QUALIPORT
Qualiport Shuns Supermarkets

By Maynard Paton (TMFMayn)
July 15, 2002

"The big supermarket chains are ideal QP fodder", writes Foolish discussion board regular Marklucas1.

I'm not so sure. Here's why.

Supermarket sweep

Here are the major quoted companies in the sector:

Company       Market Value    Share Price     Sales    Pre-tax profit
                 (£m)            (p)           (£m)        (£m)

Tesco           15,619           223          23,653       1,221
J Sainsbury      6,380           330          17,162         630
WM Morrison      2,998           192           3,918         242
Safeway          2,656           252           8,560         369
Somerfield         530           107           4,966          22

Missing from the list is ASDA, which is owned by US firm Wal-Mart (NYSE: WMT).

The investment attractions to this particular industry are:

* Demand for food is steady and stable;

* The growing size of the major supermarkets means many suppliers and smaller competitors can be squeezed, and;

* Increased planning restrictions in what is a largely saturated sector creates few openings for rivals.

Not so stable

Given the sturdy characteristics of the industry, it's surprising to discover that many of the companies involved have given shareholders a tough time.

The last decade has seen:

* Asda nearly go bankrupt in 1991;

* Both J Sainsbury (LSE: SBRY) and Safeway (LSE: SFW) generate earnings in 2002 that were lower than their 1992 efforts, and;

* The purchase of Kwik Save causing Somerfield (LSE: SOF) to record two years of chunky losses.

The conclusion? Just selling food from a superstore doesn't guarantee decent results. Management talent plays a key role. Archie Norman turned round ASDA, while Sir Peter Davis, Carlos Criado-Perez and John von Spreckleson are currently doing their best to perform U-turns on Sainsbury, Safeway and Somerfield respectively.

The shareholder problem is simple -- food retailing is a very competitive sector. Having your rivals sell the exact same goods as you makes it hard to create a sustainable competitive advantage for the long-term. To a fair extent, supermarket boardrooms have to run to keep still. As such, the last few years have seen supermarkets move into clothing and electrical goods retailing, expand their own-label product range, introduce loyalty cards and launch online delivery services. All that on top of consistently overhauling their core food retail operations.

Here's a frightening statistic that highlights the industry's intense competition. Every one of the major supermarkets currently has an operating margin below the level seen in 1992.

Company           Operating margin 
                 2002           1992
                  (%)            (%)

Tesco             5.63          6.76
J Sainsbury       3.81          7.09
WM Morrison       5.40          5.60
Safeway           5.03          7.30
Somerfield        0.60          2.33*

(1994 figure)

Left on the shelf

In terms of suitability for the Qualiport, turnarounds Sainsbury, Safeway and Somerfield can all be left on the shelf. That leaves just Tesco (LSE: TSCO) and William Morrison (LSE: MRW).

Without doubt, Tesco and Morrison are head and shoulders above the rest of the sector. Here are the average rates of growth for both firms between 1992 and 2002:

                            Tesco                  Morrison

Sales (%)                    12.8                    13.4

Operating 
profit (%)                   10.8                    13.0

Earnings per share (%)        6.7                    12.5

Dividend per share (%)       10.3                    20.7

(As an aside, Morrison recently reported its 35th year of unbroken growth in sales and pre-tax profits)

Calculated roughly by using the increase in earnings per share (EPS) and the cumulative amount of EPS retained between 1992 and 2002, Morrison also appear to shade Tesco in the incremental return on equity stakes:

1992-2002                   Tesco                  Morrison

Increase in                                           
earnings per share (p)       5.83                     6.76

Cumulative retained
earnings per share (p)      48.71                    50.41

Incremental
return on equity (%)        11.98                    13.41

Other factors in Morrison's favour are:

* Cash in the bank: Morrison's latest annual figures showed net cash of £115m. Tesco has £3.8b of net debt, although interest payments are covered a reasonable 6 times.

* Scope for growth: At their latest year-ends, Tesco had 729 stores (covering 18.8m square feet) in the UK, while Morrison had 113 UK outlets (covering 4.0m square feet). While Tesco already has a sizeable international presence, the greater opportunity for growth in the more predictable domestic market lies with Morrison.

* Management: This is probably the most important factor. Executive chairman Sir Ken Morrison has run Morrison for 46 years, which, coincidentally, is the age of Tesco chief executive Terry Leahy. Leahy has only been in the Tesco top job for five years. In a sector where boardroom talent is key, plenty of shareholder faith can be placed with Sir Ken and his "no nonsense" approach to delivering "the very best for less".

Summary

If I were to pick a supermarket, I'd go for Morrison. It's a good firm, but unfortunately, it lags a little when compared against the other businesses on the portfolio watch list. Here are a few comparisons with Carptright (LSE: CPR) and DFS Furniture (LSE: DFS), two Qualiport retailers that, like Morrison, have a value-for-money approach to trading.

* Carptright and DFS are market leaders. Carpetright has 22% and DFS has 14% of their respective markets, while Morrison probably has below 5%. Morrison has to compete against two larger rivals with much deeper pockets (Tesco and Wal-Mart) -- not ideal.

* Carptright and DFS have got similarly talented -- but younger -- chief executive 'founders'. Sir Ken Morrison is now 71 years old and the question of succession must come at some point. Lords Harris and Kirkham are both under 60.

* Carptright and DFS have better financials. Both have incremental return on equity levels up in the 70%-plus stratosphere. Regularly paying out a large part of their earnings as a dividend (and in the case of DFS, special dividends) highlights the more asset-light nature of their businesses.

Then there are other companies on the watch list -- such as Johnston Press (LSE: JPR) -- that are very much business 'franchises'. I'd far rather focus on businesses such as these rather than add another where management skills are critical.

In short, Morrison is a good company, but not good enough for the Qualiport.

The author owns shares in Carpetright and Johnston Press.