Interactive Investor

The supermarket shares to buy and sell

30th April 2015 12:48

Lee Wild from interactive investor

It's been an awful two years for the supermarket sector. German discount stores and increasingly disloyal customers have made life incredibly difficult for the big three listed. In fact, none of the CEOs in charge back then have survived. But the sell-off appears to have run its course and, following extensive research, one analyst has drawn up a comprehensive list of their favourite and least-favourite grocers.

"The earnings outlook for the European food retailers is better than it was," writes Andrew Gwynn, an analyst at UBS. "We see two key forces at work: (1) the price competition that has dogged the sector should ease as the grocers become more rational, and focus on differentiation and price perception; and (2) space opening is slowing. Combined with some early signs that the discounters are becoming capacity constrained, we are particularly positive on the UK."

Overall, UBS forecasts are in line with consensus estimates, and the sector valuation is not far off its 10-year average, largely due to a drop in margins and earnings expectations. But Gwynn reckons the UK looks oversold, and believes that a reduction in price competition and capacity limitations on the discounters' growth are clear positives.

And that valuation argument is backed up by data. For the past 10 years, the food retailers have traded at a 10% premium to the market. In recent years, however, the sector has traded at a 10% discount on a forward price/earnings (PE) basis; the switch caused by that weaker earnings outlook. "Though the premium has returned, margin expectations have fallen heavily, implying the market has little confidence in recovery," says UBS.

So, what does the broker think of the Big Three?

"Given our positive stance on the UK, we like Tesco and Sainsbury's, but we think Morrisons needs to invest more than consensus models," Gwynn says. "We think Tesco can recover its UK business and continue to rerate upward from its lows. We think the market is too nervous on Sainsbury's longer-term earnings outlook, and also think it can rerate upwards."

"Though we have a supportive stance on the UK, we think consensus estimates do not leave enough room for Morrisons' new CEO to turn around the business."

In a separate 24-page note, UBS begins coverage of Tesco with a 'buy' recommendation and 260p target price. As well as UK recovery story, the broker reckons there's also the potential for a surprise from a disposal, most probably from Eastern Europe.

Tesco is in the process of selling its data analysis unit Dunnhumby, which UBS thinks is worth £1-£1.5 billion, less than some other estimates. Eastern Europe could bring in £1.4 billion, although it's likely to be sold in parts. Asian operations could be worth billions more.

"We're encouraged that aggressive price investment is not on the agenda for Tesco in the UK," writes Gwynn. "Instead, we see enough oxygen from fixing other parts of the offer plus a better industry outlook as sufficient to allow Tesco UK to recover sales and margins. We initiate with a 'buy' rating and 260p price target."

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.

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