Best supermarket stocks to watch

Understanding the UK supermarket industry

The UK supermarket industry continues to evolve at pace after experiencing significant change during the last decade.

One of the biggest disruptors has been the rise of discount chains that has been gradually eroding the market share of the ‘Big Four’ supermarkets – Tesco, Sainsbury’s, Asda and Morrisons. The rise of German outlets Aldi and Lidl have been the predominate driver as they have challenged the business model used by their larger counterparts and undercut them on price. Other discount retailers that also sell food, such as B&M and Poundland, have poached customers too.

^{Source: Kantar. Market share as of 14 June 2020 vs 15 January 2015. *No figures available for Ocado}

The entry of discount chains has transformed the battleground into one that is almost solely fought on price, especially as customer loyalty has gone out of the window. This, in turn, has been the reason why the Big Four have been in consolidation mode over recent years as they try to achieve greater scale to better compete with their discount rivals.

We saw Tesco buy wholesaler Booker Group in 2017 and a year later it formed a strategic alliance to work with French peer Carrefour to achieve better prices by buying bulk items together. Sainsbury’s diversified by buying Argos in 2016 but failed in its bid to merge with Asda last year after being blocked by regulators. Smaller chains have also banded together following the merger of the Co-op and Nisa convenience chains in 2018.

Technology also continues to shake things up in the sector. Whether it be the rise of online shopping, till-less supermarkets, automated warehouses or the digital revival of loyalty and reward schemes, technology is rapidly changing the ways people shop and the way supermarkets operate. Ocado has demonstrated that technology is the next frontier for an industry trying to improve their paper-thin margins and differentiate themselves from competitors as more retailers adopt its automated offering, while the likes of Tesco and Sainsbury’s have both piloted new store models in recent years that have tried to reduce labour and trialled concepts like scan-and-shop or till-less stores.

Coronavirus has shown how vital supermarkets are, being one of the only retailers that have remained open throughout lockdown. The outbreak has accelerated many of the trends that were already occurring in the market. For example, it has encouraged more people to try online shopping sooner than they otherwise would have and, as a result, many of them are expected to utilise online offerings over the long term. Research from Mintel suggests the UK’s online grocery market will grow by an impressive 33% in 2020 to be worth £16.8 billion, up from £12.7 billion in 2019.

While the coronavirus has demonstrated the resilience of the sector and seen an uptick in demand, it has not come without its costs. Things such as reduced capacity, having to hire thousands of new staff, and the introduction of additional measures to protect them and customers have pushed up costs, while an uncertain economic outlook has injected further uncertainty going forward.

The other big hurdle to clear will be Brexit and the impact it will have on supply chains once the UK leaves the European Union (EU). The UK only produces enough food to satisfy about half the nation, and a large amount comes from the EU.

The issue remains up in the air and we still do not know whether a trade deal will be struck before the UK is due to leave at the end of 2020 (unless the transition period is extended again). This could make importing food a more arduous task and could push up prices of imported food, while also risking shorter shelf lives because of increased border checks and other red tape. This could result in supply chains being overhauled considering price is so important to UK supermarkets.

Top 5 supermarket stocks to watch

All of the publicly-listed UK supermarkets are distinctive from one another and offer something different to investors.

1. Tesco
2. Sainsbury’s
3. Morrisons
4. Ocado
5. Marks & Spencer’s

Tesco

Tesco is by far the largest supermarket chain in the UK, but it also has operations in Ireland, Eastern Europe and Asia. It has non-food operations too through the likes of Tesco Bank and Tesco Mobile. It boasts over £55 billion worth of sales each year and its main advantage is its unrivalled scale that was bolstered by the acquisition of wholesaler Booker Group, which also added thousands of convenience stores to its network. Owning the largest wholesaler in the country not only makes it a major supplier to its rivals, but also allows it to source goods at a cheaper rate.

Its vast scale is further enhanced by its strategic alliance with the French peer Carrefour. The company has also launched a new store format named Jack’s (after its founder Jack Cohen) that stocks a smaller range of its own-brand products aimed at attracting customers from the discounters. Tesco is attempting to double its online capacity, but has admitted that most demand will still have to be met in-store for the foreseeable future.

Tesco’s financial performance has been steadily improving since it was rocked by an accounting scandal back in 2015, and it has been increasing dividend pay-outs since reintroducing them in 2018. Unlike the majority of the stock market, Tesco has refrained from cutting or suspending its dividend amid the coronavirus crisis, and it is still paying special dividends, partly thanks to its decision to sell its operations in Thailand and Malaysia.

