New supermarket tips from Goldman Sachs

UK supermarkets have been a terrible investment this year. Competition from the discounters and a switch from vast out-of-town shops to convenience stores and online has eaten into profits at Tesco, Sainsbury's and Morrisons. Now, Goldman Sachs has decided there's only one way the big listed three can start growing profits again.

"Our analysis of the UK grocery industry suggests capacity exit is the only viable solution for a return to profitable growth," says Goldman. Forget price cuts; anything Morrisons, Sainsbury's or Tesco can do, the German discounters can do better.

Why? Well, Aldi UK's lease adjusted return on invested capital (ROIC) jumped from 2.6% in 2010 to 10.1% in 2013. That compares with Goldman's estimates that the three UK listed grocers have seen their returns slump from 10.5% to just of 7% in 2014. Clearly, Aldi and Lidl have the firepower to keep undercutting the big stores. Says Goldman:

This suggests that any price initiatives will be matched or exceeded by the discounters and is why we believe a broader price war is unlikely. We therefore think the only way to protect returns is to cut invested capital. By exiting underperforming stores, we believe the UK grocers would improve their returns through cutting the asset base while also improving profitability. We believe they need to cut invested capital c.20% to return to the c.9% lease adjusted ROIC they earned in calendar 2013.

And the domestic retailers had better shape up. Goldman predicts that channel shifts to convenience and online stores is structural and its analysis suggests that large stores will see a like-for-like compound annual growth rate (CAGR) to 2020 of minus 3% if no further competitive, or strategic response is made. "On our estimates, negative leverage through core assets drives a 60% fall in the listed 3's operating profit through CY13-17E."

And Goldman thinks industry consolidation, while at an attractive valuation is ideal, is made unlikely in the short term because of regulation "…and therefore capacity exit from the largest store operators appears to be the only solution. Alternative use property valuation suggests no support at current share prices."

Buy/Sell/Hold?

Sainsbury's - Sell

"As Aldi and Lidl gain increasing traction with the middle classes, and their higher ROICs allow them to continue to lead on price, we believe Sainsbury's will struggle to reverse negative sales growth and thus negative leverage. (We) believe dividends will continue to fall beyond FY15E. Our 12-month price target is 155p, implying 42% downside."

Tesco - Sell

"We believe structural shifts away from large stores means over-spacing and not price is its biggest problem. Our SOTP continues to show downside and we remain Sell rated with a 12-month price target of 155p." Its target was 250p previously.

Morrisons - upgrade to Buy

We model the largest price investments and the deepest volume declines at Morrisons, but with cost savings and asset disposals we still believe it will remain the least levered (lease-adjusted) grocer, with the most visibility on cash generation. Despite this, MRW trades on an average 6.6% dividend yield over the next three years (Bloomberg consensus) vs. Sainbury's on 4.8% and Tesco on 3.0%. We see a deep value opportunity here and as a result upgrade to Buy from Sell on a relative basis with a 12-month price target of 207p.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.