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supermarket aisle

Sell-by date?

15 October 2014

There is trouble in the aisles for UK supermarkets, but investors continue to see long-term opportunities for market leader, Tesco.

The supermarket has long been a fixture on the high streets and ring roads of the UK’s towns and cities. Reaching all aspects of the lives of British consumers, it is not surprising that Britain’s big grocery chains are a staple of many a fund manager’s investment portfolio. But there does seem to be more than a one-off spillage in the aisles of Tesco, Morrisons, Sainsbury’s and Asda. A well-documented fight is afoot among the UK’s supermarkets. And the encroachment of European discounters – namely Aldi and Lidl – has started to raise questions about whether the empires that supermarkets have carved out of consumers’ habits might even be in decline or falling.

Shoppers no longer frequent, or identify themselves with, any one store.

The promise of lower prices at the two discount chains from Germany has continued to erode sales figures for the ‘big four’. The supermarkets are now locked into costly skirmishes with each other to arrest falling sales, with senior management forced to use profits and cut margins to quell the threat from the German discounters. In response, the big four have even reverted to an old ally to lure customers back – loyalty cards. Meanwhile, shoppers’ habits have shifted – alongside the demise of the weekly shop and the rise of the internet – with Deloitte research identifying that shoppers no longer frequent, or identify themselves with, any one store.

But these actions come amid a series of high-profile blows for the sector. In recent weeks the pain has continued, with Sainsbury’s revealing a quarterly sales slump, while the Financial Conduct Authority launched an investigation into Tesco’s £250 million accounting black hole. At the start of October, each of the large supermarkets suffered their worse week on the stock market for more than a decade, with Tesco’s shares down by 10.5%, Morrisons 7.9% and Sainsbury’s 9.2%. Even US investor Warren Buffett described his investment in Tesco as a “huge mistake”.

Autumn fall?

Amid these setbacks as autumn sets in, it is easy to overlook the fact that Tesco, despite losing its allure in recent months, has remained a firm favourite among British investors. Unfortunately for Britain’s largest supermarket chain, the announcement that it had overstated first-half earnings came within a month of a 75% cut in its interim dividend. The error means the UK group is likely to see trading profits nearly halved from the comparable period last year. In the meantime, four senior executives have been suspended; its lawyers Freshfields with accountants Deloitte have launched an investigation; interim results have been postponed; and Tesco’s senior management could face a parliamentary committee grilling.

But trouble has been in store for a while now at the UK’s largest supermarket retailer. Amid a series of profit warnings, Tesco’s former finance director, Laurie McIlwee resigned in April (and his replacement Alan Stewart was drafted in two months early at the end September). Industry analysts Kantar Worldpanel report that sales over the three months to mid-September were down 4.5%, leaving Tesco’s market share at 28.8% compared with 30.2% a year ago, with its customers spending £332 million less than a year earlier. Rating agencies Standard & Poor’s, Fitch and Moody’s have all placed Tesco on negative watch. Shares in the beleaguered supermarket have almost halved over the past 12 months, losing 12% or £1.5 billion on the day of the announcement of its accounting error.

Understandably, shareholders are puzzled as to how a company the size of Tesco has arrived in this predicament. There is concern as to why management did not act more swiftly when reports first emerged this summer of an accounting overstatement. There have been calls for a wider parliamentary inquiry into the grocery industry and its relationship with suppliers. In the meantime, shareholders, rightly, will want to know if the group’s accounting misstatement is a short-term error or part of a long-running problem. Without doubt, Sir Richard Broadbent, Tesco’s chairman, and the new chief executive, Dave Lewis, face a challenging end to 2014.

However, the pressure on Tesco’s bottom line has been well documented. It is well known that negotiations between Tesco and its suppliers have become more fraught, and the company’s much-criticised ability to drive supplier costs down has come under pressure too. Certainly, the recent setbacks seem a long way from the era of former chief executive Sir Terry Leahy, who left the business in 2010 with a seemingly robust business model. Subsequently, Tesco, like the other big three supermarkets – Asda, Morrisons and Sainsbury’s – defended its profits during the downturn by pushing up prices, and this allowed Aldi and Lidl to undercut their rivals and launch a price war.

However, there is confidence that the scale of the 3,400-store business can keep it on course in the medium to long term, despite its short-term travails. Fund managers Artemis, Artisan and Magellan, all managers of funds for St. James’s Place, have acknowledged that Tesco’s struggle is one of the main UK corporate developments over the summer, with the cut in its dividend and profit warnings taking the shine off this once-favoured company. Majedie Asset Management, which is a long-term holder of Tesco’s shares, readily concedes that Tesco has been a portfolio laggard of late, but has confidence in the new management’s ability to refocus the business.

The underlying business is well-positioned and has a sensible-looking new management team.”

James de Uphaugh, chairman and chief investment officer of Majedie, says he retains his overall view on Tesco, despite trimming his holding after its July profit warning to 2% of his portfolio. “It is a cheap share, pricing in a lot of bad news, with an underlying business that is well-positioned, and a sensible-looking new management team,” explains de Uphaugh. “If we assume that it can sell its operations in Korea and Thailand at a 20% discount to local competitor valuations, then the UK business is currently trading on a valuation that implies long-term margins below 3% – this looks too low to us for a business with Tesco’s scale.”

Back to basics

The traumas of the last three years have forced Tesco to take a cold, hard look at itself. “The focus is now on building a solid, sustainable business with better capital discipline and a clearer focus on shareholder value, rather than just pumping the assets to fund an empire,” adds de Uphaugh. Daniel O’Keefe of fund manager Artisan, which has owned Tesco since 2013, believes the group is well- placed, despite the failure so far to put the business on a solid footing. “We continue to believe that Tesco’s scale and reach provide it enormous advantages that should serve as the foundation for a meaningful improvement in performance,” says O’Keefe. “Tesco is one of the few securities in the portfolio where pessimism is clearly implied in the valuation.”

Certainly, the competition is intense, but the scale of Tesco and its rivals means that, despite the setbacks, it should remain a major feature of the high street, out-of-town roundabouts and investor portfolios. As fund manager Richard Oldfield observes: “People will always buy food, and most of the food that they buy will be in supermarkets, and most of the supermarkets that they buy from will be those which are nearest to them.” In this environment, being a leader remains a big strength. “We expect, therefore, some ugly quarters in profitability, but ultimately re-emergence,” concludes Oldfield.

The opinions expressed are those of Majedie Asset Management, Artisan Partners and Oldfield Partners and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views are not necessarily shared by other investment managers or St. James’s Place Wealth Management.

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