Real Estate Insight UK supermarkets - is the pessimism overdone?

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1 Real Estate Insight UK supermarkets - is the pessimism overdone? February 2015 The document is intended for institutional investors and investment professionals only and should not be distributed to or relied upon by retail clients.

2 Introduction Simon Kinnie Head of Real Estate Forecasting UK supermarkets have come under significant pressure lately, resulting in pessimism among investors over the sector s prospects. We believe current issues are caused by a combination of structural factors affecting both demand from consumers and the future supply of supermarkets. In this paper, we examine the changes taking place and outline their impact on real estate. We then give our outlook for the sector and provide recommendations on future strategy within our real estate portfolios. Executive summary Current dynamics within the supermarket sector Food retail sales are trending downwards, while stagnant demand and falling inflation are putting pressure on food retailers volumes and margins. Discounters are increasingly taking market share. This process has been ongoing but there are limits to the amount of market share they can take because of their smaller store size and limited stock. Shopping habits are changing, as time-pressed consumers no longer make a large weekly shop. Instead, they are purchasing frequently and often from four or five outlets. As a result, convenience stores are increasingly popular but this is cannibalising existing store sales. Some food retailers (particularly Tesco) have pioneered internet retailing but this has involved a large upfront infrastructure cost. Furthermore, this channel is very low margin as consumers are reluctant to pay enough for delivery to make internet retailing profitable. The largest stores and hypermarkets (again Tesco) are most vulnerable to these changing dynamics. Many are attempting to reinvent themselves as destination centres by allocating space to non food offerings such as leisure, services and catering. Impact on real estate Despite long-term outperformance, returns from supermarket real estate have fallen sharply. Supermarkets have maintained property yields at close to their historic lows, making current pricing levels unattractive. Real estate transactions involving supermarkets have fallen sharply over recent quarters. There is still a large construction pipeline that supermarkets cannot switch off quickly because of long development lead times. Conclusions and recommendations From a real estate perspective, relative returns from supermarkets will be lower than other sectors while the strong growth environment persists. However, given their defensive characteristics, supermarkets should provide reasonable returns in falling markets. Given the weak fundamentals, we expect modest rental growth in the sector and prices to fall as real estate investors take account of the unappealing outlook. However, pricing is unlikely to slip too far given the long leases and inflation-linked income for a significant proportion of the assets. For funds aiming to outperform a UK real estate benchmark, we propose moving to a very light position for supermarkets with rents on an open market review.

3 Current dynamics within the supermarket sector There are a number of structural factors currently affecting the UK supermarket sector. In this section, we examine the main issues. Pressure on food sales An examination of recent food sales data shows the extent to which major supermarkets are struggling. Food retail sales continue to trend downwards, coming under pressure from intensive discounting and muted inflationary pressures (see Chart 1). Non-food retail has revived somewhat recently but internet retailers such as Amazon have raised their game over the last few years, making it increasingly difficult for food retailers to compete. Hence, hypermarkets with a large non-food offering remain most vulnerable to continuing sales decline. Chart 1: Grocery retail market share 7% 6% 5% 4% 3% % p.a. 2% 1% 0% -1% -2% -3% to date All retailers Foodstores All non-food retailers Source: ONS In addition, Chart 2 clearly illustrates a sharp fall in like-for-like sales for the big four food retailers (Tesco, Asda, Sainsbury s and Morrisons). In contrast, discounters and high-end food retailers continue to increase sales and market share. Chart 2: Supermarket like-for-like sales 2013/2014 Morrisons Tesco Sainsbury's Asda M&S Food Waitrose Lidl Aldi -10% -5% 0% 5% 10% 15% 20% 25% 30% Like-for-like Total Sales Change % pa 2013/14 Source: PMA

