There are signs of a growing shift in the UK retail sector away from the supermarket giants toward discount retailers. But how can investors access this growing area of the market? And does the rise and rise of discount really mean the end for supermarket stocks?
2014 has been a tough year for all three major players in the UK – none more so than for Tesco, whose most recent profit warning quickly escalated into an accounting scandal after the supermarket admitted pre-tax profits had been overestimated by £250m.
Sainsbury’s has also seen a fall in sales for the third quarter in a row, while profits at Morrisons dropped 51 per cent in the first half of 2014.
Shares in the three supermarkets have suffered as a consequence, with Tesco currently down 42.6 per cent year to date followed by Sainsbury’s, which has fallen 35.4 per cent. Morrisons is down by 33.9 per cent compared with -1.64 per cent for the wider FTSE All Share index.
So what has been driving the recent downturn in supermarket stocks? A number of investment experts point to signs of a shift in the UK retail sector away from big names in favour of the discount retailers.
Thomas Miller Investment head of UK private investment management Andrew Herberts says the major UK supermarkets are losing market share to discount stores as well as to “high-end” retailers in the sector.
He says: “The large, traditional supermarkets face competition from both sides of the spectrum and appear to be losing share to the ‘high-end’ players and the discounters.
“Over the last decade supermarkets have been squeezing suppliers on behalf of the consumers that now appear to have turned away from them.”
Ardevora partner Jeremy Lang has been negative on established supermarket chains for some time now while he expects the discount store model to “flourish” going forwards.
“If you look where the growth is coming from, it is not in the big stores – it is from convenience stores, discount shops or online outlets,” he says.
Despite the growth available in discount supermarkets, it is not yet possible to fully tap into the opportunity in this area of the market as the two major names in the space, Aldi and Lidl, are not currently quoted.
However, manager of the £4.2bn Axa Framlington UK Select Opportunities Nigel Thomas has looked outside the supermarket space to buy into other discount retailers as an alternative way of playing the discount theme.
He says: “There has been a change in how the retail world is operating. You cannot buy Aldi and Lidl shares as a UK investor and yet discount is a part of the market that is obviously growing.
“B&M and Poundland are two very different discount businesses that we have recently bought through the IPO market.”
Discount store Poundland came to market in March of this year valued at £375m. Poundland has so far returned -3.24 per cent since its stock market debut but this still marks a significant outperformance above the sector average of -38.52 per cent for the FTSE food and drug retailer index.
B&M also raised a massive £2.7bn when it floated this year, putting the stock just outside the FTSE 100. Data from FE Analytics shows B&M has returned -9.65 per cent since its IPO in June.
Thomas acknowledges the valuation of B&M was “fairly” highly priced at 27x earnings but argues that the growth potential on offer makes the stock attractive.
He adds: “B&M has got already 350 stores in the UK – the target is to go to 700 – and it does not advertise. When it tried to advertise once, the store got overrun. It is also rolling out a similar model in Germany, with subsidiary JA Woll, competing with the hard discounters there.
“The B&M IPO was fairly highly priced at 27x earnings but the company is growing at 20 per cent per annum and it has some interesting characteristics.”
However, valuations and concerns of overcrowding in the sector have seen some fund managers avoid the discount retailers altogether.
The £1.4bn Old Mutual UK Mid Cap fund manager Richard Watts did not participate in either the B&M or Poundland IPOs due to high valuations.
Focusing on Poundland, Watts warns the stock’s valuation could be at risk from challenges to profitability in individual stores.
He says: “We are concerned about the amount of capacity being added to the space by a number of 99p retailers. This has potentially negative implications for store-based profitability in the future. While there are no signs of this yet, the valuation multiple leaves no room for error.”
By contrast, B&M has a “very rob-ust” business model with the decision not to invest in the IPO based purely on valuation, adds Watts.
But supermarket stocks should not be counted out entirely either, even against this trend toward discount retailers, says Herberts, although shares could decline further in the near term.
He says: “In the end, the big supermarkets aren’t going away and they will adapt to the new environment. Margins may well be structurally lower, but the major grocers provide a service that consumers are unlikely to be willing to lose.”
Thomas believes a change in “pricing architecture” will be necessary for the supermarket giants to catch up with their discount counterparts, something that has already begun to take root among the major names, with Morrisons the first of the big three stores to make changes to its pricing.
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