Food retail players set for all-out price war

Warring grocers is good for shoppers, but not necessarily for investors, says Stephen Pritchard
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The row this week among the top brass at J. Sainsbury shows that, far from being dull, grocery retailing is a game played for high stakes. The disagreement at Sainsbury over a trading statement broke out even before the company's chairman and chief executive had taken up their new jobs.

The row this week among the top brass at J. Sainsbury shows that, far from being dull, grocery retailing is a game played for high stakes. The disagreement at Sainsbury over a trading statement broke out even before the company's chairman and chief executive had taken up their new jobs.

Sir Peter Davis, who moves from chief executive to chairman on Monday, appears to disagree with Justin King, who is due to take the chief executive's chair. Sir Peter wanted to talk up the outlook for the group. Mr King, a former executive at Marks & Spencer, is said to have urged greater caution.

And well he might: Sainsbury has been losing market share to competitors including Tesco and especially Asda. The latter, owned by the US giant Wal-Mart, overtook Sainsbury as the UK's second largest grocer last year.

Consolidation has reduced the number of players in food retail, and also the investment opportunities.

Since William Morrison bought Safeway, the sector consists of just three quoted, "pure" supermarket groups: Morrison/Safeway, Tesco and Sainsbury. The London Stock Exchange includes Somerfield in its food and drug retailer category, but the company is now branding itself more as a convenience store company, competing in the high street rather than the out-of-town superstore market.

At the other end of the business, the upmarket retail chain Waitrose is expanding, and agreed last week to buy 19 stores from Morrison. At a cost of £158m, it is the largest ever acquisition by John Lewis and gives Waitrose a valuable bridgehead in the north. This will increase Waitrose's capacity by 20 per cent. But, as part of the John Lewis Partnership, Waitrose is effectively employee-owned and not open to outside shareholders.

The UK's second largest supermarket company is now Wal-Mart's Asda. Adventurous investors could look at buying Wal-Mart shares on the New York market, but investing in Wal-Mart represents a very different risk profile than investing in the UK retail sector.

Sainsbury, with 35 per cent of its stores competing directly with a Safeway branch, could bear the brunt of a new price war. And that war might not be far off. According to research by analysts at Merrill Lynch, Tesco and Asda broadly tend to track one another in price terms. Morrison's original stores, mostly in the north of England, follow a similar price strategy.

But Safeway and Sainsbury are consistently more expensive to shop at. Merrill Lynch tracked a basket of 3,000 groceries across the UK supermarket sector and found that Asda and Tesco were cheaper than Safeway on 89 per cent of their goods, and cheaper than Sainsbury on 74 per cent. The bank estimates that prices at Safeway are some 10 per cent higher than Asda's or Tesco's; Sainsbury is around five per cent more expensive.

Morrison has firm plans to cut that gap. The company has already announced that it will slash prices on 4,300 products in Safeway stores over the next few weeks. This will be driven by cost savings from the merger. Morrison estimates that buying synergies from the larger business will save £215m.

If other supermarkets move to match these prices, it will be good news for shoppers but not necessarily for investors. Morrison could be looking at cutting its gross margins by as much as five per cent, according to Barclays Stockbrokers. And Merrill Lynch calculates that if Sainsbury were to bring its prices down by five per cent, it would cost £650m, or almost a year's pre-tax profit.

The very public disagreement at the top of Sainsbury supports the view, held by many City analysts, that the company is now the weakest of the mainstream supermarket groups.

Tesco has a very strong war chest, as it raised £810m last year in the market. And Asda can call on both the financial might and the buying power of its American parent to ensure it competes with Morrison/Safeway on price.

"There is a huge overlap between Sainsbury and Safeway, and with Safeway now in the hands of a price-driven operator, Sainsbury's pricing strategy is dangerously exposed," says Simon Proctor, retail analyst at the stockbroker Charles Stanley.

But short-term price wars are not the only issue facing the UK's food shopkeepers: there is also the issue of longer-term strategy. The grocery business is effectively split along two lines: range and price/quality.

