Paul Hill, one of Britain’s most successful private investors, picks the best – and worst – tips from the press and brokers’ reports
This week my top recommendations come from the cut-throat £120bn UK grocery market. Three of the leading protagonists – Tesco, Sainsbury and Morrisons – are FTSE 100 companies and were all featured heavily by analysts and the press last week. When it comes to supermarket shopping, price plays an important part in customers’ decisions, and it should for investors as well. With that in mind, which supermarket stocks are worth holding on to, and which are simply too expensive?
What are their respective growth rates and (three month rolling) market shares? Clearly this is important because, in an industry where many of the products are homogeneous (bread, butter, detergents, etc), price plays an important part in shoppers’ buying decisions. The bigger the grocer, the greater the purchasing power with suppliers, the more that can be invested in price discounting. Tesco, by far the largest player, is consistently found to be the cheapest over a basket of items.
Size matters. The biggest operators possess the greatest economies of scale and generate the highest profit levels. UBS are forecasting operating margins in 2006 for Tesco, Sainsbury and Morrisons of 5.8%, 2.4% and 2.5% respectively.
Clearly, Sainsbury and Morrisons are playing catch-up to the all-conquering Tesco. Are there any other key factors which we should consider? With a stable population and tight planning restrictions on building new stores, growth across much of this tough industry is pedestrian, particularly within the more mature aisles of food and drink. Here success is driven by price, range, quality and service. However, the sub-categories of non-food, convenience store and online sales offer more attractive returns – and again Tesco has been first off the blocks in exploiting these trends. It is the UK’s number one online retailer, with sales of £1bn, and has recently widened its internet service to include 8,000 non-food items under the Tesco Direct brand.
Other factors shaping the sector include the extension of store opening hours, improved performance due to the World Cup and more ‘data mining’ via loyalty card schemes. At the premium end of the market, Marks & Spencer and Waitrose have each benefited from consumers trading up to better quality food, on the back of healthier eating habits, as well as the desire for organic and fresh produce.
Finally, in relation to investor sentiment, the defensive qualities of the industry have come back into fashion. Valuations have risen as fund managers have bid up the price of these stocks, which are perceived to be less risky.
Tip No. 1: Sainsbury (SBRY, 379p), tipped as a SELL by Panmure Gordon
Under Justin King (CEO), Sainsbury has successfully managed to reverse its past revenue declines, and delivered like-for-like sales growth since the start of 2005. The signing of Jamie Oliver to promote its “Try Something New” campaign has been a masterstroke. The company has also improved in-store availability and slashed prices in order to regain customer trust and stabilise market share. Volumes have soared, but grocery prices have fallen – and so have profit margins.
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Stage one of the recovery plan is nevertheless complete. But the harder job of restoring profitability will be much more challenging. With intense competition and higher energy costs, this will be an uphill task. The City is forecasting operating margins of around 3.5% for the year to end March 2009 – equivalent to an earnings per share of around 22.5p. At 379p, the shares trade on a 2009 p/e multiple of 16.9 – far too rich for a number three player in such a competitive sector.
Fortunately, the balance sheet is strong, with UBS estimating that Sainsbury’s property portfolio is worth some £6.2bn – which after subtracting net debt of £1.4bn and a pension deficit of £100m, would give an underlying valuation of 280p per share. Even though this, together with ongoing takeover speculation, should provide support, I would still recommend investors take profits as the stock is simply too expensive.
Recommendation: SELL at 379p
Tip No. 2: Tesco (TSCO, 367p), tipped as a HOLD by Deutsche Bank
Unlike Sainsbury, Tesco is one of the best UK success stories over the past ten years. It has consistently outperformed its rivals, having transformed itself in the 1980s from being a cheap-and-cheerful food retailer into a world-class supermarket juggernaut. It leads the sector across most measures – market share, non-food, online and convenience store sales, and its impressive loyalty card operation and overseas expansion. Tesco is such a first rate business, that even Wal-Mart, through its Asda chain, has found it difficult to compete against this nimble, yet ferocious giant.
But what are the risks? The main concern is that management could take its eye off the ball while launching its US division. As painfully discovered by its competitors – M&S and Sainsbury – the discerning American consumer has proved a graveyard for many a UK company. Tesco would be hit by any consumer downturn, although its strong credentials as a discounter could mean that it wins market share as people tighten their belts.
At 370p the shares are not cheap, since they trade on a current year p/e ratio of around 17. Nonetheless, with its excellent track record together with the prospect of returning £5bn from its property portfolio, I would rate the shares as a hold and advise taking profits if they hit 400p over the next three months.
Recommendation: HOLD at 367p
Tip No. 3: Morrisons (MRW, 248p), tipped as a BUY by ABN Amro
In March 2004, Morrisons acquired Safeway for £3.4bn and became the fourth largest UK grocer. Integrating these two businesses proved much harder than expected, and performance suffered, leading to profit warnings and boardroom resignations – but there is light at the end of the tunnel.
At last week’s interim results, first-half like-for-like sales (ex-petrol) rose 6%, while gross margins increased by 1%, driven by reduced wastage and improved procurement. Although good news, Morrisons – like Sainsbury – is not yet fixed. Delivering profit margins that will justify the current share price of 245p will be extremely challenging.
The City is forecasting earnings per share of around 15p for the year ending January 2009, representing a forward p/e ratio of over 16. Again, this is simply too rich for a number four player in such a competitive sector – even with the possibility of future corporate activity. UBS estimates that its property portfolio is worth some £6.7bn, which, after allowing for debt, generates a fair value of around 190p per share. This should provide some support, but again I would suggest shareholders lock in some gains.
Recommendation: SELL at 248p
See also: Gamble of the week, in which Paul Hill suggests a share for the brave.