Is Tesco's recovery sustainable?

A decade ago Tesco would have been seen as a very dependable share to own. It had built up a dominant position in UK food retailing that looked unassailable and was comfortably more profitable than any of its peers. It had set out to conquer the US market while continuing to grow in central Europe and Asia.

Then came the great recession. While Tesco seemed to come through it well at first, the way people shopped for their weekly groceries was undergoing a revolution that continues to this day. The rise of the hard discount retailers in the form of Aldi and Lidl, with their no-frills business models and very cheap prices, has torn the hearts of UK food retailers and destroyed their profitability. Even Tesco could not escape from the turmoil.

To make things worse, Tesco had to own up to the fact that it had overstated its profits back in 2014. Its venture in the US failed and profits overseas stopped growing. Like its UK peers, it was complacent in its response to the hard discounters and was too slow to change its offering to customers. Many customers deserted Tesco and its profits collapsed.

Tesco has done a good job in rebuilding its profits, but its core UK business – which provides the vast majority of its profits – still faces the continued growth and competition of Aldi and Lidl. Investors still do not know how resilient Tesco’s profits will be, especially in a recession when discounters tend to do well.

Why Aldi and Lidl have done so well

Tesco remains the UK’s biggest food retailer with a 27.4 per cent share of the market according to Kantar WorldPanel, but has been losing market share over the past five years to Aldi and Lidl. 

The privately-owned German discounters have been in the UK since the 1990s but only really started to gain traction with UK customers during the last recession. Since then, their combined share of the market has rocketed.

Source: Kantar WorldPanel

Back in 2009, Aldi and Lidl had just a 4.4 per cent share of the UK food retail market. Today they have 13.6 per cent. This makes them bigger than Wm Morrison (MRW) and perilously close to the size of J Sainsbury (SBRY) (15.3 per cent) and Asda (15.4 per cent).

But how have they been so successful?

There is no doubt that the last recession pushed many people through the doors of Aldi and Lidl due to necessity. The savings they could make compared with shopping at the big four supermarkets were sizeable and many have not returned. More have joined them as the buying power of their take-home pay has declined as wages have failed to keep pace with prices

So how can Aldi and Lidl offer such cheap prices?

Food retailing might seem very simple – buying and selling food – but getting it right to attract customers is far from easy. Aldi and Lidl’s success is based on many things, but the bulk of it can be attributed to the following key factors:

• Fewer products on sale.
• A big focus on private-label products.
• Smaller stores in cheaper locations.
• Great cash flows that fund store expansion.

Unlike the big supermarkets, which can stock anything between 50,000 and 90,000 different products, Aldi and Lidl stores tend to stock between 1,000 and 2,500. This gives them a number of big advantages in attracting customers.

Firstly, it means that it can offer a very simple and convenient choice to customers by stocking mainly essential products. For example, instead of a dozen different brands of washing powder it will offer one or two. The customer is not daunted by the complexity offered by the huge choice found in bigger supermarkets.

By selling fewer products the discounters can generate much larger volumes per item of product. This in turn increases their buying power with their suppliers, which allows them to negotiate lower prices, which can be passed on to customers.

The selection of products on offer are predominantly unbranded, private-label ones. These are much cheaper than the selection of branded products found in many big supermarkets. 

Aldi and Lidl have been very good at developing long-term relationships with private label suppliers. This has not only helped them to offer cheaper prices, but has also allowed them to have a big say on product quality and attract more upmarket customers. The fact that many Aldi and Lidl products win awards is evidence of this.

A big factor in the success of Aldi and Lidl’s operating model is that their stores are a lot smaller. Instead of the 30,000-60,000 square feet (sq ft) of the big supermarkets, their stores tend to be in the 8,000-15,000 sq ft range. This brings a number of benefits.

As the stores are small, they lend themselves to secondary locations where the investment cost of getting stores up and running is much lower. The store interiors are also minimalist, which also keeps costs low. Smaller stores are also quicker and easier to shop for customers.

The businesses are also very efficient due to smaller stores and fewer products. Labour productivity is high due to things such as shelf-ready packaging. Fewer stock units means that logistics costs are also much lower than those of the bigger supermarkets.

The combination of growing sales volumes, fewer products and lower store costs has created a very profitable and cash generative business model. This provides funds to open up even more stores, which both Aldi and Lidl have been doing. Aldi in particular has been extremely proficient in this. 

With around 800 stores in 2018, Aldi has plans to take the number to 1,000 by 2022 and 1,200 by 2025. London, where it currently has a relatively low presence is a big focus area for it. As well as cheap prices, Aldi and Lidl have inflicted harm on the big supermarkets by changing the perception of its business in the eyes of consumers. They have gone from places where only the less well off shopped to ones frequented by middle-class shoppers. Just take a look at your local Aldi and Lidl car park and you will find plenty of posh 4x4s and premium-branded vehicles in there. 

