Supermarkets (TSCO, SBRY, MRW)

Some figures

I like the supermarkets. I like the supermarkets because they’re the best example I can think of of capitalism in action. They’re relentlessly profit driven machines in constant competition; they expand everywhere there are consumers and they compete for said consumers on, more than any other sector I can think of, price. They represent, to me, the ultimate embodiment of the ‘vote with your money’ mentality. Anyway, before I get all misty eyed and reverential (as an economist (of sorts) you don’t tend to find many industries which act anything like the textbooks say they should), I just wanted to share a couple of stats I put together. The supermarkets are all trading at quite depressed prices historically at the moment, and my gut feeling was that they were undervalued. Here are a few figures, then:

Headline metrics

Unsurprisingly, the supermarkets all trade at fairly similar multiples of their earnings. They tend to be fairly correlated in share price movements; while there is always an outperformer in the sector, it’s still a group of companies which are fairly exposed to the macroeconomic environment. We talk about company performance being correlated to ‘consumer spending’, but when so much of consumer spending is made up by these 3 companies and their Walmartian sister, ASDA – about 25%, at a guess – correlation gains significantly more meaning. Here’s the share price of the 3 companies over the last year:

The real divergence, of course, coming in the last few weeks. Probably the best metric to look at when comparing across the three is like-for-like sales, excluding petrol; Tesco are down 2.4% on this metric, Morrisons down 5.6% (!), and Sainsbury’s up a rather creditable 0.2%. The impact of that is fairly obvious from the graph, though note that the colours might be slightly confusing (Tesco isn’t blue – blame Google Finance!).

Valuation

While they trade at similar multiples on an earnings front, the difference is fairly obvious on an assets one:

Tesco trades at a premium to both other supermarkets in assets terms – and it’s quite substantial, too. When we see a similar earnings valuation but diverging asset valuations, it tells us one clear thing about the companies in question – returns on equity aren’t uniform. There are three factors to returns on equity, and they’re captured in the DuPont equation;

Return on Equity = Profit margins * Asset turnover * Leverage

We’ll broadly focus on the first two headings then, in spirit (I adjust several things). Here are operating margins over the last 8 years:

Tesco, by virtue of their size, earn better operating margins than either other company. I should note that the Tesco figures are for all their operations worldwide, but UK margins specifically aren’t very different from this – they do contribute the vast majority of group revenues and profits, after all. Either way; this isn’t a very surprising result. Scale brings efficiency advantages, and Tesco’s UK operations are very roughly about 3 times bigger than Morrisons and about 2 times bigger than Sainsbury’s. What’s crucial from both the consumer and investor point of view is that they manage to do this while keeping prices lower than their competitors; here’s the Grocer 33 index, a survey conducted for the Grocer which tracks how expensive a given basket of goods (which changes every week, preventing gaming) costs at each of the 5 major supermarkets:

Data taken is freely available going further back than I charted from: http://www.thegrocer.co.uk/grocer-33/ (obviously, the data is all theirs. I just charted it.)

The chart is indexed so that Asda’s prices for the week = 0. This is a fairly intuitive way of doing it, since Asda are nearly always the cheapest supermarket – bar one week at the end, where you see Tesco slightly beats them. This is a winning proposition, though; Tesco charge the least and make the most. Such is the power of scale. They’re also ahead of all the other supermarkets on the convenience front, which is the fastest growing segment..

We’ve done one half of the return on capital mix, then – margins – which measure how much profit you make from every pound of sales. The other half finishes the circle. How many pounds of revenue can you make from your assets? Clearly, it’s no good being able to earn 100% margins if you have to buy a showroom worth £2m and you only sell a few items each year; your returns on capital will be terrible. Calculating an asset turnover gets a bit more complicated here because of the lease setups used by the supermarkets. Capitalising operating leases is important if you want to compare across supermarkets. Take the thought experiment – if I buy a megastore worth £10m, and make £1m, I have a return on capital of 10%. If I lease the same megastore, I no longer have the asset on the balance sheet, and my return on capital is hugely inflated.

The tricky bit is deciding how to value the rental portfolio of the businesses. In this case, I’ve used a multiple of 12.5x last year’s rental expense. This would likely be a big point of contention if you were to ask the supermarkets, though; Morrisons capitalise theirs at 20 (!) times, though they probably have a vested interest in being super-conservative, since they rent very few properties comparatively.  Either way, take the following with a pinch of salt, then – changing how you capitalise will change the volume of difference, though you’d have to make a very substantial increase in multiple to change the broad conclusions.