4 Stagnant demand and falling inflation Demand is a function of consumer confidence and average earnings. Despite an improving economy, relatively flat volumes suggest that consumers continue to buy the same amount of goods. As earnings improve and consumers become more confident, we would expect volumes to pick up. However, given that food purchases are a necessity, any pick up is unlikely to be significant. Chart 3: Grocery store volume and value of food sales Index points (2011 = 100) Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct Amount spent Quantity bought Store price inflation Source: ONS Meanwhile, UK retailers have passed on significantly higher levels of price inflation than their European counterparts over the past ten years (see Chart 4). Prices have grown more rapidly for food stores than non-food over this period, although rising commodity prices, such as wheat, have had an impact. More recently, however, the ONS reports that food price inflation has reduced sharply, putting pressure on food retailers volumes and margins. In its latest inflation data, the ONS reported that food prices fell by 1.6% over the last year. Chart 4: Food price inflation across different countries 4.5% 4.0% 3.5% Food CPI, % 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% UK Spain Germany Italy France Portugal Netherlands Average CPI of food and non-alcoholic beverages ( ) Source: Datastream

5 Rise of the discounters After several years of above-normal profits because of the demise of key competitors (Safeway, Somerfield, Kwik Save, etc.), discounters (mainly Aldi and Lidl) have been able to readily enter the market and compete very effectively. Of the big four food retailers, Tesco and Morrisons have been most vulnerable to this mid-market profit erosion. Asda has not been as badly affected as it generally operates on much lower margins than the rest of the sector. Chart 5: Supermarket profit margins Tesco Sainsbury s Morrisons Asda Waitrose Aldi Operating Margin % 2008/9 Operating Margin % 2009/10 Operating Margin % 2010/11 Operating Margin % 2011/12 Operating Margin % 2012/13 Operating Margin % 2013/14 Source: PMA, Company Reports, Retail Knowledge Bank Having improved their offering, discounters have made significant market share gains in recent years. However, they remain a small proportion of the overall UK market (see Chart 6). In addition, they are constrained by space and will have to rapidly open new stores to continue gaining market share at current levels. Arguably, discounters have made the easy gains and the next phase of their growth will involve riskier development and more costly market intelligence as they reach new markets outside their traditional target areas. Furthermore, it is not clear whether ongoing austerity has led consumers to become more cost-conscious. As the economy recovers, this may reverse. Generally, analysis suggests that consumers are much more price-conscious for staples but are willing to spend on luxuries when necessary. The discounters mix of these two types of food retail is attracting savvy shoppers. The big four supermarkets are expected to retaliate with more price reductions of their own but this will impact margins. Projections from the Institute of Grocery Distribution (IGD) reflect the polarisation in prospects at present. They suggest that sales at superstores will grow by 6% from 2012 to 2017 while takings at convenience stores will rise by more than 28%. The IGD also projects that sales for discount retailers will grow by 65% and online sales will increase 97.7% over this timeframe.

6 Chart 6: Grocery retail market share 35% 30% 25% 20% 15% 10% 5% 0% Tesco Asda Sainsbury's Morrison Co-Operative Waitrose Aldi Lidl Iceland Farmfoods Other 12 wks to October wks to October 14 Multiples Source: Kantar World Panel Changing shopping habits In recent years, changing shopping patterns have also affected the sector. Consumers are generally less reliant on one large weekly shop. Instead, they are shopping more often in a larger number of food stores. The number of convenience outlets opened by the big four over the last five years has increased, which has helped accelerate the change in shopping behaviour. An increase in single person households, as well as more price-conscious consumers, suggests this trend is only set to grow. In addition, Chart 7 clearly illustrates the race for space from 2006 onwards, with a significant number of Tesco Metro/Express outlets opening. Chart 7: Number of branch outlets Tesco Extra Tesco S'mkt Tesco Metro / Express Sainsbury s S'mkts Sainsbury s Local Morrisons Morrisons C-store Asda Waitrose S/mkt Waitrose - C-store Aldi Lidl Sources: Retail Knowledge Bank, PMA However, it is no surprise that these convenience stores are cannibalising sales at the big four s other outlets.

