Food retailers seek to prove their value credentials – to both customers and investors

One way in which “value” investors operate is to look at what has done badly and to see if there is potential for a change in fortunes, which could leave a stock or even a whole sector looking underappreciated, oversold and – ultimately – cheap.

One grouping which remains in the doldrums is the Food & Drug Retailers sector. This is dominated by the FTSE 100 giants Tesco, Morrisons and Sainsbury’s, although it also features Ocado, Greggs, SSP, Crawshaw and McColl’s, as well as wholesaler and Tesco-merger-target Booker.

In the freezer

In the first half of 2017, the sector fell 8.5%. That compared to a 4.0% advance in the FTSE All-Share (capital return only) and left the group languishing in 36th place among the 39 industries that make up the All-Share.

Food & Drug Retailers have left a nasty taste in investors’ mouths so far in 2017

Source: Thomson Reuters Datastream

Only Oil & Gas Producers, Fixed Line Telecoms and Oil Equipment & Services did worse and this dismal showing added to a lengthy period of poor performance both relative to the index and also in absolute terms.

As this next chart shows the sector in absolute terms is trading at levels last plumbed in 2003-04 (before the current malaise, which dates back to 2014).

In relative terms, the picture is even worse, with the sector trading at levels last seen in 1999 when many investors were focused almost exclusively on tech, media and telecoms stocks (to their ultimate detriment when the bubble burst in 2000).

Food & Drug Retailers sector is trading near 14 and 18 year lows in absolute and relative terms

Source: Thomson Reuters Datastream

Ready to de-frost?

Although relative performance will be of little interest to private investors – who can only use real profits and cash to the pay the bills, not outperformance – it is a metric watched closely by professional fund managers, who are usually paid to outperform a benchmark.

And it may be that Food & Drug Retailers could come on to a few radars given that there is a lot going on in the industry right now and not all of it is bad, after the profit warnings, food supply scandals and dividend cuts which have dogged the sector over the last three to four years (to explain its awful showing):

• Morrison, Sainsbury’s and Tesco are all in the middle of wide-ranging restructuring programmes designed to cut costs, improve profit margins and boost cash flow

• Tesco is looking to further rejuvenate its profits and cash flow prospects with a £3.7 billion merger with wholesaler and retailer Booker, while Sainsbury’s is busily integrating Argos, which it acquired in 2016

• Seemingly helped by a little inflation the UK food retail industry is showing its best sales growth in five years, according to industry consultants Kantar Worldpanel. In the 12 weeks to 18 June, revenues rose 5%. The same data shows how Tesco’s sales rose 3.5% for the period, Sainsbury’s by 3.1% and Morrisons by 3.7%.

Past their sell-by date?

The upbeat readings were seemingly confirmed by relative upbeat first-quarter trading updates from both Tesco in June and Sainsbury in early July, on top of similarly encouraging commentary from Morrisons in May.

All three statements showed improved like-for-like sales growth and all three firms need the top line to grow if they are to draw the maximum profit benefit from their cost-cutting and acquisition strategies.

The Big Three are showing improved like-for-like sales momentum

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Source: Company accounts. Based on like-for-like sales excluding VAT and fuel. Tesco based on UK operations only. Sainsbury basis for preparation changed from Q3 2016-17 onwards to reflect Argos deal and change in reporting structure so prior periods not strictly comparable.

Yet the shares are currently refusing to listen, judging by the prior chart.

This may be for four reasons:

• Aldi and Lidl, remain a formidable force. The same Kantar Worldpanel numbers showed that the discounters each grew sales by nearly 19% year-on-year as they gobbled up 1.4% of market share (exactly the sum lost in total by Asda, Morrison, Sainsbury and Tesco) to take their combined total to 11.9%.

• There is a chance that the upbeat sales figures this year have been flattered by unusual factors, such as a 20% jump in the cost of butter, a 14% hike in fish prices and also the hot summer weather.

• There is no guarantee that the Tesco-Booker deal (if approved by the authorities) and the Sainsbury-Argos integration will deliver the targeted benefits, as most merger and acquisition activity undershoots expectations (although the early signs from Sainsbury are encouraging).

• Competition from other areas remains formidable, too. Home delivery services of fresh foods, such as Hello Fresh!, could make their presence felt on top of the challenge posed by Ocado and online shopping and the home delivery services of cooked food, like Just Eat and Deliveroo. Then come Google Express and Amazon Fresh. The former is being trialled in the USA and the latter is already available in London. Even if Amazon Fresh has yet to make the inroads in the US many expected after a decade of operation, it is possible that the $13 billion purchase of Whole Foods means Amazon is about to raise its game in groceries – although Whole Foods relatively limited UK footprint should mean this threat is not an immediate one (and Amazon CEO Jeff Bezos has yet to outline his strategy behind the purchase anyway).

Price must be right

There is a fourth consideration – valuation.

Tesco’s chief executive Dave Lewis has targeted a 3.5% to 4.0% operating margin by 2020, a figure which compares to the 2.3%, 2.4% and 2.6% made by Tesco, Sainsbury and Morrisons in their last financial years.

Even if investors believe this can be achieved – and the Booker deal may help, even if Aldi, Lidl and possible Amazon may not – they still have to consider whether the share price and stock market valuation of the company already take this into account.

This column has therefore crunched the numbers for each of the Big Three – looking at near-term metrics such as price-to-earnings, dividend yield and enterprise value multiples, and then a range of margin scenarios for 2020.

On the near-term metrics, Morrisons looks best on cashflow-based valuations and Sainsbury the most attractive on dividend yield, earnings and asset-based ones; the latter perhaps reflects ongoing scepticism over the Argos deal.

Sainsbury looks to be the cheapest of the Big Three on most near-term metrics

Source: Digital Look, analysts’ consensus forecasts

If all three achieve 4% margin targets in 2020, Sainsbury again comes out cheapest, applying a sensitivity analysis, although all three would not look unduly inexpensive, in absolute terms, relative to their own history or relative to the broader UK market.

Sainsbury looks to be the cheapest if the Big Three can make a 4% profit margin a reality once more

Source: Digital Look, analysts’ consensus forecasts, AJ Bell sensitivity analysis

French connection

But the big word there is “if”.

The experiences of France’s Carrefour offer a potentially cautionary tale here. It has been battling with the discounters for a lot longer than its British grocery counterparts and has been selling assets and cutting costs for a lot longer too.

But its 2016 operating profit margin was just 3.0% - lower than it had been in 2007.

Profit margins at France’s Carrefour are still under the cost

Source: Company accounts.

The burden of proof therefore rests with the UK food retailers to show that they can reach that 4% level – and that their shares are cheap as a result.

Russ Mould
AJ Bell Investment Director