Change has come to feel like a constant in the UK supermarket sector, creating new opportunities for expert investors.
Supermarkets in the UK have had plenty on their plate in recent years, and now, it seems, they need to worry about consumers tightening their belts too. In May this year, a leading gauge of UK retail sales recorded the sharpest annual dip in its 23-year history.1 The governor of the Bank of England said real household incomes are £900 a year lower per household than forecast prior to the Brexit referendum.2
Against this backdrop, news of mergers and acquisitions perhaps comes as no surprise. Last month Sainsbury’s, the UK’s second-largest supermarket chain by market share, announced that it will (subject to regulator approval) take over Asda, its third-largest, helping to cement its hold on the middle ground.
“Politely, it is a case of two hill walkers sharing a compass in order to navigate the radical changes in the retail market,” says Adrian Frost of Artemis Investment Management. “Expect to see more of this type of union.”
Since the announcement, Sainsbury’s has said that it will cut prices, prompting Lidl and Aldi, the two largest budget supermarket chains, to pledge to maintain the lowest prices on the market. Does the Sainsbury-Asda tie-up pose a threat to Tesco?
“Not necessarily, as Tesco has by far the largest market share – more than 25%,” says Nick Purves of RWC Partners. “So the new tie-up won’t really have more buying clout than Tesco.”
Inevitably, the rise of the discounters has also gained investor attention in recent years, as Aldi and Lidl made significant inroads into what was already a crowded market. Yet that trend may have partly played out already, judging by recent results. Chris Field of Majedie Asset Management, co-manager of the UK Growth and UK& General Progressive funds, points out that new store applications from the two discounters have dropped significantly."
“Tesco is also working far better with its suppliers than it used to,” says Field. “It used to set very tight criteria for its suppliers, allowing competitors to access anything that fell short of those criteria at a much lower price. Now, however, it’s cutting off the discounters’ ready source of cheaper goods. Operationally, Tesco has changed dramatically to match Aldi and Lidl’s 3,000-product businesses.”
Behind the changing outlook for Tesco lies a significant shift in focus under Dave Lewis, who has been CEO since September 2014. This shift has seen the supermarket chain turn away from some of its more tangential projects in order to boost its central offering.
“Having let its prices drift too high, principally compared to Asda’s, Tesco has become competitive again,” says RWC’s Nick Purves. “As a result, it has cut its profit margins quite dramatically, but it is reaping the benefits. As the company starts to grow a sales line again, we’re hopeful that margins can recover.”
The company has also been dispensing with some recent ventures. Notable among these is Tesco Direct, the non-food online shop it launched in 2006. In some ways, this might seem surprising, given the rise of online shopping. But when Tesco announced the closure just last month, the company said it was struggling to see how the venture could turn a profit; Argos and Amazon have proven to be more adept at selling TVs and sofas online.
“The company was trying to do too many things in too many different geographies – Tesco Direct was just one example,” says Purves. “What has worked under Lewis has been focusing on core competencies and pulling out where it is uncompetitive. Shutting down Tesco Direct won’t make a massive difference to profitability, but it’s another sign the company is moving in the right direction.”
Moreover, even in the current environment, there are some retail trends that may actually benefit the supermarket giant. Among them is the gradual consumer shift away from long-established, pricier brands towards accepting supermarkets’ own brands. Only this month, Tesco announced that it would be removing thousands of brands from its shelves. It will also relaunch 10,000 Tesco-branded products.3
“It’s part of the broader simplification process,” says Purves. “Reducing complexity has economic benefits and increases Tesco’s buying clout with the brands that are left.”
Artemis Investment Management, Majedie Asset Management and RWC Partners are fund managers for St. James’s Place.
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