7 Online retailing a double-edged sword Online retailing provides both an opportunity and a threat for food retailers. The online channel accounts for approximately 4.4% of overall grocery sales (versus closer to 10% for overall retail sales). Of these online sales, Tesco has around 50% market share, followed by Asda with around 20%, Ocado on 10% and Sainsbury s just below this. Morrisons online offering is marginal. In terms of internet fulfilment, grocers models are a trade-off between efficiency and capital expenditure. At one end of the spectrum there is Ocado, which has a very sophisticated, fully automated fulfilment capacity with dark stores (no lights, no customers, just bays of goods) that serve as distribution hubs. As there is no cross subsidisation, this model is the most expensive and is very low margin because of the investment required. At the other end, there are simply regular food stores where pickers put together orders, which are then despatched to customers. The pick rate is obviously much lower for this model. Range can be a problem if a small store with a limited stock is used but large stores with extensive stock are ideal if they are in a densely populated location. This model continues to evolve and retailers are keen to adopt the continental model where customers pick up the ordered goods themselves. In general, attracting customers online helps engender loyalty and cross selling but at the expense of margins due to the investment needed. Size exacerbates structural factors The largest stores and hypermarkets are particularly vulnerable to the structural factors we have outlined. Within the UK grocery sector, Tesco has the largest current market share followed by Asda, Sainsbury s and then Morrisons (see Chart 8). Together, Aldi and Lidl account for 8%. In terms of store numbers, the big four plus Waitrose have 5,556 branches amounting to 97.5 million sq. ft. The average store size is 17,500 sq. ft. and average sales densities are circa 1,150 per sq. ft. For the discounters, Aldi and Lidl have 1,179 branches totalling 9.1 million sq. ft. and an average store size of 8,000 sq. ft. Sales densities are around 580 per sq. ft. However, both Aldi and Lidl intend to increase their store sizes to 12,000 sq. ft. so stores opening in the future will deliver 50% more space per unit. Chart 8: UK grocery market share 35% 30% 25% % Share 20% 15% 10% 5% 0% Tesco Asda Sainsbury's Morrison Co-Operative Waitrose Aldi Lidl Others Source: Kantar

8 Meanwhile, Chart 9 shows the proportion of space above 40,000 square feet for Tesco, Sainsbury s and Morrisons (data from Asda was not readily available). It is clear from this that Tesco is most exposed to ongoing structural factors and this has been compounded by poor management decisions, such as failed expansion in the US, and mis-statement of profits. This is likely to affect profits and lead to accelerated retrenchment from Tesco s current activities. On the upside, CBRE argues that large out-of-town stores above 40,000 sq. ft. are key to online fulfilment as they have the necessary depth of range and quantity of stock to be used as picking locations. Furthermore, well-located superstores generate the greatest profits and 15 convenience stores would be needed to match the average superstore profit. Additionally, where a hypermarket is under trading, planning regulations are generally flexible, allowing stores to sell different types of retail goods without restriction. This enables the subletting of space to other formats (coffee shops, gyms, travel agents, etc.). Chart 9: Percentage of supermarket space above quoted sq. ft. 40% 35% % of space above quoted Sq Ft (000 s) 30% 25% 20% 15% 10% 5% 0% > 60 Tesco Sainsbury s Morrisons Sources: Mintel, Goldman Sachs Research

9 Impact on real estate As we have shown, there are a number of structural factors at play within the UK supermarket sector. Next, we examine their impact on UK real estate. Downturn in performance First, we look at the performance of supermarkets in a real estate context. Recently, returns from the sector have fallen sharply and supermarkets have underperformed the wider All Property sector despite a reasonable income return. However, on a longer-term view, the sector has outperformed All Property over the last 10 years (by 350 basis points (bp)) and the IPD Quarterly Digest over the years of historical data provided (by 400bp). Generally, supermarkets have performed as expected, producing solid income despite the prevailing environment. In the current growth market, we would expect other sectors to grow more strongly, as is the case at present. Conversely, in falling markets we would expect the sector s defensive characteristics to help provide a solid return. Chart 10: IPD Q quarterly performance 10 Investment Performance Q Supermarket Standard Shop Rest UK Std Shop SE & Eastern Dept / Variety Store Leisure Retail Warehouse Std Shop Rest London Shopping Centre Std Shop Central London All Retail Std Office Rest UK Office City Office Park Std Office Inner S Eastern Std Office Rest London Office West End/MT Std Office Outer S Eastern All Offices Income Return Rental Growth Yield Impact Total Return Average Total Return Std Industrial Inner S Eastern Std Industrial Rest UK Std Industrial London Distribution Warehouse Std Industrial Outer S Eastern All Industrial All Property Source: IPD

