisons. We will also separately look at internet supermarket Ocado to see whether selling food online makes financial sense.

Have supermarkets ever been quality companies?

High-quality companies consistently earn a high rate of return on the money they invest in their businesses. In financial jargon, they earn a high return on capital employed (ROCE). ROCE compares a company's trading (operating) profits with the money (capital) employed.

ROCE rather than earnings per share (EPS) is arguably the best measure of a company's profitability. This is because it takes into account all the money used to make a profit, which EPS doesn't.

The best way to think about ROCE is that it's like the rate of interest you get on a savings account. The higher the rate of interest (ROCE), the better a company's financial performance is. Good companies consistently produce ROCEs of 15 per cent or more.

As you can see in chart 1, Tesco (pink) got close to meeting that quality threshold back in 2007, but it and the others have not done so since then. What the chart above is telling you is that the profitability of the sector has collapsed. ROCE is now in the mid single digits.

Just to give you a bit more of a historical perspective, Tesco's and Sainsbury's ROCE in the mid to late 1990s was in the mid teens. Before it bought Safeway in 2004, Morrisons was making 20 per cent ROCE. So why has profitability declined so much?

From what I can see there are three main reasons:

1. The supermarkets spent too much money on opening new stores.

2. They failed to adapt to the rise of the discount supermarkets such as Aldi and Lidl and the increasing number of people doing their weekly grocery shopping over the internet.

3. Selling grocery goods over the internet might not be very profitable.

How the supermarkets spent too much

If you want to make more money from your investments there are two things that you can do. The first is to try to get a higher return on what you already have invested (generate a higher ROCE) or you can invest more money. For most of the past decade, supermarkets took the second option.

From big out-of-town hypermarkets, to regular supermarkets and convenience stores, the big supermarket companies opened up a lot of new selling space, as shown in chart 2.

As you can see, Morrisons (MRW) (green) and Tesco (TSCO) (blue) have been shrinking their selling space during the past year in an effort to improve returns, whereas J Sainsbury (SBRY) has kept on adding space. That said, all the supermarkets have a lot more stores and selling space than they did a decade ago.

The supermarket space race

The problem has been that all this new space has not made enough money in return. This means a lot of this money spent has been effectively wasted and has done considerable damage to the finances of the supermarket companies. Sales are higher, but profit margins have either stayed low - in the case of Sainsbury's - or collapsed.

How the supermarkets compare

To put this spending into some kind of perspective, the supermarkets were spending very large proportions of their trading or operating cash flow (the cash that comes into the business from selling goods) on capital expenditure - opening new stores and fitting them out, as well as keeping their existing stores in good condition. As you can see from chart 3, Sainsbury's (light green) has consistently spent almost all of its trading cash flow on capex.

This has meant that the companies' cash flow performances were dire. The amount of money left over after capex, tax and interest was paid - known as free cash flow - has been considerably less than the companies' reported profits. In fact, you could be forgiven for asking yourself what the true profitability of supermarkets actually was.

Sainsbury's free cash flow per share, shown in chart 4, has been negative for every year of the past decade due to its high capital spending. As the cash spent on new assets has been considerably more than the depreciation expense in the income statement (a dubious proxy for the amount of money needed to maintain a company's existing assets) there has been a big gap between free cash flow per share and earnings per share (EPS).

Tesco and Morrisons (charts 5 and 6) have not fared much better on this key test of profit quality for similar reasons. It should have been no surprise to investors that dividends eventually had to be cut or scrapped entirely in recent years.

That said, both companies have seen a recent improvement in their free cash flow performance as they have slashed investment in new assets (the black line in the chart).

A note of caution is needed here. Tesco's spending is now below its depreciation expense, which could be a sign that it has moved from overinvesting to underinvesting in its assets.

This level of spending cannot continue for long before stores start to look tatty and tired. Tesco needs to improve its free cash flow by increasing its profits not by underinvesting in its stores.

As well as seeing their cash flows deteriorate, Tesco and Sainsbury's also sold off many stores to property companies to raise cash to invest in their businesses. At the same time, they agreed to long-term commitments to rent them back in what is known as sale and leaseback transactions. These transactions created a big increase in hidden, off-balance sheet liabilities for Tesco and Sainsbury's, and with it the financial risks for their shareholders, as shown in chart 7. The higher rent bills increased the cash fixed costs of their businesses and therefore made their profits more sensitive to changes in sales.

In financial jargon, they increased their operational gearing. This is not a smart thing to do in the face of increased competition. Morrisons did fewer sale and leasebacks and looks to have much stronger finances than its larger peers.

Arguably, the key measure of a company's financial strength is a ratio called 'fixed charge cover'. It measures how many times a company's trading profits can cover the annual rent bill and the interest payments on borrowings. Morrisons has the highest fixed charge cover of the big three quoted supermarkets. Tesco is close to the danger zone.

Morrisons also has the lowest debt to net operating cash flow (OPCF) ratio. Put simply, its after-tax trading cash flow could repay its debts in just over two years. It also has the lowest total borrowings and hidden debts.

