Supermarkets have been woven into the everyday fabric of our lives for generations, and as such, the industry can appear to change at a slow pace. For example, Asda – by far the youngest of the big four UK supermarkets – was founded in 1949. While the major players have diversified their operations into new formats like hypermarkets and smaller urban shops, the physical store remains at the heart of the business model.
Beneath the surface, however, the sector is an extremely dynamic early adopter of technological innovation, and the fact that the same brands remain on top reflects their operational excellence and firm grasp of customer behaviour. The level of innovation taking place extends far beyond the self-service checkouts, loyalty schemes and home deliveries with which consumers are now familiar. In recent years incumbent players and new startups have deployed a wide range of strategies to ensure that their businesses run as efficiently as possible and that their margins hold up. From revolutionary supply chain management systems to complex customer relationship management processes, the sector is constantly pushing itself to be able to meet an ever-expanding range of consumer needs.
From an investor standpoint, supermarkets have an obvious attraction. The counter-cyclical nature of the sector makes them a strong defensive option for investors looking to weather macroeconomic uncertainty. Furthermore, management teams’ operational nous provides a high level of assurance and certainty; they are fundamentally well-run businesses. While large operators like Tesco have weathered their share of challenges in recent years, these rarely derail them, and brands typically bounce back quickly and effectively.
From conversations with European players, it is abundantly clear that the supermarket sector came out of the chaos of the pandemic in a relatively strong position. According to Rob Abraham, Managing Director at Atrato 1, the investment advisor to Supermarket Income REIT, supermarkets were “a net beneficiary of the pandemic and the changes to consumer behaviour that it accelerated”. He continues that “while volumes are down on a year ago, this is because the sector was one of relatively few that were open to consumers during the lockdown periods. When compared to pre-pandemic times, supermarkets are up by around 10%”.
Philippe Scheirlinckx, Asset Management & Acquisitions Director at Ascencio, backs this up, saying that “during the pandemic, the supermarkets have been part of those called ‘happy players’ due to the fact that they were part of the few stores that were allowed to remain open. People consumed more of their products because of factors like homeworking, the closure of restaurants, and restrictions to travel”.
This does not mean that the sector is without its challenges. Like all businesses, supermarkets are facing inflationary and supply chain pressures that work to squeeze margins while making it more expensive to service debt and tougher to raise fresh equity. “Most of the supermarkets face a profitability challenge due to rising costs from their suppliers. One of the consequences can be found on the social level: fewer new staff are being hired, which puts more pressure on the existing staff who are already tired after two years of the pandemic,” explains Vincent H. Querton, CEO of Ascencio.
However, one thing that separates the sector from many alternative categories is its ability to deal with the effects of these external factors. Investors point out that supermarkets operate on thin margins and so are ultimately forced to pass on increased costs to consumers through price rises while the volume of purchases consumers make remains stable. Rob Abraham points out that “when you look through the historical numbers over the last twenty years, the correlation between the total grocery market and inflation is around 90%, which demonstrates that the sector is efficient at passing through inflation. Ultimately the sector is defensive and non-cyclical – the place to be right now”.
Supermarkets’ robustness in the face of inflationary and supply chain pressures will be a valuable tool in the coming months. Russia’s invasion of Ukraine is having a catastrophic impact on the global food supply, points out Vincent H. Querton, CEO of Ascencio: “Russia is using its food production as a weapon of war. It will undoubtedly have an impact on the supply chain. Food retailers will have to adapt their offer quickly while consumers will also have to adapt their way of consuming or accept paying a higher price for the same product.”
While supermarkets are forced to pass on inflation to consumers, investors point out that the sector is fundamentally a socially responsible one and is taking great care to support its customers during the cost-of-living crisis. Many are acutely aware of how tough times are for much of the public and are working hard to ensure that groceries remain affordable. Atrato’s Mr Abraham explains that the UK’s Sainsbury’s, for example, is investing GBP 500 million in the prices of essential items and helping customers manage inflation.
The renewed importance of the physical store
At the same time, supermarkets have evolved how they meet consumer demand for groceries by embracing new distribution models. Interestingly, this has had the effect of making the physical store more important than it has ever been to the operational success of key players.
Those unfamiliar with the industry might find this counter-intuitive. There is an expectation that as online retail grows as a proportion of a business’s revenue, the importance of physical retail sites diminishes. This is not the case, however: “There is this perception that large-format stores won’t be needed as the model evolves, yet these stores are actually perfect for online fulfilment and are a cornerstone of the new delivery supply chain that brands continue to build,” says Rob Abraham. He continues that these stores are now “basically operating as distribution warehouses while also doing really good in-store trade”.
This is part of a broader strategy that bigger operators are pursuing to double down on their grocery businesses. Observers will have seen supermarkets try to expand their operations into areas like banking and mobile phone networks in recent years, but many are now streamlining their operations to focus their attention on their true north. The physical store network – working in tandem as a strong home delivery network – is a cornerstone of this. Philippe Scheirlinckx points out that “at this stage, we have not seen any impact on the space needed by the supermarkets”.
The above approach has interesting ramifications for the way operators use their physical assets. One growing trend is for supermarkets to offer space to third-party retailers. Philippe points out that “we see some of our supermarket retailers creating diverse partnerships with certain brands for ‘shop in the shop’ corners”, while Mr Abraham cites Sainsbury’s acquisition of general retailer Argos as a great example of the synergies achieved through maximising efficient use of stores. Bringing diverse-yet-complimentary retail businesses together benefits both parties’ footfall.
Spend any time in a Western European city and you may see fleets of bicycle couriers delivering groceries. New digital-first upstarts – often backed by private equity – are sparing no effort in trying to break into Europe’s multi-billion grocery business. There is scepticism about whether their efforts will land them a seat at the top table, however.
The big supermarkets, Rob Abraham points out, have proven their ability to adapt in the face of competition and remain well-positioned to outmanoeuvre these newer companies. He explains that “the scale of their operations, their investment in product ranges and the strength of their supply chains mean that it costs them much less money to fulfil orders than the rapid grocery players”. This scale enables them to outflank smaller rivals: “During the pandemic, the incumbents doubled down on home delivery. Tesco, for example, grew their online capacity by three times as much as Ocado’s entire delivery volume in just a number of weeks by adding home delivery vans to existing stores,” he says.
Similarly, the model that many of these businesses are offering might be a step too far for many consumers. Ascencio’s Aurore Angbergen says that “most of these challengers are still looking for some profitability, and if they do, it is mostly in large city centres. Not all markets are mature enough for these new means of consumption. For example, Gorillas recently announced it is stopping its activities in Belgium”.
The new financial reality is not ideal for startups either. Rising interest rates and tapering private equity investment are making it harder for these newer businesses to raise funds, which in turn curtails their ability to grow aggressively and reach new consumers. At the same time, their cost bases are rising, making it more difficult for them to keep the cost of their products down. Mr Abraham points out that their products are already an average of 30% higher than their equivalents at incumbent supermarkets – they cannot afford for this gap to increase much further.
In conclusion, Europe’s supermarket sector is in a strong position to overcome what will be a testing few months for the continent’s economy. Its solid foundations, evolving business model, and ability to sail through economic headwinds will help ease investors’ nerves. Furthermore, the sector looks well placed to see off potential threats. This is good news for the real estate industry, with the physical store remaining at the heart of the action.
1 Atrato Capital Limited is an appointed representative of Atrato Partners Limited, Authorised and Regulated by the Financial Conduct Authority (FRN:830613).