The growth of the discounters continues to be a worrying development for the UK’s big supermarkets. It is not too far fetched to think that Aldi and Lidl could have 20 per cent of the market at some time in the next decade. With the grocery market barely growing, that market share will come from the existing big players. It explains why Sainsbury’s and Asda want to get together and why Tesco is working hard to reduce costs.

This is all before the possible entry of Amazon (US:AMZN) is considered. It is taking a slow and steady approach to its Amazon Fresh business in the UK, but it has the potential to add to the problems of the big four supermarkets.

Tesco's fightback

Tesco has arguably been the most adept of the big four supermarkets at countering the threat of the discounters. It has also helped itself by getting out of problem businesses overseas and marginal ones in the UK. As a result, its profit margins have increased.

Tesco retail profits and margins

Source: Tesco annual reports

What I have attempted to do is to look at the changes in Tesco’s retail gross profit margins and operating profit margins over the past decade. Its accounts give the amount of stocks expensed against revenues as well as stock losses. This allows the calculation of an estimated gross profit margin.

The operating margin is made up of the profits of the UK, central Europe and Asian food retail businesses as well as the wholesale food operations of Booker. The gross margins are volatile due to the presence of fuel sales, which distort the picture slightly. That said, it is possible to get a sense as to what has been going on.

Tesco costs and margin as % of revenues

Sources: Tesco annual report & Investors Chronicle

There’s no doubt that Tesco has cut its prices, but that is not showing up in my estimates of gross margin where the cost of goods as a percentage of revenues has stayed relatively stable. The margin improvement has come from big reductions in store operating costs and logistics, and other operating costs as a percentage of sales come down significantly.

Operating margins have also been helped by the acquisition of Booker, which has higher profit margins than Tesco’s supermarkets. In central Europe – markets with many discount supermarkets – Tesco has moved to a simpler, lower-cost operating model, which has helped to cushion the effect of a continuing decline in like-for-like sales.

Tesco is looking to take out a further £1.5bn of operating costs in 2019-20 with much of it probably reinvested into lower prices, but some should contribute to higher profits.

However, it would be wrong to assume that Tesco’s margin recovery is just about cost-cutting. It is not. A lot of credit is due to it offering a better shopping experience. I have visited a few Tesco stores over the past few years and have noticed an improvement in price and quality of products. So much so, that the Oakley family weekly delivery now comes from Tesco instead of Sainsbury’s. I am not the only one to notice this, as Tesco has attracted 149,000 more customers over the past year.

Tesco has been copying some of the strategies of Aldi and Lidl. It has improved its relations with suppliers and made a big push behind private-label products by relaunching 10,000 of them. Its “Exclusively at Tesco” brand is doing extremely well and is ending up in a growing number of customer baskets.

Tesco has also teamed up with French supermarket Carrefour with the aim of delivering meaningful cost savings on private-label and branded products.

It has also launched its own discounter brand called Jack’s (named after Tesco’s founder, Jack Cohen). These stores will stock around 1,800 products and have average store sizes of around 10,000 sq ft. That said, I think this format may struggle to make a big difference to Tesco’s overall profits given the small scale of its roll-out, and it may even cannibalise sales from its existing stores.

Tesco’s achilles heel – still too many big stores

My big concern about Tesco – and the other big supermarkets – is that it still has too many big stores. The overheads these bring make it very difficult to match the business model of the discounters – and make reasonable profits. My concern is that in an economic downturn, cuts in prices to keep customers from defecting to discounters could really hurt its profits.

Source: Tesco

Tesco’s store portfolio is dominated by large stores with an average size of 39,358 sq ft which account for over 80 per cent of its selling space in the UK. These larger stores are struggling and underperforming its smaller stores. This is evidenced by the fact that like-for-like sales at its larger stores grew by only 0.3 per cent on the last quarter of 2018-19 compared with 3.3 per cent growth from smaller stores. It seems that the lesson for UK food retailers is that small stores are the way to go.

Tesco's shares – a cash cow and dividend yield story

Tesco has got itself back on a firm footing. As well as cutting costs and reconnecting with customers, it is not opening much new selling space. It is sweating the assets it has already got. This is producing a significant amount of free cash flow, which is allowing it to pay down debt, reduce its pension deficit and improve its fixed charge cover – the ability of its operating profits to pay interest and rents.

Source: SharePad

The free cash flow is also feeding through into much bigger dividends for shareholders. Last year saw a hefty hike in the payout, and dividend growth is still expected if all continues to go well.

Tesco has turned itself into a reasonable yield stock. At 249p, it has a forecast yield of 3.5 per cent, rising to 4.3 per cent based on 2021 forecasts. While I still have some concerns about the resilience of Tesco as a business, the yield looks attractive.