It’s fair to say retail stocks have been a contrarian play for investors this year. With inflation rising, wages stagnating and household budgets under pressure, it’s been a year of winners and losers in British retail. But one clear trend to emerge from this is a recovery for grocery stocks, many of which suffered badly during the last recession – not to mention the destructive price wars that followed. Inflation, intuitively a bugbear for retailers, has actually done the supermarket sector a favour, ending the deflationary imperative that has undermined high-street margins in recent years. Crucially, this has also put a pause on the advance of the limited assortment discounters (LADs) – including German brands Aldi and Lidl. Britain’s four largest supermarkets – Tesco (TSCO), Asda, Sainsbury’s (SBRY) and Morrisons (MRW) – have all worked hard to put various strategic stumbles behind them and even large-scale acquisitions seem to be back on the agenda. But how well-prepared are these companies to face down the biggest threat of all: the onward march of US online retail giant Amazon (US:AMZ)?
The price is right
Amazon’s decision to take over health-conscious Whole Foods has sent the grocery sector into a tailspin. Just last week, share prices for UK supermarkets tumbled after Amazon decided to lower prices on best-selling grocery staples including bananas, eggs and apples, as well as introducing Whole Foods' own brands to its Amazon Fresh, Prime Pantry and Prime Now offers. Even shares in Marks and Spencer (MKS) were on a downward trajectory, reflecting investor fears that M&S Food could lose market share once the Whole Foods range becomes widely available across the iconic UK retailer’s target demographic.
Waitrose is another high-street grocer that could feel the pinch, but Amazon’s foray into food retail is embryonic, although the consternation it has generated is testament to the seemingly unassailable position it has built in e-tailing. And it’s certainly got its timing right judging by the latest high-street stats. Market researcher Nielsen said better than expected summer weather supported another good round of supermarket sales over the four weeks ended 15 July, while Kantar Worldpanel recorded 3.9 per cent sales growth over the 12-week period ended 16 July – the first time since November 2013 that sales have exceeded 3 per cent growth for four consecutive months. But at the same time, Kantar also reported that grocery price inflation had risen 3.2 per cent – which automatically explains a chunk of this top-line growth.
It’s all in the margins
However, it’s one thing leaking market share to Amazon; quite another if it decides to replicate the pricing strategies that decimated booksellers up and down the country. Investor trepidation isn’t necessarily rooted in sales cannibalisation – but in margin contraction. By keeping prices – not to mention delivery costs and shopping methods – competitive (some might say ‘artificially low'), the online behemoth risks precipitating another race to the bottom.
Low food prices and razor-sharp competition may be great news for shoppers - but they’re anathema for investors in the sector. A deflationary spiral – at least, one that isn’t driven by normal market forces – usually ensues when retailers aggressively cut prices to drive volumes and maintain revenue. But if supermarkets are forced into strategic discounting by a market disrupter such as Amazon, where will it all end? The Seattle-based company has placed no limitations on the breadth and scale of its retail ambitions thus far. Why should the UK grocery market be immune to the Amazon effect?
Merge and grow
So why didn't Tesco's share price keep up the momentum attained through 2016? Well, it's fair to say that the group’s proposed takeover of wholesaler Booker (BOK) has been seen by some analysts and shareholders as a distraction from the task at hand, while the 2014 accounting scandal continues to haunt it. At the last set of annual results released in April, pre-tax profits of £145m were down more than a quarter, largely thanks to a £235m charge in relation to the regulatory settlement and the related compensation scheme.
Unsurprisingly, Tesco management wants to focus on other figures: adjusted operating profits managed to break through the £1bn mark thanks to consistent like-for-like sales growth over the financial year and – crucially – operating margins widened from 1.8 per cent to 2.3 per cent. According to chief executive Dave Lewis this hasn't been achieved through the simplicity of price rises as industry data would have us believe. Instead, improving the product range, changing the sales mix and trimming £226m-worth of costs against a £1.5bn medium-term target all helped to improve the underlying performance. What's more, Mr Lewis says top-line improvements can continue to be achieved via volume growth rather than hiking prices. That, of course, remains to be seen, but the sentiment would certainly play well with the value-conscious Tesco customer base.
The Booker deal has attracted a great deal of attention from competition authorities, but investors seem more preoccupied with whether Tesco will be able to achieve its original recovery goals while it integrates the heavyweight wholesaler. In recent weeks, renewed momentum in the share price suggests underlying trading is strong enough, and some analysts – although not all – believe that the rationale for the Booker deal is compelling: gaining instantaneous exposure to the boom in the convenience market and the growth of coffee shops and restaurants.
Field notes
A recent Kantar spending survey said Tesco is still setting the pace among the big four grocers, despite poor August weather, showing a 3.2 per cent increase in cash sales for the 12 weeks to mid-August. If Tesco can keep this sales momentum up, clear the Booker deal with regulators and realise the promised synergies, it will look like one of the only food-centric companies with enough vertical integration to legitimately challenge Amazon's encroachment on the sector.
Although Tesco might be considered the leader of the pack right now, it comes from a lower base (effectively reset in 2014) – which arguably makes its progress look more dramatic. Another company also firmly in recovery – but garnering far fewer headlines – is Morrisons. This has been the surprise recovery many had doubted when the group suddenly shut down its convenience outlets in 2015. But the group has now reported five consecutive quarters of positive like-for-like sales growth and kept a close eye on costs to make sure as much of this falls down to the bottom line as possible. Last year, a helpful £32m in disposal profits ensured that statutory pre-tax profits leapt by 50 per cent. The company has also adopted an “if you can’t beat them, join them” approach and taken on a wholesale supply agreement with Amazon to make its goods available via its delivery service. Along with its Ocado (OCDO) contract, this gives Morrisons wider online reach without the capital investment.
Sainsbury’s also deserves a mention in dispatches. Unlike its aforementioned sector peers, it hasn’t thrown the kitchen sink at its business in order to start over. Instead it took first mover advantage by agreeing to take over the Argos brand from Home Retail Group in early 2016 – largely for access to its widespread distribution operation. The placement of Argos booths in Sainsbury’s superstores has been undertaken in a bid to boost footfall and increase wider cross-selling opportunities.
