It used to be safe to depend on the firms resident in the supermarket sector as reliable, cash-generating dividend payers. Companies such as Sainsburys (LSE: SBRY),Morrisons (LSE: MRW) and Tesco(LSE: TSCO) were defensive to the core. When we invested in such companies, we didnt walk around buzzing from the adrenalin rush but we did sleep at night.
Unexpected bungee jumping
Supermarket defensives have shot us full of stimulants for all the wrong reasons lately, as profits plunged pitching share prices into an unwelcome bungee jump. We didnt sign up for this, goes the universal cry, but discounting competition is changing the rules of the game we wanted tiddlywinks, not extreme sport!
One popular investing strategy is to seek out unloved and out-of-favour sectors and companies with dwindling valuations due to lack of interest, or because of short-term operational challenges. Such a contrarian approach can pay well for the patient investor if a sector becomes fashionable again, or if an individual firm overcomes its temporary setbacks and valuations once again rise.
No doubt, the plunging share prices in the supermarket sector this year seem tempting to those wondering if a profit recovery is possible in the sector. Tempting to some, maybe, but not tempting to me.
Naturally, the supermarkets on the London stock exchange are doing everything they can to hang on to market share and maintain profits. For example, Sainsburys aims to improve quality and reduce prices with its food products, and to balance such lower-margin turnover by growing non-food business. Meanwhile, Morrisons is slashing the prices of 1,200 products, finding 1 billion in cost savings over three years, improving the layout of big stores, and investing in the opening of 200 convenience stores. Then theres Tesco. What can I say about Tesco? The firm is surely changing just about everything about how it goes about its business!
These are desperate measures, but price slashing does not make a profit recovery. If we are lucky, cheaper prices may stem the flow of market share to competitors, but Im not holding my breath in anticipation of such an outcome. Then theres diversification to non-food retailing. The trouble with that is the non-food space is already crowded. Maybe such a switch of focus wont end up being as cash-generative as hoped if it ends up as cutthroat as food retailing.
Sainsburys, perhaps the most respected and slickest operator in recent years, sounds a powerful warning:
We expect supermarket like-for-like sales in the sector to be negative for the next few years
Morrisons reckons the sector faces:
a period of intense industry competition and structural change
Tescos new chief executive sums conditions up like this:
Our business is operating in challenging times. Trading conditions are tough and our underlying profitability is under pressure.
The sector walks into powerful headwinds and such a weather circumstance is not the ideal metaphorical trading condition for a recovery play. These supermarkets present with a broken business model in my view things may never be the same again.
Why the supermarkets are no longer safe
Any improved profitability in the sector seems to depend on establishing new lines of business rather than reinvigorating food retailing. To me, food retailing seems like a busted flush worthy of a struggle to maintain breakeven or meagre profits rather than an area likely to deliver the cash flow it once did.
So, we are looking for growth in new areas to drive the share prices of the supermarkets back up. Seeing such high-volume, low-margin enterprises as growth firms is a stretch to far for me. Meanwhile, theres the threat of further attrition from the supermarkets old business model as we go into 2015 and beyond.
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Kevin Godbold has no position in any shares mentioned. The Motley Fool UK owns shares of Tesco. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.