Can J Sainsbury plc And WM Morrison Supermarkets PLC Survive The Aldi & Lidl Onslaught?

The supermarkets have been caught in the perfect storm this year as discounters, stagnant wages and rapidly changing shopping habits shattered the defensive image of the entire industry.

Sainsbury’s (LSE: SBRY) and Morrisons (LSE: MRW) have seen their share prices crash 39% and 33% respectively this year.

In my view, the supermarkets must shake up their offering fast or risk losing even more customers to the discounters. A determined and precise strategy is needed to turn their fortunes around, but planning and executing a change of direction for such massive companies is not an easy task. I expect it will take significant investment and time to have a positive impact on such massive portfolios of stores.

Worse still, there is no guarantee a strategy will pay off. There is no room for error here.

Have Sainsbury’s and Morrisons got it right, or are dodgy strategies dragging them underwater?

Unclear Messaging And Late To The Party     

The big four have often been criticised for complicated BOGOFs and other offers, and you’d think the exodus of customers to the simply priced discounters might have finally pushed the message through to management.

But old habits die hard, and incredibly Morrisons has managed to put together one of its most confusing offers yet to challenge the discounters.

Enter the “Match & More Loyalty Card.”

At the checkout, you present your card and your shopping is compared to the competition. If it is more expensive, you are refunded the difference in points that can be redeemed in-store (but not for cash). It sounds okay on the face of it, but dig a little deeper and the weakness of this offering is obvious.

As Aldi’s fantastic advert recently pointed out, the card should really be named the “charge more and refund” loyalty card. After all, why go through all that hassle when you could just buy cheaper goods in the first place?

The company has slashed prices, too, and was the first of the big four to do so. It has pledged to invest £1bn into cutting prices over three years, but the supermarket still lost a further 3.2% of sales in the last 12-week period monitored by Kantar Worldpanel, the most of all the big four.

Even more disconcerting is that Morrisons does not have a meaningful presence in either the convenience or online markets, the fastest growing areas available to the supermarkets. They opened 90 convenience stores in 2014, but when compared to Sainsbury’s, who has over 650, or Tesco, who boasts 1,867 stores, it is instantly clear that Morrisons is not a competitor in this field.

Similarly, turning up years late to online ordering is absolutely unforgiveable in my eyes. They are trying to redeem this obvious error now but for me it is too little too late. I simply don’t have much faith in the management.

Taking On The Discounters

Sainsbury’s, too, saw sales fall in the last 12 week period reported by Kantar, but only by 1.8%.

17% growth at its convenience chain certainly supported that figure, and proves that Morrisons is missing out on a good thing.

But Sainsbury’s trump card against the discounters is its joint venture with Danish discount chain Netto, which will take the battle to Aldi and Lidl’s home turf. Initially testing the waters, only 15 stores are planned to open at the moment, but expansion could be rapid if successful.

The discount market already accounts for £10bn in annual sales in the UK and is forecast to double in the next five years, so alongside its convenience and online offerings Sainsbury’s seems well positioned to resume growth if it can arrest the sales decline in its main stores.

This seems a good move for Sainsbury’s, whose customers are often willing to pay a bit more for quality than the other supermarkets, leaving less scope for price cuts in its large supermarkets.

Instead of just attacking prices, Sainsbury’s has invested in the quality of 3,000 of their own-brand products. This further differentiates them from the competition of Tesco, ASDA and Morrisons who are battling it out in a race to the bottom.

Unfortunately for shareholders, Sainsbury’s cut its dividend recently to pay for £150m of further discounts. Dividend cover is now fixed at twice underlying earnings. Once the expected fall in profit is calculated then, the dividend is worth roughly 10p per share next year, or a yield of around 4.5% at current prices. This is a considerable and disappointing drop from the 17p paid this year.   

The real problem with paying out a percentage of earnings is that the dividend is susceptible to swings in profit. As we have seen recently with Tesco, supermarket profits are anything but assured these days, especially as the ongoing price war squeezes margins and so investors have no certainty about what they will receive.

At least this cut will afford management extra breathing space as they are no longer hamstrung by large pay-outs. It is probably prudent given the situation Sainbury’s finds itself in. Morrisons also looks unlikely to sustain its dividend, with this year’s 7.8% pay-out only covered 1.1 times by earnings.

Personally, I think Sainsbury's looks likely to outperform Morrison in the future, but I am going to avoid the sector altogether. Investing while such strong headwinds exist just doesn't make sense to me. I prefer to find seriously strong companies in growing industries to look after my hard-earned cash.

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Zach Coffell has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.