Investment Column: Squeeze is on for Somerfield

It has been a strange year for Somerfield. Following its difficult flotation in August 1996 when the issue price had to be cut twice, the group's shares spent most of last year trading virtually in line with the market. This was in spite of the fact that it floated on a forward earnings multiple of five and with a yield of 10 per cent. Then in the last month the shares have soared from around 190p to a high of 251 last week.

This was either bid speculation - with the group being identified as a potential merger target in a sector keen on consolidation - or a catch- up process as Somerfield shares had missed out on much of the upgrading in supermarket ratings since the summer.

Whatever prompted the buying spree, it certainly cannot be trading. Somerfield did well to report a 12 per cent increase in underlying profits to pounds 56.9m in the six months to 8 November. But the problem is that the growth all seems to be coming from widening margins. Like-for-like sales growth in the period was just 0.3 per cent and current trading is not much better at 0.6 per cent.

Given that the company said in the summer that its target was sales growth above the industry average this is an under-achievement. Tesco, for example, reported like-for-like growth of 6.5 per cent on Monday against an industry average of 3.3 per cent. With sales virtually stagnant, Somerfield is having to rely on squeezing suppliers to drive margins. They rose from 3.4 per cent to 3.8 per cent on the year.

Management is talking about improving sales with better product availability, refit programmes and an improved product mix. With costs on the up and the tax charge rising, however, this may not be enough. There is some scope to improve the store portfolio with refits but the large sales increases have already been achieved.

A merger is always a possibility though it is difficult to see any of the big UK supermarkets paying 300p a share for a company that was offered to them for 160p by Kleinwort Benson just before the flotation. Assuming full-year profits of pounds 115m, the shares, up 4p to 241.5p yesterday, trade on a forward p/e ratio of 8 and yield almost 5 per cent. Still a substantial discount to the sector but, given the recent strong run, it may be time to lock in some profits.

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