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UK supermarket stocks: who has the best strategy to invest in?

The supermarket industry is undergoing drastic change, leaving investors wondering which of the major players - Tesco, Sainsbury’s, Morrisons, M&S or Ocado – have adopted the right strategy to adapt.

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Times are tough for UK supermarkets. Discount chains continue to steal their customers and squeeze their margins by driving a race to the bottom on price. Online shopping and new technology is reshaping how they do business and requiring large sums to be invested at a time when growth and profitability are both under strain. The worst of Brexit and other trade wars, which will undoubtedly affect supply chains, is yet to come. And, even when some have come up with big ideas to address the big problems – like Sainsbury’s attempt to combine forces with Asda – they have been squashed by the regulator.

Read more about Sainsbury's and Asda supermarket merger blocked by competition watchdog

The Big Four supermarkets are all facing the same challenges but are riding the wave of transformation differently, and this is not easy nor cheap. But who has what it takes to keep up with the rapidly evolving market?

The rise of Aldi and Lidl

German discount chains Aldi and Lidl have poached significant business from Tesco, Sainsbury's, Walmart-owned Asda and Morrisons over recent years - Aldi’s UK sales alone sit above £10 billion per year. It was a slow start for them both when they entered during the 1990s, having taken just 6% of the market by 2011, but that has accelerated over recent years and today they share just shy of 14%. That should continue to rise as both expand, with Lidl opening up in more affluent areas such as central London and Aldi aiming to double its estate over the coming years to 1500 stores (which would be larger than Sainsbury’s store network). Other non-food discounters, such as B&M and Poundland, have also stolen business in some product categories like toiletries and biscuits.

UK grocery market share

May-15 May-16 May-17 May-18 May-19
Tesco 28.6% 28.3% 27.8% 27.7% 27.3%
Sainsbury's 16.5% 16.2% 15.9% 15.7% 15.2%
Asda 16.6% 15.8% 15.4% 15.4% 15.2%
Morrisons 10.9% 10.7% 10.5% 10.5% 10.4%
Aldi 5.4% 6.0% 7.0% 7.3% 8.0%
Lidl 3.9% 4.4% 5.0% 5.4% 5.8%
Co-Op 6.0% 6.2% 6.1% 6.0% 6.1%
Waitrose 5.2% 5.3% 5.2% 5.1% 5.1%

(Source: Statista, Kantar Worldpanel)

As Aldi and Lidl continue to deliver double-digit rates of growth, everyone else is struggling to grow at all. Tesco’s retail like-for-like (LfL) sales in the UK and Ireland slowed to 0.8% in the first quarter (Q1) of its new financial year from 3.5% the year before, and that still outperformed the market. Morrisons’ Q1 LfL sales also slumped to 0.2% from 1.8%. Sainsbury’s LfL sales fell into decline during the second half of its last financial year, and hopes aren’t high for its Q1 results when they are released on 3 July.

Read more about 4 things we learnt from Tesco's Q1 results

The UK grocery market will continue growing over the coming years, in fact, IGD, a training and research charity for the food and grocery industry, predicts the industry will grow by 14.8% between 2018 and 2023, giving it a value of £218.5 billion. But, while growth is expected across all major channels, discounters are set to grow sales four times faster than that of traditional supermarkets. In fact, discounters are expected to account for 14.4% of total UK grocery spending in 2023 compared to 12.1% last year, while the supermarkets’ share of the pie is expected to fall from 46.8% to 43.9%.

UK supermarkets: where’s the growth?

2018 value (£, billion) 2023 value (£, billion) % change
Hypermarkets 16.4 16.7 1.40%
Supermarkets 89.1 95.9 7.70%
Convenience 40.1 47.2 17.60%
Discounters 23.1 31.5 36.70%
Online 11.4 17.3 52.40%
Other retailers 10.2 9.9 -3.50%
Total 190.3 218.5 14.80%

(Source: IGD, June 2018)

Tesco, Sainsbury’s and Morrisons have all proven their ability to adapt to shifts in growth in the past, such as moving away from large hypermarkets in favour of smaller, faster growing convenience stores. As growth starts to shift once again, this time to discounters and online, they must do it again.

Tesco has led the way by experimenting with new store formats. Tesco has launched discount stores named Jack’s to entice customers with a limited but cheaper range of products, mostly its own label goods, in an attempt to beat the discounters at their own game. Plus, Tesco has also recently suggested it could look to open new ‘Finest’ stores to target the premium end of the market, where companies like Waitrose have managed to hold market share far better than those serving the middle ground.

Supermarkets race to consolidate, scale up and diversify

The focus on price and rising costs such as labour and business rates has also pressured margins. At their peak, the Big Four boasted world leading margins close to 7% but that fell closer to 3% as Aldi and Lidl gained traction and today they are battling to deliver margins between just 1% to 2%.

