FTSE 350 food & drug retailers: Food retail going stale

"We are not fans of food retailing and have negative recommendations on all the major players and see more interesting investment opportunities in non-food," was Seymour Pierce analyst Kate Calvert's scathing summary of the sector. Supermarkets should be worried - Christmas trading statements this year have done little to boost confidence, with flat or declining sales growth. Revenues are still sluggish and margins are under pressure. Dave McCarthy, an analyst at Investec Securities, warned of pessimistic consumers, declining real incomes and rising real prices. He expects forecast downgrades in 2013, as retailers continue to suffer like-for-like volume declines in larger stores.

But Mr McCarthy says there are also bigger structural issues at play. For starters, the more that sales rise online and at convenience stores, the more sales fall at large stores. This is worrying as many supermarkets subsidise the distribution costs of their online service from their stores. Meanwhile, peripheral grocers at the high and low end of the market, such as Waitrose and Aldi, are stealing market share from the likes of Sainsbury (SBRY), Tesco (TSCO) and WM Morrison (MRW), while opening new stores at a faster rate.

"The sector is going through a once-in-a-generation shift that's changing the fundamental economics of the industry and its players," believes Mr McCarthy. "New channels are emerging, new competition is developing and old ways of analysing the sector need reviewing. Investors should be careful. Even if the cyclical issues improve, the structural issues will still need addressing."

Supermarkets should also be worried about shopper behaviour. Impulse buying is falling as cash-strapped shoppers stick firmly to their grocery lists. Tech-savvy shoppers are shedding brand loyalty, and are instead searching for the best bargains, using mobile phone apps to instantly compare prices in-store. It's also questionable whether supermarkets can continue to absorb inflationary rises rather than pass them on to consumers.

Morrison's Christmas trading figures laid bare the problems that it's facing - same-store sales fell 2.5 per cent, excluding fuel, despite an ongoing self-help initiative to lure shoppers through the door. The retailer has also been slow to innovate. It has only just started to roll out its M Local convenience stores and does not yet sell food online.

Tesco's woes have been among the most publicised, following a profit warning in January last year, an exit from Japan and a strategic review of the US operations. Its share price fell 16.7 per cent in 2012, one of the worst in the FTSE 350. However, the company is nine months into a UK recovery plan and there are signs that this could be starting to pay dividends. Its Christmas trading statement reported like-for-like sales growth in the UK of 1.4 per cent, which is a significant improvement and ahead of consensus expectations - suggesting that Tesco could be recovering somewhat after a difficult 12 months. That said, UK sales growth remains comparatively weak, despite significant investment, and sales continue to fall in the company's international business.

The only supermarket out of the big three to be reporting any good news is J Sainsbury. The supermarket's third-quarter trading update marked the 32nd consecutive period of like-for-like sales growth, which included a 0.5 per cent contribution from store extensions. Yet management is cautious about trading conditions and Seymour Pierce has cut its 2013 pre-tax profit forecast by 2.5 per cent, saying that the supermarket will struggle to outperform as Tesco fights back.

Meanwhile, budget bakery Greggs (GRG) has also had a fraught year, taking on the government for proposing a potentially costly levy on hot food - the so-called pasty tax. Its financial year-end saw same-store sales drop 2.7 per cent. But the good news is that Greggs plans to open between 80 and 90 shops this year and give its rather drab-looking high-street stores a much-needed makeover. Investment in its wholesaling and franchising arm is paying off, too, and includes a new deal to supply Iceland with bake-at-home products and a partnership with Moto - although the departure of chief executive Ken McMeikan to food service group Brakes is a worry.