Shares in focus: Who to back in the supermarket wars

Beware – they’re all cheap for a reason, says Phil Oakley.

Supermarket group Morrisons is in big trouble, but it only really has itself to blame. Customers who were flocking to its stores five years ago to buy good-quality fresh food and pick up a few bargains along the way have decided to go elsewhere.

Morrisons has been too late to recognise that people are using different ways to buy their groceries, such as over the internet and in local convenience stores. It has also alienated its customers by trying to go upmarket – in essence chasing customers who were unlikely to come to Morrisons anyway.

According to Morrisons’ chief executive, Dalton Philips, there’s an even bigger problem: cheap discount supermarkets Aldi and Lidl are eating its lunch. Last week, Philips hit the panic button and announced that Morrisons would slash prices to take them on. Profits in 2014 would probably halve as a result.

Unsurprisingly, the stock market didn’t like the sound of this. Investors started to worry about the prospect of a supermarket price war and the damage it could do to profits. The share prices of Morrisons, Sainsbury’s and Tesco tanked.

Is this an overreaction that has created a buying opportunity? Or is the world of food retailing going to be transformed forever, with lower returns to be expected from now on?

How’s business?

According to Philips, the competitive landscape has changed. Aldi and Lidl have to be taken on. It’s not difficult to see why he is saying this. Aldi in particular is doing a lot of damage. Its sales have grown by a third over the last year, which has seen it win plenty of new customers. Lidl has also been making gains.

Both have been able to win over a lot of cash-strapped customers with low prices. They have been able to do this by having cheaper, smaller stores and a much narrower product range to concentrate their buying power.

At the top end of the market, Waitrose has been wooing an increasing number of customers due to what’s perceived to be its higher-quality food. According to Kantar Wordpanel, a market-research firm, these three companies have grabbed an extra 3.5% of the UK grocery market (see table) over the last three years – equivalent to £4.4bn of sales.

Although the value of the market has been growing, because the price of food has been going up, the big losers have been Tesco and Morrisons. Sainsbury’s has been holding its own.

But is Philips right when he says that the market is changing forever? It might have changed for Morrisons more than for some of its competitors. Given that the bulk of Morrisons’ stores are still in the north of England, where customers tend not to be as well off as those in the south, it has been more exposed to the rise of Aldi and Lidl.

And just how big can the two discounters become? At the moment they have 7.5% of the market. No one is currently predicting that they will end up having 15% or 20% in a few years’ time.

Who will they take customers from? It’s difficult to see Waitrose and Marks & Spencer customers changing supermarkets. Sainsbury’s seems to be keeping its customers happy with its products and price match promises and has lots of stores in the more affluent south.

Both Tesco and Wal-Mart-owned Asda have immense buying power and could – and might – compete on price if they need to. The Co-op remains an easy target, although its many local convenience stores are an advantage.

That leaves Morrisons. It doesn’t have the buying power of its three big competitors, but does make a lot of its own food. It needs to get back to making this a key point of difference. The danger is cutting prices won’t bring the customers back and profits will remain lower permanently.

How the big players compare

Market share March 2014 A year ago
Tesco 28.7% 29.6%
Asda 17.5% 17.8%
Sainsbury 17% 17%
Morrisons 11.1% 11.8%
Co-op 6.1% 6.2%
Waitrose 5% 4.9%
Aldi 4.3% 3.3%
Lidl 3.2% 2.8%

 

Source: Kantar Worldpanel

Are supermarket shares cheap?

After last week’s share-price bloodbath, you could be forgiven for thinking that some supermarket shares might have fallen to bargain levels. After all, the stock market often gets too preoccupied with short-term profits and forgets about the long term.

The shares are now offering pretty chunky dividend yields, while Morrisons and Sainsbury’s are even trading below their respective net asset values (a price-to-book-value, or P/BV, of less than one – see table below).

Company Share price (p) P/e Dividend Yield P/BV Dividend cover ROE
Morrisons 208 11.82 6.56% 0.90 1.29 7.64%
Sainsbury’s 314.5 9.65 5.66% 0.95 1.83 9.90%
Tesco 301.39 10.46 4.91% 1.29 1.95 12.31%

 

Let’s take the dividend issue first. Morrisons is trying to keep shareholders happy by promising to increase dividends. Yet, based on its forecast profits (earnings per share of 17.6p), the ability to pay that dividend is becoming more stretched – as shown by its low dividend cover.

Morrisons is also looking to get its dividend cover back to two times. With an expected dividend payout of 13.65p per share, this implies earnings per share of 27.3p, or 55% more than it is expected to make this year. At best, Morrisons’ dividend looks like it won’t grow much.

A more likely scenario is that it will be cut. The big yield could be a trap. Sainsbury’s and Tesco’s dividends look more secure, but probably won’t grow much.

Moving on to asset values, much has been made of the value of the supermarkets’ property portfolios. Not so long ago, analysts used to speculate about how a huge amount of value could be realised by supermakets splitting themselves into real-estate investment trusts (Reits), which could then lease the stores back to the supermarket chain.

The logic was that the rental income of the Reit would be valued more highly and that this would make both businesses worth more separately than than they would be worth together.

Any property firm would probably have to be financed with lots of debt, which might be hard to come by. Rising interest rates could cause problems and would also lower the value of the property. You also have to consider the ability of the tenant to pay the rent. For a firm such as Morrisons, whose profits are falling, this could become a major problem.

So are any of them a buy?

Just a few weeks ago, I tipped Morrisons’ shares as a possible property play. The trouble with this approach is that these properties only have value as supermarkets. They are not about to be turned into residential housing sites. The value is therefore determined by the profits that they make.

Low or modest returns on shareholders’ equity (ROE) suggests that at the moment there isn’t a lot of extra value on offer in the sector. In fact, Morrisons has written down the value of its properties and may be forced to do so again.

In general, supermarkets look to be horrible investments right now and deserve to be cheap.

Verdict: avoid

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