Tesco PLC (LON:TSCO), WM Morrison Supermarkets PLC (LON:MRW) and J Sainsbury PLC (LON:SBRY) are set to benefit from easing inflation and a more supportive consumer outlook, according to Jefferies.
The UK's biggest supermarkets were last year hit by a weaker pound following the Brexit vote, which pushed up input costs and prompted hard-hit consumers cut back on spending.
The grocers were also affected by rising competition from discounters Aldi and Lidl.
“A year later £/$ has rallied by well over 10%, CPI (consumer price inflation) has likely peaked and a number of commodity inputs are seeing rapidly moderating inflation,” Jefferies said.
“In addition, whilst sustained levels of wage increases will remain a feature, the industry has widened the premium it pays relative to the living/minimum wage from 3% two years ago to 5% now.
Jefferies said lower inflation and a higher minimum wage should improve disposable incomes, meaning UK consumers will be "less challenged".
It added: “Elsewhere, discounters' new store applications have dropped by 25% in the past two years, and reduced trading down by consumers should become a more likely scenario.”
Morrisons is Jefferies top pick
Jefferies thinks Morrisons is best placed for outperformance as inflationary pressures ease after being the most affected by sterling weakness in its food business.
The broker raised its rating on the stock to ‘buy’ from ‘hold’ and lifted its target price to 265p from 225.50p.
READ: Morrisons to slash 1,500 management roles and focus on customer service
Jefferies noted that Morrisons has had less power than its peers to push back against suppliers’ demands for price increases since one fourth of its sales are internally sourced.
But the grocer has made progress in addressing this issue by internalising parts of its supply chain, most recently by purchasing free range egg supplier Chippindale Foods.
It has also lifted its minimum wage and bonus pool to improve its attractiveness as an employer.
“We believe Morrisons made significant inroads in its price relative position in 2017, and this should be a helpful lead indicator for LFL (like-for-like sales) performance in 2018,” Jefferies said.
Tesco-Booker deal expected to lift margins
Jefferies also increased its rating on Tesco to ‘buy’ from ‘hold’ and hiked its target price to 250p from 208.60p following the supermarket’s £4bn takeover of wholesaler Booker Group.
READ: Tesco completes £4bn takeover of Booker after getting shareholder approval last week
It expects the deal will boost margins and deliver cost synergies of £105mln in fiscal year 2018/19 and a further £60mln in 2019/20. The deal will also increase Tesco’s talent pool and expand its target market, Jefferies said.
However, Jefferies said it was less optimistic than most analysts that believe Tesco’s margin guidance of 3.5% to 4% will be achievable as a stand-alone company.
“But Booker's accretion can swing the cashflow dial sufficiently to justify a Buy upgrade (and in the near term paper over any concerns we may have on investors being over exuberant on stand-alone prospects).”
Sainsbury’s Argos withstands Amazon pressures
Jefferies left its rating on Sainsbury’s at ‘hold’ but raised its target price to 270p from 256.50p, saying the company’s integration of Argos is progressing much better than it had expected, considering higher input costs and weakening demand in the latter part of last year.
READ: Sainsbury’s lifts full-year profit guidance after record Christmas sales
It said Argos, unlike many other peers, has so far been able to withstand the pressures from Amazon’s rapid expansion.
However, the catalogue retailer is let down by a much inferior website interface than Amazon, Jefferies said, adding that its sales remain vulnerable to shortfalls in big-ticket spending in the UK.