Why Invest in Supermarket Stocks?

Supermarket stocks have taken a bashing over the past year thanks to the expenses scandal at Tesco and the rise of budget food retail usurpers. Is there any value to be had?

Ken Perkins 8 April, 2015 | 10:04AM
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Tesco

We think Tesco's scale allows the firm to operate more efficiently than many competitors, and its convenient locations and loyalty program should continue to drive traffic. However, we don't have enough confidence in Tesco's ability to sustain excess returns over the long term to assign the firm an economic moat. Switching costs are non-existent in grocery retail, and competing on price while sustaining excess returns is a tough proposition. Moaty defensive retailers tend to have clear cost advantages, and because Tesco's competitors have sufficient scale to remain competitive on price while touting points of differentiation many of which could be replicated over a decade, we don't think Tesco has a material leg up on its peers.

Tesco is the largest food retailer in the U.K., where it also sells petrol and higher-margin general merchandise in multiple channels, including large-store formats, online, and convenience stores.

Tesco also operates more than 3,500 stores in Europe and Asia which make up 30% of sales and profits. We think the firm remains well positioned in Korea, Malaysia, and Thailand, but results in other regions have been more challenging. The company recently decided to exit the U.S., where its Fresh & Easy concept failed to gain enough traction to support adequate returns on invested capital. It also exited Japan in 2011, as deflationary pressures, cost-conscious consumers, and fierce competition weighed on profitability. China and India remain areas of opportunity, but achieving results comparable to those in the U.K. will be no small feat given regional market dynamics.

Sainsbury

Sainsbury was the leading U.K. grocer until the mid-1990s, but Tesco and Asda - owned by Wal-Mart, garnered scale by building out store concepts and better articulating value propositions, and both of these firms now lead the market ahead of Sainsbury. We still think Sainsbury has enough scale to remain reasonably competitive on price, but we don't believe it possesses a cost advantage relative to other market leaders.

Moreover, switching costs are virtually non-existent in the grocery industry, and it's not clear that Sainsbury's points of differentiation are strong enough to ensure that excess returns on capital can be sustained over the long term. Because of these factors, we do not assign Sainsbury an economic moat.

Our fair value estimate for Sainsbury is £2.95 per share, which implies a forward price/earnings of 11 times, enterprise value/EBITDA of 5 times, and a free cash flow yield of 5%. We expect Sainsbury to increase its total square footage by a low- to mid-single-digit percentage annually over the next 10 years, with a majority of the growth driven by convenience store expansion.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Sainsbury (J) PLC265.20 GBX-1.04Rating
Tesco PLC318.30 GBX1.37Rating

About Author

Ken Perkins  is a Morningstar equity analyst covering consumer packaged goods firms.

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