The advance of German discounters Aldi and Lidl is likely to continue this year, although it seems deflationary pricing pressures are starting to abate for the UK’s supermarkets. It’s predicted that grocery discounters will still take market share, albeit via new store openings as wider inflationary trends play out across this part of the retail industry. This could give a bit of breathing space to Britain’s ‘big four’ – Asda, Tesco (TSCO), Sainsbury's (SBRY) and Wm Morrison (MRW) – as the competitive environment eases slightly.
That’s not to say that these companies don’t face an enormous task. As last year's major tie-up between Sainsbury’s and Argos demonstrates, customers’ expectations regarding convenience and product availability are higher than ever. This will require significant investment by the grocers in their distribution capabilities, online interaction and customer engagement.
The Amazon question
We started to see hints of this last year. The arrival of Amazon's (US:AMZ) pantry service via its Prime membership scheme has put the pressure on UK supermarkets
to bring their digital and distribution capabilities up to scratch. Admittedly, some have taken the ‘if you can’t beat them, join them’ approach: Morrison, for example, has signed a supply and distribution agreement with the internet giant. Prime members can now order Morrison’s products via the Amazon website, while those living in London or Hertfordshire can even opt to have their groceries delivered within one hour.
This isn’t good news for online grocery service provider Ocado (OCDO), which spent the past year failing to sign another high-profile contract despite talk of ongoing negotiations. Another crucial operational development for Ocado has been the renegotiation of its existing contract with Morrison. The new terms are far more preferable for Morrison compared with the previous contract, which was originally signed by the supermarket’s ex-boss, Dalton Philips, in 2013. It was heavily criticised at the time, with City analysts calling the deal “a big transfer of value”, specifically referencing the sudden outperformance of Ocado’s shares compared with the substantial loss of momentum for the grocer’s stock.
Morrison’s Amazon deal almost certainly forced Ocado into these renegotiations, although – to try to sweeten the deal – the supermarket agreed to take on capacity in Ocado’s new multimillion pound distribution centre in Erith, south-east London, and contribute 30 per cent of the building costs. It’s worth remembering, however, that the new capacity arrangements come with a five-year break clause.
Inflation has picked up after sterling's fall
The price of recovery
The two big recovery plays to keep an eye on this year are still Tesco and Morrison. The former is still trying to distance itself from the 2014 accounting scandal, but chief executive Dave Lewis is doing well to create positive sentiment among the group’s investors. Over the past 12 months, the stock has risen by a third, and the chain reported year-on-year like-for-like sales growth of 1.5 per cent, or 1.8 per cent in the UK alone, for the 13 weeks to the end of November.
Then, over Christmas, like-for-like sales grew 0.3 per cent at the total level, or 0.7 per cent on the home front. However, Britain’s largest supermarket still faces a significant revenue challenge if it’s to meet its operating profit margin target, not to mention the issue of rising prices for goods. That said, the group did well last year to shake off its momentary price war with consumer goods giant Unilever (ULVR). The latter, reacting to last year’s sterling slump, demanded higher prices for a number of the products it supplies to Tesco. But former Unilever employee Mr Lewis was able to resolve the issue quickly and snagged Tesco a significant post-referendum PR victory.
If Tesco can prove it is chasing sales and margins, we expect there’s further for the shares to run – and the same with Morrison – while the discounters are still expected to expand their UK footprint further. Where does that leave J Sainsbury this year? It has a lot on its plate in terms of integrating Argos, not to mention reinvigorating underlying sales growth, but at least the company is laying out a vision for how it thinks the sector – and, more importantly, the consumer – is changing.
| Company | Price (p) | Market value (£m) | PE (x) | Yield (%) | 1-year change (%) | Last IC view |
| Booker | 188 | 3,335 | 24.6 | 2.4 | 25.3 | Buy, 182p, 19 Sep 2016 |
| Greggs | 1,022 | 1,034 | 17.9 | 3.0 | 2.7 | Buy, 1,037p, 25 Aug 2016 |
| Morrison (Wm) | 239 | 5,579 | 26.3 | 2.1 | 49.6 | Hold, 221p, 23 Nov 2016 |
| Ocado | 264 | 1,661 | 118.4 | 0.0 | 8.9 | Sell, 262p, 14 Sep 2016 |
| Sainsbury (J) | 266 | 5,808 | 11.4 | 4.4 | 10.9 | Buy, 271p, 11 Jan 2017 |
| Tesco | 202 | 16,484 | 30.1 | 0.0 | 24.8 | Hold, 208p, 5 Oct 2016 |
Favourites: Our firm favourite in this space is wholesaler Booker (BOOK). The company sits outside of the traditional grocery space and has diversified its business through acquisitions of German chain Makro, and convenience chains Budgens and Londis. The company has a strong track record for preserving profit growth, and while the shares are pricey they’re worth it in our view.
Outsiders: For us, the real outsider this year is still Ocado. While all the grocers are under threat from the advance of the mighty Amazon, none face as direct a challenge as the online grocer. Future growth is still heavily reliant on further distribution deals, while the lack of clarity on margins outside of formal results statements has us worried. Betting on Tesco and Wm Morrison is also a risky game, not to mention the fact that the forward ratings on both stocks have us thinking any recovery prospects are priced in for now.