"There are two different business models," says Tony Shiret, a retail sector analyst at Credit Suisse First Boston. "There is the mixed model, based on clothing and non-food. That is the Wal-Mart model in the US, and what Tesco and Asda are doing. Tesco is about a third of the way through a programme to double its number of hypermarkets to 120. Then you have the more focused food retailers, such as Morrison."

The mixed retailers can draw on their fast-growing non-food businesses, where margins are more generous, to support price cutting in their food operations, should they need to. The more food-focused retailers will find this more difficult.

The food-focused retailers also face added competition at both the high and the low end of their markets. At the low end, the so-called hard discounters, such as the foreign-owned Aldi and Netto, compete almost purely on price, with stripped-down outlets and packing cases ripped open and placed straight on the shelves to emphasise the no-frills approach.

At the upper end of the market, John Lewis Partnership's Waitrose and Marks & Spencer compete on quality. As a result of the recent strategic activity involving the supermarkets cautiously exchanging assets, CSFB has put an underperform rating on Sainsbury while it expects on Tesco and Morrison to outperform their rivals.

Investors might be deterred from putting money into Morrison right now because, despite strong results announced this month - profits for last year were up 13.2 per cent to £320m - there is still uncertainty about the costs of the Safeway deal. This leaves Tesco as the front runner, but much of the good news could already be in the price. Its shares have risen 41 per cent over the year; Barclays Stockbrokers describes the company as "the darling of the sector".

In fact, Tesco is increasingly the main reason for investors to consider the FTSE food and drug retail sector at all. "The attraction of the sector is the attraction of Tesco," says Richard Buxton, head of UK equities at the City fund manager Schroders. "One reason for being in the sector is the might of Tesco, marching further into non-food retailing."

Tesco's success at selling anything from electronic goods, to clothes and financial services is worrying retailers far beyond the supermarket sector.

And, despite the fact that competition rules make it unlikely that Tesco could expand its store portfolio dramatically, analysts still expect the company to produce organic growth, and to embark on smaller, tactical acquisitions. Tesco, unlike Sainsbury and Morrison, also has substantial business interests outside the UK.

"Tesco is not a cheap share, but it is not expensive given the momentum within the business," says Mr Buxton. As the company continues to expand, by extending stores and adding new lines, profits could rise still further.

But not everyone at Schroders is filling their trollies with Tesco stock. According to Mr Buxton, the fund manager's value team are buying supermarket shares, but they are buying J Sainsbury.

THE ANALYSTS' VIEW: 'Tesco's going in our trolley first'

Sainsbury, brokers say, faces a difficult time if a new price war does break out. Of 14 brokers listed on Sainsbury's own web site, only one has a positive recommend- ation to buy the shares.

The City is also cautious about William Morrison, suggesting that the company might find that the Safeway takeover will be more expensive than the retailer anticipated. Merrill Lynch says that rebranding Safeway could cost as much as £130m more than Morrison has set aside. Charles Stanley also has worries: the broker downgraded Morrison from "accumulate" to "hold" on news of the merger. The stockbroker arms of the investment bank Dresdner Kleinwort Wasserstein also downgraded Morrison, from "buy" to "hold", this month.

Among the quoted players, Tesco remains the City's favourite. The company's shares were upgraded last week by Goldman Sachs, from "in-line" to "outperform". The stockbroker Charles Stanley's stance on the company is "buy".

Investors looking to buy into the retail sector could, though, also consider one wild-card alternative. Marks & Spencer is not classified by the markets as a food retailer, but food represents a significant part of its business. In 2002-03, M&S expanded its operations with 19 more food-only stores under the Simply Food banner, which operates almost exclusively out of national rail stations.

Despite its ups and downs in the last few years, Barclays Stockbrokers likes the share; CSFB thinks that Marks and Spencer will outperform the market, although the bank cautions that general retail - the home sector for M&S - is predicted to do less well, attracting an "underperform" rating.

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