Sinking supermarkets: Tesco has had a disastrous year. Can it recover?

The UK’s supermarkets were once investment darlings. The likes of Tesco and Sainsbury’s emerged on the stock markets, radically changed our shopping habits and then rose to dominance on the FTSE 100. 

 

But times have changed, and the supermarkets have been down on their luck. Are they still worthwhile investments? 

 

“Part of the supermarkets’ success in the 1980s and 1990s was that they were innovators. They changed our habits,” says Leigh Himsworth of Fidelity Worldwide Investment.

 

The Big Four – Tesco, Sainsbury’s, Morrisons and Asda – command 74 per cent of the nation’s grocery spend, according to analysts Kantar Worldpanel, with £1 in every £8 spent at the king of supermarkets, Tesco.

 

Investors who bought shares in these were rewarded too. Tesco was the most successful of all, and was the most widely-held supermarket stock. Its share price grew 856 per cent from 1988 to its pre-crisis peak in October 2007, and was still up 788 per cent in April 2010.

 

But things have begun to change. Despite these impressive statistics, the supermarkets have been struggling to grow sales and profits.

 

They say the bigger they are, the harder they fall – and Tesco has suffered more than the others. It has had a disastrous two years. In September, news emerged of an accounting scandal at the retailer. The Serious Fraud Office is now investigating after the methods Tesco used to book sales caused it to overstate its profits by £263m. Then in April it announced a record £6.4bn loss, the largest in its 97-year history.

 

Unsurprisingly, given this string of bad news, shares in supermarkets have fallen considerably. Tesco’s stock is 39 per cent cheaper than two years ago, although it has picked up in the last few months. It’s a similar picture for Sainsbury’s and Morrisons, as both companies’ share prices are down around 30 per cent in two years, but have risen a little this year.

 

The chief problem for the supermarkets is changing consumer habits. “It is no longer convenient to drive to a big out of town shop. We are doing a big bulk shop online and topping up with convenience shopping,” Himsworth explains.

 

This has left the supermarkets with falling sales at their superstores. “The fundamental problem for the likes of Tesco is that their stores are the wrong size. If you look where the growth is coming from, it is not in the big stores – it is from convenience stores, discount shops or online outlets,” says Jeremy Lang from Ardevora.

 

He says there has been a “structural evolution” in the market which Tesco’s management failed to spot in time. Although Tesco does have a wide network of convenience stores, it has been left with many underperforming superstores. “Essentially, Tesco has been left with a legacy store base, which does not make sense given the new trends in the market,” Lang explains.

 

In their clamour to dominate the retail market, supermarkets have also spread themselves thin by trying to sell everything to everyone. It is costly for a retailer to house slow-moving stock such as home furnishings, and Tesco in particular has been criticised for taking its focus off the core food offer, allowing the quality of its ownbrand food to decline.

 

“The issue for Tesco, as well as similar chains, is it tries to do everything: cheap food, expensive food, clothes, toys – but it ends up lacking in most areas,” Lang says.

 

He is sceptical that Tesco will be able to fix its problems anytime soon. “The idea it can easily adapt its existing store base is mistaken – it is wedded to its previous business model. While this was extremely profitable in the past, the world is changing.”

 

But some fund managers have faith that Tesco can turn its fortunes around. The company has reshuffled senior management and has an experienced team in place. When its share price slumped, some viewed this as an opportunity to buy up shares.

 

Top manager Richard Buxton from OMGI was one. Although he was very bearish on the company last autumn, he now believes chief executive Dave Lewis is doing all the right things. Although the business is going through a rough patch, it is not in a distressed state, Buxton says. 

 

“Yes, the balance sheet is stretched, the debt is high but it is not in distressed asset sales mode. They can work their way through this.”

 

Buxton acknowledges the scale of the challenge facing Tesco and says “it’s going to be an incredibly long haul”. However, Tesco is still an enormous business, with half a million staff spread across 12 countries. It has a lot of scope for improvement, and for a patient, long-term investor, buying shares at these low levels could prove to be a good move.

 

Where the supermarkets have struggled, there are other companies muscling in on their market share, which could make good investments.

 

Food delivery firm Ocado is a company with “enormous potential”, says Stuart Mitchell from SWMC. He believes there is only one major area of commerce which the internet is yet to fully penetrate, and that is groceries. Although he admits Ocado has been a “controversial” investment in the past – its share price has fluctuated widely – the possibilities for growth over the longer term are definitely there.

 

“The only company to master the technique and skill of selling grocery products online is Ocado. Others have tried to do it, by basically sending people into stores to hand select items to send in vans to the countryside. This is much more inefficient and far less profitable than the fully automated warehouse system Ocado operates,” Mitchell explains. “Penetration of the internet grocery industry will continue to grow, Ocado will no doubt keep its share, and its technology is also something it could look to sell to other retailers in Europe and the rest of the world.”