Citi upgrades Tesco but downgrades Sainsbury and Morrison

Citi has upgraded Tesco to 'buy' but downgraded Sainsbury's to 'neutral' and Morrison to 'sell' as the UK supermarket's big players jostle for position against the fast-expanding discounters in the ongoing industry price war.

Published just before data from Kantar and Nielsen showed continuing revenue weakness in the industry, Citi said that while the UK grocery backdrop remained challenging, it thought Tesco "has the scope to be more competitive, to rebuild its profitability and to repair its balance sheet".

While quarterly sales figures can be volatility, especially over a tougher Christmas compared to last year, the bank believes momentum in earnings before interest and tax (EBIT) is set to increase and, if needed Tesco could sell further assets.

Citi believes the group has "no alternative" but to invest £500m-£700m in price to disrupt the discounters but as they approach a 10-year lows the risk reward profile for the shares is "skewed to the upside", with Citi's new target price on Tesco of 230p.

Sainsbury's is, on the other hand, a "good house in a tough neighbourhood", with an encouraging response in sales volumes from Sainsbury’s recent initiatives that should allow it to ‘manage through’ but leaving Citi forecasting negative like-for-like (LFL) sales and margin erosion for "this year, next year and probably the year after".

Although well-positioned though its premium mass market positioning and London/South of England bias, and with a balance sheet "stretched but not stressed", Citi said Sainsbury is no doubt well aware it cannot afford to sit back in such a cut-throat market and is expected to "go again" with further price investments funded by further efficiencies.

A target price of 265p is cut from the previous 290p, with the rating downgraded from 'buy'.

As for Wm Morrison, Citi's downgrade from 'buy' and cutting of the target price to 130p from 225p reflects the fact that customer numbers and volume trends have yet to turn positive despite it being over half-way through its three-year, £500m plan.

"New CEO David Potts has rightly focused on retail basics and costs but we expect volumes to remain stubbornly negative for FY15E/16E."

With the balance sheet a clear positive, Citi's main worry is that Morrison’s historical virtues of a smaller range and vertically integrated manufacturing provide less of a competitive advantage as rivals restructure their offers to combat the rise of the discounters.