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Price war déjà vu? – look beyond market panic to see a little bit of history repeating

15/09/2014

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

Consider the following excerpts taken from the national broadsheets: “the discounters are moving in at one end of the market ... and some blue-chip suppliers are discounting their premium brands. The supermarkets' middle-ranking, own-label products are looking vulnerable.”

“Tesco, Asda, Sainsbury’s and Morrisons are all lowering the price of key grocery items as they battle for sales. The price cuts are a response to the German discounters Aldi and Lidl grabbing sales.”

Both could have been clippings from the same day, but in fact 23 years stand between them. When the former was printed the Soviet Union still existed and Queens’ Bohemian Rhapsody was set to be Christmas Number One. The ink on the latter dried only two months ago.

As was the case in 1992, when Kwik Save, Iceland and Gateway were in ascendance, in 2014 the ‘hard discounters’ of Aldi and Lidl do pose a real threat. To combat this, Tesco are cutting prices which places its profit margins under pressure. Given these circumstances, it’s valid to ask; what is the likely impact on Tesco and its shareholders?

To determine a floor valuation for the business, we assume that Tesco’s UK profit margins halve from their historic average. Because of its scale (it has almost twice the market share of its closest UK competitor) Tesco's long-term profit margins have been 6%, whereas its peers have been circa 3%. Imagine a pessimistic scenario whereby Tesco’s profit margin in the UK comes down to 3% in perpetuity and that the UK grocery market never grows again. With Tesco’s margins at this level its UK based peers are presumably significantly loss making. Just to be on the conservative side, let’s also assume that margins in Tesco’s European business fall from 6% to 3%. With these considerations in mind, the business will generate operating cash flow of £3bn per year. If we also assume – again conservatively – that capital expenditure remains higher than depreciation into perpetuity, we arrive at a figure of circa £1.2bn of distributable free cash flow per annum. Compare this will the £15.5bn market capitalisation and, in our bearish scenario, the shares still trade at an 8% free cash flow yield, whilst its balance sheet remains robust.

Tesco’s current valuation implies the present tough environment lasts forever, that most supermarkets will make no money and Tesco will never grow its revenues again. To us, this seems like an unlikely triad of circumstances. We cannot know if Tesco’s share price will emulate the stellar performance of the food retailers in the early 1990s. However, 130 years of stockmarket history suggests buying a portfolio of 100 businesses with Tesco’s characteristics will result in significant outperformance over the long term.

Dame Shirley Bassey may well have said it best… The word is about, there's something evolving, whatever may come, the world keeps revolving, they say the next big thing is here, that the revolution's near, but to me it seems quite clear, that it's all just a little bit of history repeating.

Author

Kevin Murphy

Kevin Murphy

Fund Manager, Equity Value

I joined Schroders in 2000 as an equity analyst with a focus on construction and building materials.  In 2006, Nick Kirrage and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Nick and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.

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