Andrew Miller: Food for thought - retail sector difficulties in plain view

The difficulties being experienced by the listed-UK food retail sector were in plain view as Morrisons issued a huge profit warning that sent share prices in the sector tumbling

Andrew Miller
Andrew Miller

The difficulties being experienced by the listed-UK food retail sector were in plain view as Morrisons issued a huge profit warning that sent share prices in the sector tumbling.

Slowing market growth, increased competition and the shift online have helped push the sector out of favour for investors, but this could present an opportunity for more long-term positions to be established.

Industry sales growth has slowed sharply compared to a decade ago. Before the crisis, a strong economy, rising incomes, non-food expansion and a more fragmented market all helped to support growth.

Post-crisis, disposable incomes have been under pressure (reducing impulse purchases), the shift to private labels has hit top-line growth, and non-food sales are being lost online. The largest concern, however, is the growth of the discounters, namely Aldi and Lidl, which are now more than just a threat: together, their market share has gone from 4% to 6% in the past three years and both are consistently growing at a 20%+ clip.

Interestingly, they both entered the UK market in the early 1990s, but consumer suspicion and entry-level private label ranges from the incumbents helped to stifle the threat.

The financial crisis and improvements to business models have boosted their growth in recent years, leaving little left to be fought over by the larger players. With the discounters’ shares of the UK market still far lower than that of many European markets, they are – with the support of their store expansion programs – likely to continue to gain share in the coming years.

On top of that, the food retailers have had to deal with the shift to online shopping, both in food and non-food.

The profitability of online groceries is uncertain at this stage, while existing players are losing a slice of the pie to new entrants such as Ocado. In non-food, previous growth areas such as consumer electronics are now proving to be a headwind due to the emergence of online competition.

We have no strong counter-arguments to any of the bear points on the overall sector and it is difficult to build a compelling investment case. However, that does not mean that there aren’t individual companies within the sector that could prove to be a good investment. As we point out on a regular basis, equity markets are driven by how expectations measure up to reality. Top-line sales growth is unlikely to return to pre-crisis levels, but it doesn’t need to: signs of stabilisation would likely be all that is required, considering the valuation discount the shares are trading on.

Tesco has recently announced a significant reduction in capital expenditure, and Morrisons announced a further reduction in its spending. Clearly this will help free cash flow, potentially allowing for targeted investment in pricing, and should help to counter the view that cash flows are not covering dividend payments.

There is also the potential to extract greater value from property assets in the form of commercial partnerships, such as Tesco’s tie-up with restaurant chain Giraffe, and financial services.

While a recovering UK economy is unlikely to reverse the share gains achieved by the discounters post-crisis, we believe it can prove positive for the food retail sector in general. We see the food retailers as an inexpensive way to gain exposure to a stronger employment picture and rising disposable incomes.

Understandably, none of these options are being factored into share prices, and it could be argued that an all-out price war is now widely expected by the market.

The problems for the listed-UK food retail sector will not be solved overnight, but the long-term investment case is largely centred on the view that much of the bad news is now in the price.

:: Andrew Miller, Barclays Wealth and Investment Management, Newcastle

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