Sainsbury’s

Sainsbury’s has had the toughest time of the Big Four supermarkets in recent years as it has struggled to face both the discounters and its older rivals. It’s big response to Tesco scaling up its business and the rapid gains being made by the likes of Aldi and Lidl was to try to merge with Walmart-owned Asda last year, claiming it would help them cut prices of everyday goods by up to 10%. However, its attempt was blocked by regulators that claimed it would result in a significant lessening of competition in the market.

That has forced Sainsbury’s to revaluate the way it competes now that it knows a big merger is off the cards. Still, the acquisition of Argos in 2016 has been regarded as a success as it has significantly expanded its offering beyond food and into other key areas like homewares and general merchandise. Mike Coupe, the chief executive behind the attempted Asda merger, has recently retired to give way to Simon Roberts.

Sainsbury’s has seen its top line perform well during the coronavirus crisis, but it has been more cautious than Tesco. Profits have taken a hit and it has suspended dividends as a precaution.

Morrisons

Morrisons is the smallest of the Big Four supermarkets but it has differentiated itself by creating large food manufacturing division and distribution network. It makes over half of all the fresh food it sells in-house with 18 manufacturing sites across the country, distributing it through its eight nationwide centres.

Its focus on producing and not only selling food means it also has a substantial wholesale arm that is close to generating over £1 billion of sales each year by selling to stores at home and abroad. Morrisons also has some notable partnerships that set it apart from Sainsbury’s and Tesco. The first is with Ocado, which helps Morrisons with its online offering.

However, after striking a deal and returning a distribution centre to Ocado last year, it has been able to expand its partnerships with the likes of Amazon, where Morrisons products are on offer under Amazon Prime Now and Amazon Pantry. Its close ties to Amazon, which has already pushed into the grocery sector by buying Whole Foods, means it is considered as a potential takeover target should Amazon make a big push into the UK market in the future. Deliveroo has also partnered the firm to offer a limited range of everyday items for quick delivery.

Revenue fell for the first time in four years in the 12 months to 2 February 2020, although profits continued to improve. Morrisons has consistently increased its ordinary dividend in recent years and has supplemented them with special pay-outs in the last three.

Ocado

Ocado has gone from strength to strength over the last couple of years. It is the ‘world’s largest pure-play online grocery business’ and is growing its market share, even if it currently owns a minuscule share at the moment. Ocado’s online service has been underpinned by its automated warehouses and distribution centres twinned with its partnership with premium supermarket chain Waitrose, although it is switching to rival Marks & Spencer at the end of August 2020.

The coronavirus crisis, together with the acceleration of online shopping, has gone in Ocado's favour, with sales having soared 27% in the six months to the end of May 2020. Ocado's uniqueness includes having a Solutions business that licences out its technology to other grocers and retailers from around the world in an attempt to improve efficiencies and reduce labour. The number of companies to have adopted Ocado’s automation technology has increased in recent years, with big names including Morrisons, American firm Kroger, Canadian outfit Sobeys and French firm Casino Groupe all using it.

Ocado is continuing to grow at a much faster rate than its larger peers. Revenue in the six months to the end of May 2020 rose to over £1 billion from just £800 million the year before, but Ocado is still making a loss and therefore doesn’t pay a dividend.

Marks & Spencer’s

Marks & Spencer’s has traditionally been known for selling clothing and homewares, but its food business has become its strongest part in recent years. It makes over £10 billion in revenue each year, with 60% coming from food, 30% from its clothing and homewares range, and the rest from its international division that is operated through a franchise model around the world.

It is hoping it can propel its food business to new heights after agreeing to buy 50% of Ocado’s grocery service and striking a deal to supply products to Ocado customers as the firm’s agreement with Waitrose comes to an end later this year. Marks & Spencer’s has said it is promoting a ‘one business’ mentality with Ocado, which could be regarded as a potential precursor to closer relations between the two stocks in the future. Marks & Spencer’s is in the middle of a transformation programme that is seeing it close stores and cut jobs.

Food has been a bright spot for Marks & Spencer’s at a time when sales of its other goods have failed to impress, but it has not stopped its overall financial performance deteriorating in recent years. Revenue and profits both fell in the year to 28 March 2020, which resulted in a 70% cut to its dividend. It said it doesn’t expect to pay a dividend in the current financial year.

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