Spaced out

The grocery sector is at the centre of a perfect storm as food retailers engage in the biggest expansion war in their history and which in the long term will hit returns and like-for-like sales.

This is the opinion of Evolution analysts Dave McCarthy and Andrew Porteous, who last week downgraded Tesco, Sainsbury’s and Morrisons, sending food groups’ share prices tumbling.

McCarthy argues that while the new space race is “not as obvious or as high profile as a price war, the long-term effects of lower returns and weaker like-for-likes are more severe, and are harder to reverse”.

With more capital investment and slower growth, and consumers still under pressure, industry returns will take a hit, he says.

Evolution’s research points to food retailers’ likely addition of more than 25 million sq ft gross over the next four years. The big four, the broker says, are accelerating openings and plan to add about 5 million sq ft a year - up from 3 million sq ft per annum in recent years.

Up to 2014, the big four grocers will open about 18 million sq ft of net new space, and the remainder will be taken by smaller retailers such as Waitrose, Co-operative Group and hard discounters Aldi and Lidl. At the same time grocers and online-only specialists are adding ‘virtual capacity’ through internet operations.

While Evolution’s note was branded “hysterical” by one broker, the research has opened up the debate about whether the grocers’ thirst for space growth will end up cannibalising their own sales.

McCarthy estimates the big four need to add about £20bn of sales to get a double-digit return on the 18 million sq ft of net new space. He says: “This looks unlikely, but it is hard to see how this war will stop.” He points out that the last time the industry faced a similar, if less severe, situation was in the early 1990s when, he says, most grocers eventually curtailed their openings as the recession hit. But, he says: “Tesco outsmarted the competition, accelerated its openings, and took advantage of competitor inactivity”.

Altium Securities analyst Philip Dorgan says lessons from the past form part of the reason all the grocers have laid out plans today. “When Archie Norman [then running Asda] said there was too much space growth in the 1990s he turned out to be wrong, and that is part of the reason Tesco became market leader. While Tesco’s position is not under threat today, the rest of the grocers don’t want to be left behind,” he says.

But the situation was different in the 1990s, says Oriel Securities analyst Jonathan Pritchard. Then the big four had about 45% market share, and now they account for 75% of the market. “Today there is a limited amount of real growth in food retail and there isn’t the same amount of market share gains to be had,” he says.

Retail indigestion

McCarthy says he is not predicting saturation, but rather that “when high sales density space comes on stream faster than demand is growing, there will be, at the minimum, indigestion with weak like-for-like sales and disappointing new store performance”. He adds: “Indigestion is particularly noticeable when there is less soft market share to go for.”

According to Verdict, food and grocery spending as a percentage share of total retailing is on the increase. In 2010 the percentage is 42.7% and is expected to reach 44.2% in 2014. One analyst says: “People are not eating more but there is a trend for food with more provenance, more fresh, more cooking from scratch, so spending on food will continue to rise.”

Shore Capital analyst Clive Black says the headline figures will not accurately reflect reality, with many retailers not realising their plans. “There are only two retailers we feel very confident will add substantial amounts of grocery space over the next three to five years, and they are Tesco and Sainsbury’s,” he says. “They both have sizeable, committed land including extensions and will no doubt meet their targets.”

Others will open more space, he says, but the picture is more complex than it may at first appear. He points to Asda, which will convert Netto stores to smaller Asda supermarkets - that space is not new to the market although it is to Asda. And Aldi and Lidl have formerly given “big headline numbers” but they “haven’t grown that much”.

“If you cut beneath the aspirations and rhetoric and look at the actual amount of space committed, you get two very different figures,” adds Black.

However, McCarthy notes: “Tesco and Sainsbury’s account for more than 70% of the big four openings,” and argues he may have understated the rest of the grocers’ plans, so “we could see more space opened than we have listed”.

Another analyst maintains, however, that building and land costs have come down “considerably”, therefore the return on capital will be higher. The analyst also points out that much of the new space is recycled - Netto is one example, as were the Somerfield stores that were either rebadged as Co-op or sold to other grocers.

One grocer also told Retail Week that when the sales densities of the UK are compared with other countries such as the US, Germany and France, the UK is underserved by the food retailers.

Areas of opportunity

Verdict senior analyst Malcolm Pinkerton agrees. “The market is not yet saturated,” he says. “There are some towns that are not served by more than one supermarket and there are pockets of the country that don’t have one of the grocers. For example, Sainsbury’s doesn’t have that many stores in the North, and Morrisons is weak in the South.”

Some argue also that the grocers’ growth is predominantly in non-food, so they will not cannibalise existing grocery stores. Dorgan says: “There may not be much scope to take share from each other, but there is opportunity to take share off the traditional non-food retailers.”

Black says about half of the new space from Tesco and Sainsbury’s will be dedicated to non-food, and “the guys that have to be worried are the general retailers”.

One analyst also says that as Tesco, Sainsbury’s and Asda are concentrating on non-food space, the most vulnerable could be Morrisons, which is “ignoring non-food”. The analyst says that on the surface, if volumes are flat, inflation“>inflation is only about 2% and the big four keep adding space, they will open stores faster than the market is growing, hitting returns. But, he says, the addition of non-food makes this space different, and therefore does not affect every competitor. “Whereas Tesco will have the highest returns, Morrisons is most vulnerable due to its lack of diversity,” he says.

Pritchard also points out that Morrisons may struggle due to its “lack of diversity” and adds: “We are one of only two bears on Morrisons at the moment, but we won’t be only one of two in six months’ time.”

McCarthy acknowledges non-food is increasing and “the non-food retailers will suffer” but maintains that “food space is the biggest and fastest element of new-space growth”. He says the “battleground is moving back towards food”. In 2008 food accounted for 50% of new space, while in 2012, the figure looks set to rise to about 57%. The issue of whether convenience stores should be included as food shops is also a moot point. One analyst says convenience provides a “separate shopping trip” and therefore doesn’t add to the food market in the same way as a supermarket.

McCarthy argues convenience stores are part of the food market. “Tesco and Sainsbury’s have moved aggressively into this market, and in some ways convenience stores can be complementary to larger stores,” he says. “But at the end of the day, convenience stores sell food and while they do not compete for all shopping trips, they compete for some.”

Limited convenience

McCarthy also says Tesco is reining back its growth in convenience this year, and Asda and Morrisons do not yet have this format, so convenience accounts for only about 15% of the total net new space and “this proportion has remained flattish for several years despite total space growth accelerating”.

The growth of online shopping is also seen by some as a sign grocers do not need as much physical space. One analyst says: “Online is growing and there isn’t perhaps the need for so much store space now.” Black argues, however, that online will always remain a small proportion of food sales, and “if everything was bought online you wouldn’t be able to walk down the street for vans”.

Pinkerton says online will remain complementary to stores, although grocers will become more multichannel. “Retailers will have to be a lot more flexible in giving shoppers options of home delivery, click-and-collect and the ease of online shopping, but physical stores will always take priority especially for food as shoppers like to pick fresh products,” he says.

Opinion is clearly divided about whether the space race will hit returns, but it is unlikely that the grocers will stop opening space. Tesco’s competitors remember only too well how it leapt into first place after buying up land in the last recession. They will not want to get their fingers burnt again.