Tesco’s (TSCO) market value has increased by a fifth over the last 12 months, yet the share price is roughly in line with its level when the UK first entered lockdown. During that benighted period, the grocer expanded its online offering and delivery service, while taking on significant additional costs to ensure the well-being of its staff and customers.
It also secured a larger customer base, thereby expanding its share of the overall grocery market through the pandemic. Earlier this year, data analytics from Kantar showed that the group’s sales were up 10.1 per cent on a two-year basis, while its market share increased by 0.6 percentage points to 27.9 per cent – the first time it had achieved that distinction since 2016. No doubt the lack of a comparable delivery option from the big German discounters – Aldi and Lidl – helped to rebuild customer numbers. Aldi did strike a limited agreement with Deliveroo (ROO) in May 2020 and rolled out the service to 20 stores in London, Greater Manchester, Cambridge and the Midlands, but its capabilities in this area pale by comparison.
Grocery sales surged in the early part of the initial lockdown, partly out of panic, but they gathered pace again through the subsequent disruptions, as consumers curtailed spending in cafes, restaurants and bars. As a result, many more meals were cooked and eaten domestically through the lockdowns and sales volumes of certain foods and beverages linked to home entertaining increased. The latter trend, assuming it is maintained to a significant degree in a post-pandemic world, could present another problem for the discounters. Overall, however, shoppers did not move resolutely upmarket as social habits changed in line with government strictures.
The consumer trends that informed supermarket strategies during the pandemic have given way to more pressing considerations over how Tesco and its peers will contend with an environment in which living costs are accelerating rapidly in relation to wage growth. On this point, the nation’s pre-eminent grocer might be better placed than you would imagine. The scale of its operations, combined with the expanded logistics function, provide a buffer even as prices for perishables and energy are skyrocketing, leaving it as a viable consumer defensive option.
Although we have witnessed a trend towards downsizing in the grocery space, that doesn’t apply to warehousing. With fuel as an increasingly larger component of the supermarket cost base, the value of an advanced distribution and logistics network such as Tesco’s will become ever more apparent. That’s partly because only about a fifth of the fruit and half of the vegetables on supermarket shelves are grown locally in the UK, so the quest for year-round availability is bound up with a logistics function in which scale really does matter. (The average storage capacity of a supermarket is only one day’s worth of fresh produce.)
And while household budgets are being squeezed, experience shows that consumers do not eschew the little luxuries of life even when discretionary incomes are falling. With pubs and restaurants nearly back in full swing, the group’s Booker wholesale arm is also now seeing improved volumes.
It’s obviously a highly competitive space, but how does Tesco weigh up against the competition after the price increase of the last 12 months? The group’s price/earnings ratio points to a clear correlation between its current market value and projected earnings growth, although you would probably expect that from and established player in an established market. Even so, it does compare favourably with industry rivals such as J Sainsbury (SBRY).
This time last year, trade magazine The Grocer was musing on the negative profit implications for the sector due to the prospect of a deflationary cycle. Things haven’t quite panned out in that direction, and the impact of increased input prices is now the primary consideration, specifically the ability of supermarkets to pass on those increases to shoppers. So, although the discount chains should attract more price-conscious custom, the ability to pass on costs without moving into loss is constrained by already thin margins. Tesco enjoys a modicum of flexibility in this regard given an average net margin of 1.3 per cent over the past five years. That may seem ultra thin to investors unfamiliar with the sector, but it stacks up well against the 0.5 per cent net margin for Sainsbury. The group trades at a relatively undemanding forward rating of 13 times adjusted consensus earnings and the shares are changing hands at a 15 per cent discount to the consensus target price. And if you’re still wary, there is an implied forward yield of around 4 per cent.