The rise of the discount supermarkets

The chief reason for the collapse in profit margins and ROCE of the big supermarkets has been the rise of discount supermarkets such as Aldi and Lidl. These companies have attracted more and customers since the recession of 2008. Cash-strapped consumers have been able to save lots of money doing their weekly grocery shop at Aldi or Lidl, which have offered much cheaper prices. This has forced the big supermarkets to cut their prices in order to be more competitive, but it has come at the cost of much lower profitability.

According to Kantar Worldpanel, Aldi and Lidl have a combined share of the UK grocery market of 10.8 per cent in September 2016, which makes them slightly bigger than Morrisons (10.4 per cent). They have been growing their market share at a rapid rate by opening lots of new stores.

It seems that the secret to their success has been a very simple and effective business model based on three key areas:

1. Smaller stores with less overhead costs than big supermarkets.

2. Ruthless in-store efficiency and logistics, which generates better profits.

3. A limited range of products in store compared with the big supermarkets. This allows them to significantly concentrate their buying power and get lower prices, which can be passed on to customers. For example, there might be one or two choices of a product in Aldi and Lidl compared with six elsewhere.

The key threat to the big supermarkets going forward is just how big a slice of the grocery market the discounters can grab and how long it will take them.

The poor profitability of selling groceries over the internet

Internet grocery shopping has been growing fast, but whether it has contributed much to the supermarkets' profits is debatable. Tesco and Sainsbury's pick customer orders from in their stores. This is very labour-intensive, and delivering to households adds on extra costs.

The supermarkets do disclose their sales from internet grocery shopping, but do not disclose how much money they are making or losing. This suggests that it has been nothing to shout about and that it is more about holding on to customers.

Ocado is a specialised internet grocer, which also looks after Morrisons' online business. This business has struggled to make money, has wafer-thin profit margins and a very low ROCE, as you can see in chart 8.

Is the worst over for supermarket shares?

Investors have been warming to the sector in 2016. The exception is Ocado (OCDO), as City analysts seem to have grave concerns about whether it can make significant profits, especially in such a competitive marketplace. However, it could be that the increases in share prices are explained by a relief that things aren't getting worse rather than evidence of a strong recovery in the sector's fortunes.

Tesco looks as though it has stopped the rot in terms of its sales performance. Its closely watched like-for-like sales figure (sales from stores that have been open at least a year) has started growing again, but only just. It must be remembered that growth of 0.3 per cent during the first quarter of its 2016-17 financial year is by no means stellar.

Morrisons' recent half-year results showed that its rate of growth in like-for-like sales was accelerating (2 per cent growth in the second quarter). Its cash flow performance was good and there was a good reduction in debt, which led it to be cautiously optimistic about its prospects.

Yet it seems that there is still a lot of danger out there for investors. The competition for market share remains cut-throat. Even the discounters are not doing as well as they were. Aldi's 2015 results released this week revealed that its sales have still been growing strongly, but that its profits fell slightly. The company stated that it intended to remain the country's cheapest supermarket and seemed to suggest that profits might not grow because of this strategy.

UK grocery market share

Of more worry to investors is what is going on at Asda. The company is losing customers and sales at an alarming rate as evidenced by the latest market share data. It will be looking to fight back and this is likely to mean more price cuts to woo shoppers.

Given this backdrop, how are supermarkets going to improve their profitability and ROCE? They can only cut costs so much and trying to meaningfully grow sales while cutting prices looks as though it will be very hard to do.

The UK supermarket sector looks like a classic case study of too many shops chasing too few shoppers. The country is oversupplied with supermarkets and this can only continue to put downward pressure on profits and returns. City analysts certainly aren't forecasting strong sales growth and a big recovery in profit margins.

A bullish sign would be to see supermarkets closing. Morrisons and Tesco have made some small steps in shrinking their selling space, but might be reluctant to do more for fear of losing market share.

Market share is a major determinant of a company's buying power with suppliers. The more it has, the more price competitive it can be, which then allows it to take more market share. This is the game that Aldi and Lidl seem to be playing.

The big advantage they have is that they are not quoted on the stock exchange and aren't heavily scrutinised by lots of shareholders. Tesco, Sainsbury's, Morrisons and Ocado don't have that luxury. This means that the quest to gain and hang on to market share might still have the potential to wreak havoc with company profits and cash flows.

The valuation of supermarket shares

Supermarket companies are going to have to work hard to grow their profits. If that is the case, then it's hard to argue that their shares are attractive right now.

Ocado shares trade on very high multiples of profits and assets, which reflect either a big increase in profits or that it will be taken over. Neither is guaranteed to happen. Tesco's shares trade on nearly 30 times forecast earnings, which is telling investors that a lot of profit recovery is already baked in to its share price. Sainsbury's looks cheapest on a forecast PE of just over 11, while also trading below its net asset value and offering a big dividend yield. Potential drawbacks are its consistently poor free cash flow performance and low ROCE.

Morrisons may be the share for investors to look at if they are feeling brave. By no means cheap on a forecast PE of over 20, it looks better value on a cash flow basis. Its financial position is strong and improving, while its prices and ranges look to be finding favour with shoppers.

Phil Oakley is a stock analyst for Ionic Inforamtion, maker of SharePad and ShareScope investment software. Read more from Phil, including his excellent Step-by-Step Guide to Investment Analysis at www.sharepad.co.uk/philoakley. Ionic is offering a 3-month subscription to SharePad for just £25. www.sharepad.co.uk