Investment: Should you invest in... food retailers?

KINGFISHER'S surprise pounds 6bn swoop on the food retailer Asda last week cast a light on the food retailing sector, which has been largely ignored by investors over the past couple of years.

The qualities that have traditionally made the supermarkets popular defensive stocks at times of market volatility have simply turned off investors and the sector's problems increased by the investigation by Monopolies and Mergers Commission (MMC) of complaints that they were overcharging consumers.

"It has been a very difficult sector to call over the past 18 months to 2 years," says Alan Perkins of Pavilion Asset Management. "Tesco has produced some very good numbers and is clearly the sector leader at the moment, but if you had stuck with quality and held Tesco you would still have underperformed the market."

Hillary Cook, sector analyst at Barclays Stockbrokers says: "The sector has been ridiculously oversold. Food retailers are not that much different from general retailers, but they have been largely shunned by the market. "The supermarkets have great out-of-town locations and they know their customers extremely well. These are supposed to be the big factors in retailing and the supermarkets are way ahead of everyone else."

Ian Brown of Norwich Union's investment management division says: "Supermarkets certainly wouldn't be my favourite place to invest at the moment. Over and above the MMC question, the major factor affecting the food retailing sector is that the market simply doesn't want to know about these plodding, relatively safe companies.

"Investors decided we are not going into recession and in a recovery there are much more exciting things to put your money into."

Christopher Willmott, director of institutional equities at Hill Samuel, says: "It is a very interesting time for food retailers because if you look at it from the macro point of view you see that demand is not strong but capacity is very strong. What you have, despite strong cash flow, is a sector that is declining and that is not a great scenario for investors looking for growth."

The result has been that the food retailers have been amassing a lot of cash, but have not been entirely sure what to do with it. Ian Brown says: "If you have excess cash you can do one of two things: return it to shareholders, through a buyback for example, or buy something with it. The supermarkets have been investing it in anything and everything they can find.

"In the case of Sainsburys, there have been disastrous ventures in the US, and with Tesco it is the still-to-be-proven investment in Eastern Europe. Supermarket managements are a pretty arrogant bunch and they have not learnt the humility required to hand back cash to investors." But this sleepy sector has crackled into life following the news of Asda's proposed merger with the general retailing group Kingfisher. "What Kingfisher is in effect saying is that MMC's report is not going to be that significant," says Hillary Cook.

"I don't see what the MMC can actually do. It can't tell the supermarkets to cut prices, since there is a high degree of price competition between the retailers anyway and all that would happen is that price cuts would force even more smaller retailers out of business."

Christopher Willmott says: "I would have thought that investors with food retailing stocks should hang on in there. The MMC will continue to create uncertainty but Kingfisher has clearly identified value within the sector and it is unlikely to be the only one."

Ian Brown has misgivings over the MMC investigation. "We do feel for the supermarkets on this one. They seem to have been targeted by a not very competent government minister with an axe to grind.

"The one thing you can say for them is that they are not making monopoly profits. Most are currently showing a return on capital of 12 to 13 per cent which is probably only a couple of points above their costs. Compare that with some of the banks, that are showing an ROC of 25 per cent plus and are getting away with it."

Hillary Cook agrees. "The MMC report has effectively stopped any merging within the sector, such as the Asda/Safeway tie-up which looked on the cards last year. What you may well see is the effective merger of two sectors, as food retailers and general retailers come closer together."

And Ian Brown points out that this process was already developing, even before the Kingfisher/Asda tie-up. "You could say that they definitely are defensive stocks, although not as defensive as they used to be. For example, a material chunk of Asda's business is already non-food retailing, which is cyclical, and, therefore, will be affected by economic conditions but will offer growth prospects at some point."

Christopher Willmott says: "The food retailers have always found imaginative ways of taking money out of your pocket. They have been trying to expand sales into the `grey market' and develop financial services and other associated services that will be driven off their existing asset base."

Hillary Cook sees two possibilities for further M&A activity. "There are two possible sorts of bidders, UK- based general retailers or overseas retailers. It has been often rumoured that Wal-Mart was looking at Asda and it may be that Asda decided to go with Kingfisher on a `better-the- devil-you-know' basis.

"It is still possible that Wal-Mart is looking around for a UK acquisition and last week's news will either flush out a higher bid for Asda or prompt it to go for another target, like Safeway." In fact, Wal-Mart undertook a major fund raising denominated in euros early last week, which gave further substance to this theory.

Alan Perkins says: "Prior to Kingfisher's move, there was a lot of speculation about Asda being the subject of a bid either from the German retailer Aldi or from Wal-Mart of the US. I think that there is definitely going to be some rationalisation of the sector, although the best in the sector, Tesco, is probably safe as it is so good at what it does.

"The obvious candidates for a takeover would probably be Safeway or one of the smaller retailers, such as Somerfield. But an overseas buyer may well look at Sainsbury which I would now say is a definite potential target."

Christopher Willmott believes the Kingfisher/Asda deal will both limit Safeway's options, because it removes Asda as a potential suitor, and also challenge Tesco's predominant position in food retailing. "The important question now is `what is going to happen to Tesco'?" he says.

"Tesco has been very explicit in expanding primarily into Europe whilst also expanding its market share in the UK. It was doing this very successfully until last Friday, with the Asda announcement, so there is likely to be more of a question mark over Tesco's ability to expand than there has been."

The creation of a new retailing giant will be felt throughout the sector. "The Kingfisher/Asda move puts Sainsburys in a difficult position as well, following its own trading statement last week," Willmott adds. "I would argue that Sainsburys' proposed solutions are not as comprehensive as they should be. It will be interesting to see what they end up doing, but if they are going to link up with someone else it is almost certain to be with an overseas partner."

Alan Perkins says: "The sector is still undervalued as a good business area with much quality management. If you are an overseas company wanting an acquisition, you would buy a quality business, like an Asda or a Sainsburys, rather than a Safeway or a Somerfield, because you would have the right management already in place."