Tesco is Analysts' Favourite Supermarket

Over the past two years supermarket stocks have taken a battering; changing shopping habits, low price threats and accounting scandals - and now Brexit

Emma Wall 25 July, 2016 | 8:00AM
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Emma Wall: Hello and welcome to the Morningstar series ‘Ask the Expert’. I’m Emma Wall and I’m joined today by Morningstar equity analyst, Ken Perkins.

Hi, Ken.

Ken Perkins: Hi, thanks for having me.

Wall: So the last time that we spoke in this studio was a couple of years ago and it was about supermarket stocks, a lot has happened in the interim period. There has been Tesco accounting scandal, there has been a rise of the challenge of supermarket in the U.K. and indeed now we’re facing a much slower growth domestic outlook. So perhaps we could take a supermarket at a time and see how that has affected the outlook. We’ll start perhaps with Tesco (TSCO).

Perkins: Yeah, I mean, I think it's been a very turbulent time for all the companies and Tesco I think has particularly been challenged given that it has more exposure to big-box stores. And so the positive thing that we see out of the U.K. grocery market now is that most of the companies have slashed their margins.

In Tesco’s case they've cut the dividend since we last spoke and so there's a real opportunity for these companies now to start focus on, getting customers back in the door and encouragingly at Tesco for the last several quarters, you’ve seen traffic going up. What’s really weighing on their prospects recently has been the fact that their prices are down so much that it's really weighing on profits.

Wall: And does that mean that they can grow their way out of this and perhaps return to the dividend table?

Perkins: I think that's the ultimate goal and I think they need to, I mean, essentially what happened is their prices were way too high, relative to an Aldi for the value that customers they're getting. But now with the prices much lower and more competitive within Aldi, that's when Tesco's bells and whistles in terms of grocery click and collect and those sort of offerings become more attractive to a customer.

And if they can continue to get people into the door and buying more goods, I think there’s an opportunity for them to really leverage their cost structure and drive the dividend back into place over the long-term.

Wall: So the second supermarket is Sainsbury's (SBRY) that is – Sainsbury's has faced a bit of an image crisis over the last couple of years, because it's not high end, it’s not Marks and Spencer or Waitrose, but equally it’s not really an Aldi or a Lidl or indeed a Tesco, is it?

Perkins: Yeah, and what’s been working well for them is the fact that they haven't been caught maybe in the fray as much on the low end, but at the same time they are struggling to differentiate themselves. And now you see the bid come in for home retail group and that whole issue is really going to create some complexity in their business model.

I think it makes sense for them to move into general merchandise, but the question really is, is how much cannibalization happens with the stores. Right now Sainsbury would expect that there wouldn’t be much cannibalisation, but it's really difficult to tell how customers will actually react to the mixes of those businesses.

Wall: And in the U.K. the standout brand from Home Retail Group is of course Argos. It's a brand that people are familiar with from their childhood, but perhaps not so much of a brand that we were used to seeing on the high street in this day and age. So Sainsbury's things that it can help it move into that click-and-collect sell space that broader access, doesn't it? It can be everything to everyone.

Perkins: Yeah. And that's really what it is, and the other side of it is just consolidating the real estate. So, if you can take Argos' stores, put them in a Sainsbury's store, you save on the real estate cost. So the question is, is how much revenue might they lose from moving the store? Sainsbury's estimates that it wouldn't be much for many of the stores that are between one and three miles of a Sainsbury store, but if it ends up being more than that, then they might lose more on sales, that they gained in rent savings, and so that's really a challenge.

And the other challenge too is the supply chain, because you have different product mixes, so Argos isn't necessarily going to be able to sell the fresh type of offering, the same way Sainsbury's does. They are very different supply chains and so I think that will be a challenge for them about how they offer certain products and not other ones and how that impacts the customer experience.

Wall: Then we come to Morrisons (MRW) the other listed supermarket in the U.K. How has Morrisons fared?

Perkins: I think they have been the most challenged, more in the cross-hairs of Aldi and Lidl, and so I think they have seen some of the same progressions in terms of traffic coming back in or basket size is going in, but it's still way too early for anyone to tell how Morrisons is going to fare. They've made a lot of efforts to somewhat monetize the real estate which used to be off the table under the former founder Ken Morrison, and so they are trying to adjust their business model, but I think for them, they have very few levers to pull to change the model particularly in online, the convenience channel which they are now exiting.

Wall: Of course they were late to the game with online, and now it looks like they are retreating from it quick as well.

Perkins: Yeah exactly. Now Amazon is also teaming up and coming into the situation, so you really have to ask yourself why is that Morrison is teaming with both Ocado and Amazon if it has such a good volume in its manufacturing facilities. I think that's a real concern is that, to keep this business afloat and profitable, they need to start selling to competitors essentially, and that's where we really get worried with Morrisons.

Wall: And then quick pick, what's your favorite U.K. supermarket?

Perkins: Tesco store remains our top pick on valuation. There is clearly lot of risk that we see them facing, but we're encouraged that the traffics going the right way and we think long-term, if they can get these things in the right direction, the dividend can grow and so can the stock price.

Wall: Ken, thank you very much.

Perkins: Thanks for having me.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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
Sainsbury (J) PLC283.60 GBX0.50Rating
Tesco PLC310.90 GBX1.37Rating

About Author

Emma Wall  is former Senior International Editor for Morningstar

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