I’m not 100% sure, but I’d attribute much of the fall in asset turnover for Tesco to the rise of convenience stores – which, as a model, strike me as being higher-margin and lower turnover. It might also have something to do with their dalliances in international (US/Japan) operations recently; that’d need more research, and I’m trying to be a generalist here. Either way, when you put the two factors together – asset turnover and operating margins – you get returns on capital. See below:

Sainsbury’s has earned consistently lower returns on capital than their peers. Morrisons is the most surprising to me – a company formed by the takeover of the struggling Safeway group, moving down from Morrisons’ traditional northern homelands, has gone on to challenge Tesco in terms of returns even though they are significantly smaller. The really interesting thing about the January announcements I mentioned above, though – when the companies talked about their like-for-like sales over Christmas – is how they tie into the returns picture.

Economics says that in perfectly efficient markets, returns will be mean reverting. We might expect Sainsbury’s to start performing better, then, and Morrrions to start performing worse; which is broadly the trend of the last year. I leave aside Tesco a bit, because I think there are genuinely good reasons why Tesco will earn a higher return than its peers – the most obvious of which is its size.

What next for investors?

If I had to think about the supermarkets with two broad themes, then, they’d be this:

Firstly, what will happen to returns for the group’s core over the next few years? If Morrisons’ performance over Christmas is anomalous – the blip in the trendline – the company is clearly better value than Sainsbury’s. They’ve earned significantly stronger returns on capital than Sainsbury’s over the last 8 years, post their modern formation. This fact isn’t even altered by the inclusion of leases on the balance sheet, so you can’t really attribute it to the way I’ve accounted.

Secondly, who will grow the most as a group? Supermarkets acquire capital cheaply because of the way they operate (Tesco’s bank might be the best example of this, frankly), their low risk business model and collateralisation and a decent level of consistency of returns. This makes growth valuable to these companies – anywhere where you can acquire capital at, say 6.5%, and invest it for a return of 8%, you’re on to a winning proposition. Tesco has grown the most over the last 8 years. Will it do so in the next 8? This is a key driver of returns.

You might notice I didn’t spend any of this post talking about the finer sectoral issues. What about the rise of the discounters, Aldi and Lidl, and the trend towards polarisation – Waitrose are doing very well, after all? What about Morrisons’ late entry into the online goods market?  For the most part, I consider the waxings and wanings of the supermarkets not much more than noise. The discounters might well rise; but like my value portfolio which delivered fantastic returns over the last two years, it’s ignorant to extrapolate cycle performance from a few years of data in the perfect environment for exactly the kind of strategy said fund/supermarket is trying to perform. Tesco historically ‘underinvesting’ or having worse stores; Sainsbury’s benefiting from the Olympic links and good advertising campaigns; none of this hugely concerns me.

These sort of things come and go over time. Unless you think the discounters will be able to muscle in and rapidly grow to significant scale – enough to challenge the might of Tesco – they’re just another competitor in a market which is already competitive. It’s not like we have a cushy monopoly about to be dismantled.

Returns and growth are what I care about most. For what it’s worth (very little, I would suggest!), I still think Tesco is where the money should be. They’re in a dominant market position – both nationally and globally – and have the foundations set up to invest wherever returns are strongest. They might be floundering a bit now, but that’s a strategy issue – and when you can deliver stronger returns with higher margins while being cheaper than your competitors, you know you’re in a good spot. It gives you flexibility.

7 Replies to “Supermarkets (TSCO, SBRY, MRW)”

    • Lewis

      Thanks Martin.

      It is pretty tedious – especially with the supermarkets and their ridiculously long annual reports.

      You could just use Stockopedia/Sharelockholmes/various websites, but since I need lots of data anyway, I just take it straight from source. Means I can decide how to interpret ‘exceptionals’ and the like, too.

