Sector in Focus: Supermarket Stocks

Ken Perkins: Thanks for having me.

Wall: So, we're here today to talk about supermarket stocks, a largest of that is being Tesco (TSCO). Tesco has had a couple of bad months, bad sales results and also its most well-known investor dropping some of their holdings, Warren Buffett in fact.

Perkins: I think Tesco is facing lot of challenges at both the macro level and a company-specific level. You've seen that over the last several months, not just with Tesco, but a lot of the big traditional grocers are facing lot of competition. You've had food inflation that's gone out up by a higher rate than wages have gone up, which pressures consumers and then on top of that you have some new entrants like Aldi and Lidl, which are hard discounters that offer pretty compelling price opportunities whereas these big store formats that Tesco operates have really come under pressure.

Wall: Tesco used to dominate the market in the U.K., you can't move for Tesco in every corner. They also expanded globally into emerging markets and then it seemed they did too much too soon and they've had to really pullback from that area haven't they?

Perkins: Yeah, they have and I think that's what you've seen, a real domestic focus. But you're getting a lot of the short-term investor concerns about things not turning around fast enough and to their credit. They are at least sticking to their guns and trying to re-ride the ship. But I think it could take time for a company like that and that's where a long-term perspective really makes a big difference and so their focus on returns on capital, we think, is really important, but they've got a lot of work to do and I think you are seeing that in the results.

Wall: What does stock valuation look like?

Perkins: We still think Tesco is undervalued. It trades around 12% below our fair value estimate. We think that of the three major grocers that are publicly traded, including Morrisons and Sainsbury, I think Tesco is actually attractively priced, simply because we think a lot of these concerns about the international growth prospect, losing market share, the discounters is being overly reflected and the valuation doesn't require robust growth from Tesco to make it a worthwhile investment, particularly if you get a 4% dividend while you wait.

Wall: Looking then at the others, Morrisons (MRW) to start with, Morrisons had quite a good year, it had investment from one of the best known income managers in the U.K., Neil Woodford, then also within six months of Neil picking up some of that stock, it announced an online venture in a partnership with Ocado. Does this mean good news for Morrisons?

Perkins: I think so. They've been a little bit behind the rest of the group in terms of getting in online in even the convenience stores, but now they are eventually getting there and I think that what's weighed on the share price probably with them is that they just haven't been in those spaces and so they've lost a little bit of market share, but they've got all that opportunity to gain it back.

And so for them it makes a lot more sense for these more established companies, even a Sainsbury or a Tesco. They are more mature both in the store bases and even online. So the concerns are, if you are losing market share and you don't have that opportunity, where are you going to grow, and I think that's what's weighing on the shares for Tesco in particular.

Wall: With Morrisons, they did have a redesign, didn't they? And that wasn't received well by some analysts. What do you think the future hold for Morrisons?

Perkins: I think the look I'm really trying to ensure that the Morrisons message of being made by, by Morrisons continues to spread whether they are purchasing online in a convenience store or in their stores are their big super markets and that's going to be important for them from a differentiation standpoint. Simply because you have so much competition that that's really what you need to get these loyal customers to continue coming back in all channels where they ultimately might spend more with you then they would otherwise.

Wall: Getting that local grocer brand.

Perkins: Exactly.

Wall: Now what about Sainsbury's (SBRY)?

Perkins: Yes, Sainsbury has been growing and they've – to their credit have been one of the big grocers that's actually been doing well, posting positive like-for-like sales growth, whereas the other ones have been declining. Sainsbury has been growing pretty aggressively on the convenience store side. I think we are positive that the company is trying to do the right things. But the returns on capital for every dollar that they invest into a new store, they're not getting the sort of profits that we would expect out of the company like that. Now granted those things take time, so we think that going forward they'll actually improve their results, but that really leads to some of our concerns because when all of these companies continue to look to grow their sales and grow their store base, they can't all win unless the consumers are spending more and we just haven't seen that recently.

Wall: That's because of food inflation isn't it?

Perkins: Yeah, you've seen – just in general over the last five or six years, you've seen food inflation outpace wage inflation and that really causes a problem, because essentially you're either going to see the volumes go down, which Tesco actually noted is that consumers in the holiday season were shifting to save for a holiday spending and cutting back on food. So there is a real trade off the consumer has to make. So you're going to see that I think more and more and even the sales line will have to come down as pricing comes down, or you can see the volumes continue to take a hit, and I think that's what we're particularly concerned about over the near-term.

Wall: Could they counter that reduction in domestic spending, perhaps with going overseas or Tesco's fingers getting burnt being a warning to everybody?

Perkins: I think that's one of the things that a lot of these international retailers have learned and not just Tesco, but even Wal-Mart and some of these other international retailers that, it's difficult to expand in the market where you don't have the competitive advantage and I think Tesco, to some extent, has learned that well entering in the United States and pulling back in Japan as that's very difficult amidst local competition to generate the sort of scale advantages and also resonate with the consumers like they do in the U.K. I think that in particularly losing their eye – taking their eye off the ball and losing some share to these other companies is a warning sign to the other companies that says maybe we should focus on our profitable core market here where we have some sort of advantage before we venture off too far and have nothing lot to show for it.

Wall: Of the three listed, which looks the most attractively valued?

Perkins: We still think Tesco looks a most attractively valued. We admit that there is probably some near-term risk to the company. But we think that even if the company loses a little bit of market share at the margin, the issue is that the company still has enough customers coming through its stores to remain profitable and to pay those profits out and the cash flow out and healthy dividend. I think that's the thing that the market maybe overestimating is the concerns about market share losses versus the company's overall cash flow generation.

Wall: Ken, thank you very much.

Perkins: Thanks for having me.

Wall: This is Emma Wall for Morningstar. Thank you for watching.