There are three main drivers of a food retailer's P&L (profit and loss): sales growth, gross margins and costs. The Oriel view is that sales growth will remain very strong this year: the consumer is coming back, and so is inflation. Cost increases have hurt in the past months, but at least some of the pressure is starting to annualise.
So, with two out of three boxes ticked so far, will gross margins spoil the party and hold back profit growth? We don't think so. We see more positives than negatives on gross margins and consider that the industry is fair set to see some excellent sales-led profit growth for the next few quarters.
So why are we so sanguine on gross margins? Firstly, the changing product mix is most helpful. The UK population is going picnic and BBQ crazy, raiding superstores like a plague of locusts and pillaging all the produce, the nibbly pre-prepared meats and anything they can griddle on the barbie. All these lines run substantially better gross margins than average: great sales are leading to great gross margins.
Secondly, we believe that industry competition is taking a quick pause for breath. We were very un-nerved by Asda's spring-time pricing decisions on lines such as milk, eggs and bananas, but the majority of these price cuts have now been reversed.
Morrisons and Sainsbury are trying to rebuild their P&Ls at present, and while they will never take their eyes off the price ball, it's unlikely that they will encourage a round of margin cutting. We also believe that the same is true of Tesco: we do not expect any pre-emptive strikes from the industry leader. So that leaves Asda as the main potential troublemaker going forward, but we're relaxed: expect guerilla warfare rather than a sustained attack.
And inflation can't hurt either. On non food, where stock turn is lower, it helps more, but even on basic fast-moving food lines, price rises have to help. Further down the chain, inflation will help the food producers too.
So, all in all, we're very encouraged on the prospects for the sector and happy to have more 'buy' recommendations than 'sells' on the food retail stocks. It might just be that it's the recovery players, Sainsbury and Morrisons, that make the most hay while the sun shines, but in a nervous stock market, there are few more attractive sectors into which investors can put their money.