  1. Andy Arizona

    Apologies in advance for my english. I think even if as you said UK retail is very competitive industry, is one of the last sector where we can still find reasonable valuations in a highly speculative market. I am long on Tesco and Morrison since last week. My humble opinion about Tesco, is the same of Vitaly K (even if he wasn’t very succesful with JCP), leader in UK that is not value as growth stock anymore after disinvesting in USA and Japan, and JV in China, and decided to defend its main market refocusing in cash flow and benefiting from economies of scale. Regarding Morrison is PE x10, dvd yield 4%, FCF £1000M (excluding growth capex) that gives them high flexibility, currently investing in convenience store and internet, and a real estate portfolio of 9bn with 90% freehold, and a hedge fund as possible catalyst. Please let me know your insights.

  2. red.

    So, these neither-here-nor-there supermarkets are earning, say 9% ROC. They can’t earn more than 4.5% margin which means that they have to turn over their assets 2x.

    At the same time, new entrants are (or will be) picking away at customers on the edges: Waitrose, Whole Foods etc; convenience stores, etc; online; hard discounters; and membership clubs like Costco. Let’s say that the combined effect of these entrants in five years time is to take away 15% of traffic from these middle-of-the-roaders and 1/2% from margins:

    Asset turns are now 2 x (1-15%) = 1.7
    Margins are 4%
    So ROC is now 6.8%

    6.8% is embarrassing so the more ROC goes down the more they’ll lever up. The more levered hey are the less likely that they’ll be acquired by private equity or that there’ll be meaningful consolidation.

    What happens then? How do they fight back? How does it not get worse in the next round of competition?

    That’s been the story of middle-of-the-road supermarkets in the US: they’ve had their clocks cleaned. Look at the department stores, also: the structure of the story is the same.

    The somewhat saving grace is that competition among supermarkets is fought catchment area by catchment area, so that there is some theoretical room for local and regional consolidation: a catchment area can sustainably accommodate one middle-of-the-road supermarket chain better than it can accommodate 3 or 4.

    And the saving grace for Tesco is that there appear to be bright prospects in its China JV.

    Anyway, long-winded way of saying that these are the sort of shares that scare me: if I’m going to lose my money, I’d like to it to come with at least a frisson of shock and confusion as to the why and the how!

    • Lewis

      Thanks Red;

      I don’t know much about the history of the US supermarkets or the structural differences in the sector – the one that immediately comes to mind is the geography (scale more valuable in UK?) – so I’m unsure how things will pan out.

      I think there’s a case to be made for supermarkets over here performing better. The hard discounters and membership clubs have been around for donkey’s years. I think much of their success is down to the recession and people feeling squeezed; their structure means they can never compete with the big supermarkets on their own terms with regard to the type of stock they have (hugely variable). Convenience, on the other hand, still represents a massive pinata for supermarkets – customers are conditioned to pay more at smaller indie convenience stores. Tesco are way ahead of the other supermarkets in muscling in on this segment, and I think all the evidence so far shows that the justification in the first place – that consumers like unified brands – seems to have been perfect.

      I also wonder how much the tilt towards the other end will have an effect. Tesco launched an enormous store with concessions, for instance, in the depths of glorious Watford. I recall some talk about them being interested in Mothercare for this reason – they talk about wanting ‘destination’ stores. In a post e-retailing environment, I think one of the few things people will still want to do offline is food shopping (though online is clearly going to continue growing rapidly); and given how poorly most of the high street is doing as a whole, perhaps one of the safest places to guarantee footfall would be at a supermarket.

      I speculate. The move away from big stores and to cheaper convenience by Tesco in the UK will be good from a capital allocation perspective because it allows them to focus on where the money really is; abroad, and not in a horribly competitive, mature market.

      In that horribly competitive, mature market, I can’t help feel like they’re the best positioned to resist the vicissitudes of that competition.

  3. Investing Sidekick

    One thing about Tesco is property development/new stores added a lot to profits the last decade. They recently announced they would stop doing this and thats when I sold the majority of my position in them. I think Tescos profits are going to suffer over the next 5-10 years as a result so they dont look as great value.

    • Lewis

      That’s true; I could’ve stripped property profits out to get a more underlying picture of performance.

      I’m not that fussed. It didn’t make a huge proportion of profits (though was a nice contributor), and I dislike companies having large freehold portfolios. If you believe in a reasonably efficient market the outcome is basically nil except easy to arrange leverage, and if you think their team is particularly shrewd they might have secured rates better than ‘average’.

      Not sure which of those I feel.

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