This ultimately comes down to a loss of buying power and has encouraged firms to bulk up through acquisitions or strengthen their bargaining position with suppliers by partnering with others. Tesco bought wholesaler Booker Group and has struck a strategic alliance with French giant Carrefour. Co-op signed a deal to supply the Nisa convenience store chain. And, more recently, Morrisons has expanded its partnership with Amazon after adjusting a previous agreement with Ocado, which in turn has agreed to help Marks & Spencer reverse its woes. However, the Competition & Markets Authority (CMA) has issued a warning about the wave of consolidation by blocking Sainsbury’s £7.3 billion merger with Asda.

Marks & Spencer and Ocado confirm joint venture deal

The CMA’s decision is will encourage firms to partner with rivals in the immediate future rather than merge, but it has left serious questions about what Sainsbury’s and Asda will do as standalone businesses. Sainsbury’s was quick to launch a new strategy and has promised to reduce debt while investing in its stores and technology, but shareholders aren’t biting until results are delivered. Asda, which forms just a tiny fraction of the wider Walmart business, is happy to tick along (Asda is now level pegging with Sainsbury’s in terms of market share, having been the smaller of the two at the time the proposed acquisition was announced) but it has been recently reported that the head of Walmart’s international division has informed staff that it is considering spinning off Asda and launching an initial public offering (IPO). However, this isn’t expected for a number of years. Walmart is in a position where it can wait for the optimal time to divest and, based on the current climate and outlook, that isn’t anytime soon.

What's the investment case for Sainsbury's after the Asda deal is blocked?

Meanwhile, rivals Tesco and Morrisons have successfully diversified into the wholesale business, which has been the key driver of growth for both businesses and why they have managed to outperform Sainsbury’s. Booker Group’s LfL growth in Q1 was 3.1% compared to the meagre 0.8% growth seen in Tesco’s core UK and Ireland retail business, and LfL sales in Tesco’s international retail operations in Europe and Asia were in decline throughout the whole of its last financial year. Morrisons, which stands out from others by making about one quarter of its own label goods, delivered 2.1% LfL wholesale growth in Q1 compared to just 0.2% from retail. However, wholesale growth has slowed at both businesses compared to last year.

Will online shopping help supermarkets fend off the discounters?

Although online will continue to remain a relatively small sales channel over the coming years, accounting for 6% of total grocery sales in 2018 and growing to 7.9% by 2023, no company can afford to ignore the opportunity. The only sales channel set to grow faster than the discounters over the next three years is online – an area where Aldi and Lidl have no presence. Plus, the imminent threat of online kingpin Amazon, which acquired a handful of UK stores when it bought Whole Foods, means existing players need to get ahead of the game before it’s too late.

The problem is, establishing online operations from scratch is hard and expensive. Supermarkets are being forced to invest heavily in online operations even if the return over the shorter-term is limited. Therefore, it is unsurprising that everyone has been rapidly buddying up, with one company appearing to be the partner of choice for the older supermarket chains – Ocado.

After years of little movement, Ocado shares have soared since late 2017, when major grocers and retailers from around the world started to adopt its online grocery delivery software and automated systems. It says a lot about where investors attribute value in the market when you consider Ocado, which reported an £8.3 million pre-tax loss in its last financial year, is worth £8 billion - twice as much as Sainsbury’s with annual pre-tax profit of £239 million.

Will more tech firms enter the supermarket industry?

Ocado, as a supplier of technology to supermarkets, is a different breed compared to the Big Four but should be on the radar of those wanting to invest in the industry. Technology is the key to solving so many of the supermarkets concerns: it can reduce the biggest expense (labour) by introducing more automation, improve supply chains with smart farming and production, or utilise the invaluable data they have on how we spend our money.

With firms like Ocado gaining momentum and the tentative entry of Amazon, it is clear more tech firms will make a push into the grocery market. For example, the challenges with offering a fast, effective online delivery service to everyone (not just those confined to densely populated cities) could introduce some surprising players. People need to be able to order groceries and have them delivered to wherever they are within the hour – much like a pizza or takeaway curry. And this has fuelled reports that supermarkets may be flirting with food delivery outlets such as Uber Eats, Deliveroo and Just Eat.

Those potential partnerships or tie-ups – while far from simple – offer obvious benefits for both sides: supermarkets finally have the logistics they need to roll out effective online delivery services on a national scale, while the fast food delivery firms gain a swathe of new business that can make their operations in less dense areas more economical. Groceries are bought during the day, whereas takeaways are mostly ordered at night. Supermarkets can’t afford to hire the number of drivers they would need to roll out services on their own, but are also reluctant to adopt the gig economy labour model that Uber and Deliveroo rely on.

