Hunting for value in UK retailers

11th October 2010

Food retailers have been in heavy focus of late, with Tesco and Sainsbury having revealed their second quarter results, with the former impressing by outpacing its fierce rival during the period, as we reported.

Still, if the UK economy falters badly and household budgets come under pressure, Tesco appears to be better placed to weather the storm, boasting as it does a more global footprint include exposure to fast growing Asia markets.

Tesco is highly regarded by many analysts, not least Sacha Sadan, senior UK equity fund manager, at Gartmore:  "It is a class act, simple as that. Certainly the group's more global reach, especially in emerging markets, is a big positive in the current climate."

But it is not just Tesco Sadan is optimistic about. He believes the UK food sector in general is a "good place to be for investors". The sector is not doing too badly considering previous predictions of gloom and doom for the entire high street.

"Yes, promotions are forming a bigger percentage of sales, certainly the most for more than 10 years, but that will reduce in time."

Food inflation a worry

There are concerns about the impact of food price inflation on shoppers but Sadan believes they are overdone:  "You could argue both ways on that. A little bit of food inflation does actually help the food retailers as it allows them to factor in rising energy costs, wage costs but, of course, too much is not good.

"We are looking at 2%-3% overall which I think is good range, manageable by both consumers and supermarket chains. 

"In any case food pricing has been extremely competitive for many years and while that is not going to change, costs now have to be passed through."

Both Tesco and Sainsbury expressed concern about rising fuel prices eating into household budgets, with the former particularly vexed on the issue, as reported in the Guardian.

Sadan agrees it is worrisome but points out that while Tesco's sales rate has recently been a little weaker than expected, sales of Tesco Finest, its premium range are on the up again.

Similarly, Sainsbury's rebranding of its high end range, Taste the Difference, has gone down well with shoppers. "Food shoppers are back to upselling again having excercised quite a bit of caution during the period when the crisis was evolving, being played out. Demand for the premium ranges is generally good lead indicator."

Look on the bright side

Sadan does not underestimate how challenging conditions still are for consumers and difficulties ahead, especially with government cuts looming. But he believes that disposable income among those people who do have a job is not too bad: "Rates are very low, and generally will stay low for quite some time, though of course they will rise a bit. That should help with mortgage repayments.

"Also people generally tend to put off purchasing the big ticket items like cars during the difficult times. With food specifically, one thing that does suffer is eating out not necessarily the shopping side, so the sector is in a better place than one might think."

In addition to Tesco, Sadan is positive on Morrison, pointing out that there is much more to come yet from integration, rationalisation and via efficiency gains following the problematic takeover of Safeway in2004.   

"The management team there is working very hard on all those issues.  For instance they have 16 balsamic vinegars and that is going to be reduced to eight. Rationalistion, streamlining like that will help create room for other things, say kids' clothes."

While a slip back into recession a major risk factor, the consensus view is that will not happen.

With generally decent profit growth, good yields and strong balance sheets evident amongst the heavy hitters in the sector, the food players could even surprise on the upside with a bit more consumer spending.

Non-food woes

Sadan though in general is less enthusiastic about the non-food retailers. He first points out that while non-food players get huge amount of coverage, in UK equity terms they only comprise 1.6% of the FTSE All Share, compared to 3% for food retailers, and over 10% for the miners.

Their importance for fund managers therefore needs to be put into that context.

Furthermore, the sector is facing a "lot of issues" over the next 18-24 months, says Sadan, not least in terms of consumer spending.  

Rising rates, even from current very low levels, coupled that increasing energy costs mean disposable income could come under pressure enough to hurt the non-food sector. "The consensus environment for the sector therefore looks quite dull."

As ever Sadan warns against generalisation, insisting that there are companies in the sector that will benefit from ‘self-help' – factors like better management, costs being taken out, being able to sell products that are in demand –  that stand them in good stead.  Carphone Warehouse for instance should do well over Christmas with new phone sales.

Spiralling cotton costs a drag   

In clothing, Sadan believes Next has a good management team but expectations are for consumer spending to be flattish.

Cost inflation in clothing is becoming a big problem, with cotton prices up nearly 40% this year and wage cost inflation taking place in countries like China and Vietnam.

With the VAT rise also coming through, and price rises of around 5% in the pipeline, demand could become an issue for clothing retailers.

Still there are some clothing retailers Sadan rates highly, including Primark : "Fabulous company, very cost conscious and excellent at creating own demand."

Even Primark, however, is suffering from rising cotton prices as reported in the Daily Telegraph, indicating how tough things must be becoming for other clothing retailers.

"We have to put it all into context however….one cannot just say the UK consumer is in bad place so therefore that is bad for all retail stocks. It is not how it works.

"As equity holders we have to price in risk and if the market is doing that properly, then stocks can still perform well in terms of yield and valuation."

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