The Guide to Investing in Stocks and Shares

Supermarkets

Dan Tebbutt - A Shareworld Contributor

Supermarkets constitute slightly more than 3% of the FTSE100 by market cap*. Of the listed supermarkets Tesco is the big beast with a market cap of £34bn, with Wm Morrison and Sainsbury trailing at £7.3bn and £6bn respectively. Asda is a subsidiary of Wal-Mart, which means (a) you can't buy shares in it, and (b) it's hard to get data specifically for Asda. In this article I'll be comparing the big 3 listed supermarkets by various financial and operating measures.

Tesco's share of the UK grocery market is 30.6%**, with Asda and Sainsbury fighting it out for second place with 17% and 16.1% respectively. Morrisons brings up the rear with 12.1%. Either this isn't telling the whole story, or Tesco is grossly overvalued.

Looking at Tesco to start with, 30% of their revenue comes from overseas – 16% from Europe and 13% from Asia. They also have a fledgling business in the US which accounts for <1%. Almost a quarter of sales in the UK are non-food. Furthermore, Tesco has a number of joint ventures and subsidiaries that are unrelated to groceries, such as Tesco Mobile, Tesco Insurance, Tesco Personal Finance. Once these are accounted for it is clear that the UK grocery business accounts for only about 50% of Tesco's business by revenue.

By comparison Sainsbury has no international operation, and its only non-retail business segments are the Sainsbury bank joint venture (<1% of profit), and a property joint venture which I assume is just a way of shuffling assets around. It has a substantial non-food retailing operation, but sadly they don't split out their non-food results in their annual report. Correlating Tesco's grocery revenue and market share with that of Sainsbury I think Sainsbury's non-food revenue accounts for 20-25% of total revenue.

The Investor Relations section of the Morrisons website is so badly designed I wasn't even able to find their most recent annual report. Judging by the interim report, about 20% of their revenue comes from fuel, and I saw no mention of any other non-food products, so I'm going to stick with that as their total non-food revenue.

Adjusting the market cap of the 3 listed supermarkets to strip out non-food and international sales, we find that Tesco is valued at £560m per % of UK grocery market share, Wm Morrison at £480m, and Sainsbury at £290m (assuming 22.5% of their revenue is non-food). Still a considerably discrepancy.

Next, let's look at profitability – after all, revenue is useless without earnings. Stripping out property-related gains and losses, Tesco made £2bn in 2009, Morrisons £460m, and Sainsbury £400m. Now we're starting to see why Tesco is valued so highly. It has a P/E ratio of 17, Morrisons 16, and Sainsbury 15. For every pound of revenue, Tesco makes 3.7p of profit after tax. For Morrisons the figure is 3.2p, for Sainsbury it is 2.1p.

There are several advantages to having higher margins than your competitors. You can compete more effectively for new business. You have the upper hand in any price war. When times are tough, you can remain profitable while your rivals go bust, and when times recover you can reap the rewards of a weakened competition.

On the flipside, this discrepancy in margins, and the fact that the market seems to be valuing the supermarkets based on their earnings, means that there are widely diverging Price to Sales ratios in the supermarket sector. Tesco's P/S ratio is 63%, Morrisons' is 50%, Sainsbury's is 32%. If the margins of the 3 supermarkets converged to the same figure, say 3%, and their revenue and P/E ratios remained the same, Tesco's share price would fall 20%, but Sainsbury's would rise 40%.

Another valuation measure relevant to the supermarkets is their book value. Tesco's P/BV is 2.6, Morrisons is 1.6, and Sainsbury is 1.4. It's difficult to know how accurate the book value is, since it's largely based on the purchase price of assets rather than their current value. All else being equal, a low P/BV is good – but so is a high RoE, and given a fixed P/E ratio they are two sides of the same coin: RoE = (P/BV) / (P/E) = E/BV. Tesco therefore have a RoE of 15%, head and shoulders above Sainsbury (9%) and Morrisons (10%). P/BV might tell you what potential a company has for releasing cash from their balance sheet and returning it to shareholders, but RoE tells you how efficiently a company can reinvest earnings and therefore generate growth.

My personal view is that Tesco's higher margins are structural rather than transient – their business model works in numerous other countries, they have maintained their current margins for over a decade, and if nothing else their economies of scale in the UK must give them an advantage over their competitors. It looks like there might be a significant opportunity in Sainsbury if they can raise their margins and free up cash from their balance sheet, but I don't know enough to predict when or if that might happen. 5% of my portfolio is invested in Tesco shares (bought in November 2008 and January 2009 at an average of 340p).

*All stockmarket data is taken from 1/1/10.

**Based on research by TNS Global for the 12 weeks to 29 November.