How are the supermarkets shaping up for Christmas?

December is here, and the festive season usually means a loosening of the purse strings. For a typical UK household, we spend on average close to £740 more in December, almost a third more than a normal month. 

A good chunk of that goes on buying things like music equipment, clothing, and electronics. But we also tend to eat and drink more. Spending on food and alcohol rises by an average of 20% and 38% respectively. That makes this time of year an important opportunity for supermarkets to bolster their sales and take market share.

But not all supermarkets are the same. Competition is at a fever pitch, so this Christmas is even more important. In this article, we break down the threats and opportunities of three of the UK’s biggest supermarkets.

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Ocado

When Ocado launched 20 years ago, it challenged the legacy bricks and mortar supermarkets, with its online-only offering. And what sets it apart is the cutting-edge technology that drives its fleets of automated packing ‘bots’.

Ocado Retail, which is 50% owned by M&S, is the online shopping arm, which uses the group’s Ocado Smart Platform (the bots) and distribution network to deliver groceries. As an online-only operator, it was well positioned for lockdowns and saw sales boom. Even today, only 14% of the UK grocery market is online which presents a significant opportunity for growth.

That said, recent events have unearthed some weak spots in the Retail proposition. A fire at one of their fulfilment centres, which lost the group around £35m of revenue, put a hefty dent in third-quarter performance. While labour shortages and rising wages are also weighing on the bottom line. 

The Retail business is important, but the real story moving forward lies with their Solutions business. Solutions charges third party retailers to use the group’s robotic systems. Conditions, in theory, can’t get much better. Lockdowns have forced retailers to invest in the kind of technology Ocado built its name on.

But this comes at a significant cost. Ocado’s putting up hundreds of millions to fund new Customer Fulfilment Centres (CFCs). Trying to strike while the iron’s hot, planned spending here has already been raised as the group tries to build as many CFCs as possible.

Capital expenditure (£millions)

Source: Refinitiv, 04/12/2021.

With the ten partners they currently have, the Solutions business is struggling to generate profits. Pressure’s on to bring more partners on board. With net cash at the half year mark of £188.5m, the balance sheet looks healthy for now. But if things don't go to plan, we can't rule out Ocado asking investors to open their wallets again. 

It’s tricky to nail down how much increased demand from the last 18 months is here to stay. If the group can deliver a strong festive period, it should help keep investors happy. But with a price to sales ratio some way above its long-term average, any performance wobbles could be felt in the share price.

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Sainsbury

Competition between supermarkets is as hot as ever. Aldi and Lidl offer cheaper alternatives, then there are more upmarket offerings like Waitrose, M&S Food and Ocado. Sainsbury has traditionally been positioned somewhere in the middle.

Groceries are very much the bread and butter. And the group’s been reliant on discounted prices to boost sales. The online offering has improved and been a positive driving force for sales, but increasing online capacity comes at a fairly heft price tag. It’s not the only supermarket chain to face hefty bills over the last 18 months, but the issue for Sainsbury is that its margins were already a little thin, partly because of those discounted prices. Underlying retail operating margins were 2.4% before the pandemic.

These days Sainsbury owns Argos. The pandemic accelerated the group’s efforts to transform the store estate, and now just north of half of all Argos stores are in a Sainsbury’s. It makes sense on paper, and with Christmas approaching it's attractive to be able to pick up your groceries and Argos orders at the same location. But there are huge costs involved, which makes execution risk a factor.

The acquisition increased Sainsbury’s reliance on general merchandise, now 21% of retail sales. It makes the group more exposed to discretionary spending. And we’re starting to see lockdown-friendly electrical and household items get removed from shopping lists. Leading to a fall in sales of 5.8% at the half-year mark. 

First-half general merchandise sales (£bn)

Source: Company interim results.

The Argos transformation is expected to reduce costs by £105m when it’s complete, which will be a boost to margins. The balance sheet looks in decent shape to keep funding the restructure, and a prospective dividend yield of 4.3% is on offer. But there’s a lot to be done before plans turn to profits.

Remember, yields are variable and not guaranteed.

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Tesco

There’s not much new or fancy about Tesco’s business model. Retail sales in the UK and Republic of Ireland make up the bulk of its revenue. But that’s not necessarily a bad thing when you’re a market leader. And the group has all the benefits that come with massive scale.

Supply chains around the world have come under increasing pressure, and that’s one area where Tesco stands above the rest. It has deep roots. Strong, varied, supplier and distribution relationships mean shelves have stayed pretty well stocked. And that’s key in the coming festive period.

The real growth story moving forward comes from the online service. The pandemic forced traditional retailers to accelerate any plans they had to strengthen their online offering. Tesco, so far, has executed well. The group’s fulfilling 1.3m online orders a week in the UK, equalling 14.6% of UK total sales. A big leap from where they were a couple of years ago.

First-half orders per week (millions)

Source: Tesco interim results.

The biggest question mark moving forward is one of competition. The grocery space is rife with competitors all trying to grab market share. The tricky thing to get right is being able to offer low prices to keep Aldi and Lidl at bay, while maintaining brand quality. And as companies try to undercut each other on pricing, margins get squeezed.

Overall, we think the group’s well placed. Sales have been strong and Tesco’s existing scale means there’s a genuine opportunity in the online space. The return of free cash flow adds weight to the prospective dividend of 3.8%, too. Of course, no dividend is ever guaranteed, and with Covid-19 uncertainty picking up, that’s especially true at the moment.

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Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Past performance is not a guide to the future. Investments rise and fall in value so investors could make a loss.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research disclosure for more information.

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