The grocery market is under severe pressure. Food price deflation and the rise of discounters are proving two enormous challenges to the UK's four largest supermarket chains: Asda, Tesco (TSCO), J Sainsbury (SBRY) and Wm Morrison (MRW). Over the past couple of years, a combination of mismanagement, profit scandals and onerous property portfolios has wreaked havoc on the industry. And next year's introduction of the new living wage could pose a further challenge. In this piece we're looking at the main trends shaping the industry and which companies are best placed to adapt to the changing dynamics.
Food price deflation and the rise of German discount chains Aldi and Lidl are inextricably linked. Born out of the recession, Aldi and Lidl have made it their mission to cater for customers looking to cut down on the price of their weekly shop without compromising too much on quality. Some premium retailers such as M&S Food and Waitrose have been left unscathed thanks to a loyal - and well-heeled - customer base. But an increasingly squeezed 'middle market' has emerged as the customers of Sainsbury's, Tesco and Morrisons see no reason to stay loyal to these retailers and end up trading down. For many shoppers, price, always a prime determinant of footfall, is now the sole consideration. The discounters have been quick to exploit the trend, but they haven't neglected what's often referred to as 'the retail experience'. Lidl, in particular, has been determined to match quality with value, so much so that it has revamped its store estate to make customers feel they're not totally compromising on a quality shopping experience in the pursuit of cheaper goods.
But the rise of the discounters hasn't been the only problem for the squeezed middle. The popularity of convenience shopping among modern consumers - particularly in city centres - has put pressure on Sainsbury's, Tesco and Morrisons to manage evermore complex property estates. And it's fair to say that some have handled the convenience chain trend better than others. Three months ago Wm Morrison sold almost all of its 'M Local' convenience stores to a team backed by Greybull Capital, a group that has a history of bailing out troubled companies. It will cull 140 stores, but only recoup £25m in proceeds, which gives some idea as to the quality of Morrisons' property portfolio. It will only hold on to five remaining outlets, all of which are located on petrol forecourts or on sites that could be converted into larger superstores. The decision was made after bosses said the M Local concept would require "significant further investment in new sites", "additional capital expenditure" and "lease commitments" to turn profitable.
But it could be wrong to label Morisson's the worst of the bunch. Tesco's shares are at an 18-year low following a less than stellar year in the wake of the group's 2014 profit scandal. It might still be Britain's largest supermarket by market share (last count 28 per cent) but that monopoly is under more and more pressure from Aldi and Lidl. Between them, the German discounters now control nearly 10 per cent of the market, according to the latest data from Kantar Worldpanel.
But analysts at Shore Capital have come out in defence of Tesco chief Dave Lewis and his team, who they say should be given more credit for stabilising a business in a "state of chaos". The broker concedes that the shares have underperformed the FTSE All-Share by 13 per cent over the past 12 months, but the Shore analysts remain confident that, should Tesco demonstrate signs of improved trading in the UK, the downward trajectory of the share price will reverse.
Aside from food price deflation, the rising popularity of convenience shopping and specific mismanagement scandals, another shifting dynamic for the grocery sector is the advent of online shopping. While this has been more disruptive for general and personal goods retailers, the supermarkets have also had to adapt to this emerging trend in the past five or so years. The demand for online shopping in the sector should not be underestimated, either. According to the Institute of Grocery Distribution (IGD), during the five years to April 2015, superstores and hypermarkets showed modest growth of 4.2 per cent, convenience stores grew sales 27.3 per cent, while online sales soared 117 per cent - albeit from a low base. This method of shopping is said to be particularly popular among larger families or domestic set-ups that buy items in bulk.
This is an area in which the discounters look ready to compete as well. Lidl recently announced plans to take its business online to cater for customers looking to buy value items in large quantities and enjoy home delivery. Arguably their biggest competitor in this space is Ocado (OCDO). Ocado's latest set of numbers were encouraging thanks to its leasing agreement with Morrisons, although margins are under pressure there, too, just like any of the bigger supermarket chains. During the first half of its financial year to 17 May 2015, Ocado earned £32.4m from that partnership, compared with £16.9m during the same period last year. The group hasn't announced any further licensing deals as yet, but management said it still hoped to sign a new contract before the calendar year is up.
IC VIEW: What makes the grocery sector even more difficult to decipher - from an investor's point of view - are the hugely disparate valuations. For a start, Aldi and Lidl aren't publicly traded companies in London, making it difficult for retail investors to gain access to the fastest-growing end of the market. And if purely online outfits take your fancy, be prepared to pay an incomprehensible 157 times forward earnings for shares in Ocado. There are also a number of challenges ahead. The introduction of the new living wage is bound to result in a higher cost base for many, while the pace of food price deflation shows no sign of slowing. The overall outlook for the sector, therefore, remains negative.