Morrisons chief executive David Potts has said he is interested in striking deals with more tech companies after breaking free of a deal with Ocado that limited its ability to have numerous digital partners. Morrisons partnered with Ocado in 2013 to utilise the tech firm’s automated warehousing and delivery service but, following a fire at one of Ocado’s warehouses, has agreed to relinquish space at another so Ocado has the capacity it needs.

That allowed Morrisons to expand its three year relationship with Amazon. People can already order Morrisons goods through Amazon and have them delivered in Leeds, Manchester, Birmingham and London but this will be rolled out to Glasgow, Liverpool, Sheffield and Portsmouth this year and to more later on.

The need for bricks and clicks

But while the focus is on clicks, let us not forget the importance of bricks. Online is growing fast and taking a bigger slice of overall sales in the market, but there is debate about the overall penetration potential in a market involving products with such short shelf lives, like fruit and veg. About a fifth of all sales are made online in the wider retail market but this only sits at 6% for groceries at present. The discounters are yet to move into the online space and many question whether they will considering growth is still strong and the costs would be high. A physical presence will remain vital and Amazon’s purchase of Whole Foods is further testament to this.

However, stores are fast becoming too expensive and unfit for the modern day consumer, which means they need to spend even more on changing the size and formats of their outlets. They need to give customers more reason to visit their stores. For example, Sainsbury’s purchase of Argos was a way of diversifying its product range and enticing people in with a wide range of general merchandise. This is also an example of how supermarkets are tapping into the likes of click and collect by giving people a reason to come and visit the store and pick up a pint of milk while they get their package. Ironically, the popularity of click and collect services is partly fuelled by the inefficiencies of the supermarket’s delivery services.

They are also using the excess space in their oversized stores by introducing the likes of garden centres or cafes, or leasing it out to third parties like key-cutting services or dry-cleaners. Waitrose recently ended a trial of offering yoga classes in store.

It is clear that stores will still be needed, but with a different purpose to what they are today. The immediate task for the Big Four is to ensure their store portfolio consists of the right sized stores in the best locations, but over the longer term the job will be to make them more efficient and profitable by injecting some much needed technology. Sainsbury’s has already trialled stores without tills whereby customers scan and pay all through their phone, following on from similar efforts by Amazon in the US. Tesco has also trialled concepts like scan-and-pay.

Costs will reduce significantly as smaller stores become automated, larger stores entice customers by offering multiple retail outlets under one roof and more online sales are made. But they must burden the cost before they can reap the reward.

The power of data revitalises loyalty programmes

Outside of the premium-end of the market, supermarkets no longer enjoy any form of brand loyalty. People are quite willing to visit different stores for different shops, so increasing loyalty and understanding customer behaviour is a crucial. While the likes of the Tesco Clubcard and Sainsbury’s Nectar programme are not new, both have had to be overhauled at huge cost. Tesco spent £150 million on revamping Clubcard last year while Sainsbury’s splashed out £60 million to take full control over Nectar.

While the pair have had to build on top of older legacy systems, Morrisons has found a faster and cheaper way to harness data and loyalty. The deal with Amazon means Morrisons forms part of the wider Prime offering, which is particularly popular in city centres where the supermarket is less represented than Tesco or Sainsbury’s. The partnership means Morrisons is not only selling to Amazon as a wholesaler but as a retailer, which means the supermarket is able to tap into a huge customer base without committing much capital. Plus, because subscribers want to get the most out of their Prime subscription, they are far more likely to use Morrisons.

UK supermarkets: where’s the value?

It says a lot when brokers fail to see upside to a staple stock like a supermarket even after a share price has taken a battering. Brokers still see very limited upside for Sainsbury’s shares despite the stock losing over one third of its value in the last year, or for Marks & Spencer after colossal declines. Plus, the fact brokers still see upside for Tesco shares in the face of a 25% rise over the last six months only makes that look worse. Similarly, Ocado is still seen as a buying opportunity despite its tremendous rise over recent years.

Reuters poll – June 25

Share price movement over 6 months Share price movement over 1 year Share price movement over 5 years Recommendation
Tesco 25% -9.30% -17% Buy
Sainsbury's -25% -37% -38% Hold
Morrisons -6.70% -19% 8.90% Hold
Ocado 53% 11% 206% Buy
Marks & Spencer -9.50% -25% -49% Hold

For investors, it shows where the confidence lies. Tesco seems to be earning kudos for its scale and willingness to adapt with new store formats and a bigger push into own label produce. The growing need for major retailers to recruit Ocado to boost their online efforts and improve efficiencies through the likes of automation also seems to have won over the market. But those that lag behind the pack – like Sainsbury’s which still has to convince investors it has what it takes to go it alone, or Marks & Spencer which is still in the doldrums – have fallen firmly out of favour.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.

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