Investors trample UK supermarket sector's green shoots

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* Deflation, competition, rising wages big issues

* Valuations not low enough to be considered attractive

* Investors could be tempted back in early 2016

By Kit Rees

LONDON, Oct (HKSE: 3366-OL.HK - news) 12 (Reuters) - British supermarkets Sainsbury (Amsterdam: SJ6.AS - news) 's and Tesco (Xetra: 852647 - news) have tentatively signaled the worst could soon be over for the battered sector, but some investors are not convinced.

The overall better tone does not detract from big strategic issues still facing the industry: deflation, brutal competition from discounters and rising wages.

"This sector ... doesn't scream out to me as one that's particularly attractive," Daniel Morris, senior investment strategist at BNP Paribas (Xetra: 887771 - news) , said. "It (Other OTC: ITGL - news) 's still under a lot of pressure."

Tesco, Britain's biggest retailer, said last Wednesday it was trading ahead of expectations, with like-for-like sales declines slowing, and late last month Sainsbury's raised its profit forecast.

While praising the improvement, Sainsbury's Chief Executive Mike Coupe acknowledged there was no escaping the "very challenging trading environment and the competitive dynamics haven't gone away". Deflation, which he said was 1.5 to 2 percent in the quarter, was unlikely to abate until early 2016 at the earliest.

"There are too many macro headwinds ... it's an area of the market that we're not compelled to invest into currently," Stephen Bailey, co-manager of the Liontrust Macro Equity Income Fund, said, adding that in any case valuations were not low enough for the stocks to be considered attractive.

Sainsbury's is trading at a price-to-earnings ratio - an equity valuation multiple - of 12.9. Tesco is trading at 21.3 and Morrisons at 15.9, according to Thomson Reuters (Dusseldorf: TOC.DU - news) Datastream.

Britain's FTSE 350 food and drug retail index, which includes three of the so-called 'Big Four' Sainsbury's, Tesco and Morrisons, has fallen 47 percent since hitting a high at the end of 2007. Listed grocers are still trading at sub-2009 levels. Asda, the other 'Big Four' supermarket, is owned by Wal-Mart.

PRICE WARS

A big concern is balance-sheet strength, after some grocers embarked on multi-year expansion sprees leaving them struggling to fight a price war to stem the loss of shoppers to German discounters Aldi and Lidl.

"I think the whole entrance by the German discounters has changed the retail space in the UK for the foreseeable future, so everyone has to accept lower prices and it's a different game now," Peter Garnry, head of equity strategy at Saxo Bank, said.

Aldi and Lidl are the fastest-growing grocers in Britain. Almost half of UK households buying groceries visit Aldi or Lidl every month, market researcher Nielsen (Frankfurt: NSLF.F - news) has said. The Big Four are struggling to claw back shoppers despite Britain's improving economy.

A minimum wage increase for employees aged over 25, set to take effect from April (LSE: 0N69.L - news) 2016, could squeeze margins further as employers may be forced to cut their work force in order to increase staff pay.

Moody's estimates that wage-cost inflation will decrease Tesco's and Morrison's core profit by around 7 percent and 10 percent respectively.

"They still have issues as a sector and those aren't going to go away," George Godber, manager of the CF Miton UK Value Opportunities fund, said, pointing to debt levels as well as the trading environment.

Tesco's debt pile of 16.5 billion pounds remains a worry, while Morrison has agreed to sell its loss-making convenience stores for 25 million pounds in order to focus on improving its core larger stores. The company also reported its lowest profit in nine years in September.

But Britain's economy, the second-biggest in Europe, is robust, which will help bolster supermarkets' investment prospects.

"They are attractive, but probably too early in the cycle to be fully invested," Atif Latif, director of equities & derivatives trading at Guardian Stockbrokers, said, adding that investors were still waiting for a recovery in like-for-like sales over the next few quarters.

Clive Black, head of research at Shore Capital, says while supermarkets do not look attractive in the near-term, investors could be tempted to have another look at the sector in early 2016 if Christmas sales are good.

But he added: "They still have to prove that this journey can be sustained."

(Reporting by Kit Rees; Editing by Susan Thomas)