10 Unattractive pricing From a pricing perspective, the average yield gap between supermarkets and All Property was around 100bp from 1998 to After 2008, the margin doubled to 200bp as investors placed greater emphasis on the sector s defensive characteristics. Despite the market recovery and increased risk appetite leading to investors paying less for longer lease income, supermarkets have maintained pricing at yields that are close to their historic lows. The deteriorating fundamentals of increased supply and falling demand also compound the elevated pricing. Chart 11: IPD equivalent yields 12% 11% 10% 9% 8% 7% 6% 5% 4% IPD All Property Equivalent Yield IPD Supermarkets Equivalent Yield Source: IPD Weaker investment Transactions have fallen sharply in the supermarket sector over the last few quarters. There were transactions worth just 145 million in Q4 2014, compared to 2,053 million in the 12 months to Q Institutional investors account for 68% of buyer activity; up from 41% in Cross-border activity has fallen from 24% to 13%, while listed/reits purchasing activity is fairly steady at 14%. Elevated future construction Despite the supermarket sector s woes, the construction pipeline for food stores remains sizeable because of the long lead times involved in securing planning, sites, developers, etc. The amount of space under construction in the first half of 2014 was 2.47 million sq. ft., marginally down on 2.95 million sq. ft. in There has been a shift away from hypermarkets but grocery superstore development, some of it out of town, remains buoyant. The ability of supermarkets to halt construction and mothball sites is limited because of contractual penalties. Therefore, this is usually seen as a last resort. However, Tesco recently curtailed development of stores at Chatteris in Cambridgeshire and Margate in Kent. Sainsbury s recently warned that one in four of its stores was underutilised and scrapped plans to develop 40 new stores over the next five years. Industry figures suggest that 60% of the big four retailer s stores are owned rather than leased. Overall, oversupply and lower sales suggests there will have to be significant consolidation, with stores sublet or sold on for other uses such as housebuilding.

11 Chart 12 illustrates the disconnect between the change in sales area over the past five years and the change in sales over this timeframe. In particular, it demonstrates the scale of the problem for Tesco, Morrisons and Sainsbury s. For Tesco, its sales area increased by almost a third over the last five years while sales only increased by 12%. Chart 12: Percentage change in sales area versus % change in sales 250 % change in sales area / sales 2008/9-2013/ Tesco Sainsbury s Asda Morrisons Waitrose Aldi (est.) Lidl (est.) % change in sales area % change in sales Source: PMA Conclusion The supermarket sector remains under pressure because of discounters taking market share, changing shopping habits, issues with online delivery and the rise in convenience outlets. Large hypermarkets are most vulnerable, although they have some potential as hubs for internet shopping. From a real estate perspective, the sector has proven to be a defensive diversifier for portfolios in a low return environment. As the wider property market moves more firmly into growth mode, relative returns have fallen as expected. It is likely that relative returns will be lower than other sectors while the strong growth environment persists. However, in falling markets supermarkets should provide reasonable returns that are not highly correlated to other real estate sectors. We expect only modest rental growth within the supermarket sector, as the prospects are not compelling, with subdued demand and elevated supply that is likely to grow further. However, like other parts of the retail sector, location is key. Therefore, less well-located supermarkets that are not in a dominant location will be the most susceptible to retrenchment. Meanwhile, pricing is likely to weaken because of the poor prospects for rental growth, with reductions most pronounced for poor quality assets. However, pricing is unlikely to deteriorate significantly given annuity funds desire for index-linked income. It is unclear what affect recent changes in pension fund rules (i.e. the change in legislation meaning DC pension schemes will no longer have to buy annuities) will have on demand. Finally, there is likely to be a sharp slowdown in future construction, although this cannot stop immediately so future developments in oversupplied areas may be mothballed after completion. Recommendations We recommend undertaking forensic analysis of the real estate assets we own within the sector to determine location strength, current and future demand levels, and overall resilience. Within our funds aiming to outperform a UK real estate benchmark, we propose moving to a very light position for supermarkets with rents on an open market review. This may involve scaling back underperforming assets but maintaining exposure to stronger assets. These are likely to underperform on a relative basis in the near term but then outperform as the real estate cycle moves past the growth phase.

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