Supermarket Bashing Won’t Bring Food Prices Down

In spring 2020, as Britain was in the grips of the first Covid-19 wave, the country's grocers were lauded as heroes for keeping the nation fed. Fast forward three years, and food retailers have become villains, responsible for ratcheting up prices. In Europe and the US, anti-supermarket rhetoric is rising too.

UK government proposals for supermarkets to voluntarily limit prices on basic food items are particularly unnecessary and unworkable. But the pressure — as well as the continuing expansion of German no-frills food retailers Aldi and Lidl — will keep British grocers from fattening margins as deflation, or at least disinflation, looms.

That's good news for consumers, much less so for investors who have seen profits from the sector shrivel over the past decade. Supermarket returns have suffered their own shrinkflation.

It's easy to see why the UK government might want to intervene. Grocery inflation remains stubbornly high, despite some commodities contracting. And Britain's biggest retailer, Tesco Plc, as well as J Sainsbury Plc and Wm Morrison Supermarkets Ltd., are already cutting prices on essential items such as bread, milk and cheese. The government could claim some of the credit as reductions intensify over the coming months.

But the interference would be misguided.

Supermarkets already battle it out on price for products that matter most to customers. These include the core grocery lines, such as flour, salt and sugar, as well as items in their value ranges, such as basic minced-meat. Margins on essential items are probably 10-15 percentage points lower than the average across the store. Grocers make this up on products that are nice to have, such as pesto sauce, prepared food and top-tier items like Tesco Finest or Sainsbury's Taste the Difference ready meals.

As Stuart Rose, chairman of Asda Group Ltd said, "clumsy" actions could lead to unintended consequences. "Let the shopkeepers do what they do well, shop keep," he thundered last week.

It's certainly hard to pin "greedflation" on Britain's grocers. While the US has some national players, such as Walmart Inc., competition largely depends on how many are present in any local area. French food retail is also fiercely fought with two large private players Auchan and Leclerc SA, as well as Aldi and Lidl too. It's more brutal across the channel in the UK, with strong national chains and the German discounters still expanding aggressively. That Walmart decided to largely exit the UK market in 2020 speaks volumes.

Take Tesco for example. It generated an operating margin of around 6% in 2012. In the year to February 2023, it made an operating margin of 3.9%, according to Bloomberg data. It's a similar picture across the industry after the mainstream supermarkets waged a vicious price war a decade ago as Aldi and Lidl captured more of their sales.

We are now at the point where the spikes in many commodities are reversing, potentially allowing margins to drift higher. It's also worth noting that the UK grocery market has changed since the last time the industry emerged from a bout of inflation a decade ago. Two of the country's biggest food retailers — Asda and Morrison — are in private hands.

With Asda set to add billions of pounds of fresh debt and rental obligations and Morrison struggling, they may be unable to compete as effectively as in the past. Waitrose, part of the John Lewis Partnership, is also suffering from gaps on shelves. Add in Iceland Foods, which has £800 million ($1 billion) of total borrowings according to Bloomberg data after a buyout in 2012, and close to a third of the market may be less able to respond to a price offensive. Tesco and Sainsbury are probably in the strongest position they’ve been in for decades.

They can't get too comfortable as their costs subside, though, with Aldi and Lidl continuing to snap at their heels. The extra scrutiny from the UK government and competition authority only adds to the pressure.

But Tesco, in particular, can benefit from this environment. I’ve argued before that it should start the mother of all price wars to put the heat on Asda and Morrison. To be sure, it has taken action on price, matching Aldi on over 600 lines, promoting another 1,000 and rewarding members of its Clubcard loyalty program with special offers. It has also been at the forefront of recent reductions.

With a market share of 27%, it has the clout to squeeze the big branded manufacturers — another important way that prices can be controlled and as yet out of the sights of government and regulators — to get the best deals for shoppers.

So far, Chief Executive Officer Ken Murphy has been reluctant to begin the assault. There is a danger that any benefits are lost as Aldi and Lidl fight back. Shareholders might also be uncomfortable with the plan. Tesco has begun to return capital to investors and this could be jeopardized.

Yet these are risks worth taking. By getting on the front foot, not only might Tesco be able to wound its heavily indebted rivals and narrow the gap to Aldi and Lidl further, but it may just emerge on the right side of consumers and politicians.