Surprise that Tesco is not immune from inflation is itself surprising. The supermarket chain is playing the long game and attempting to avoid past missteps.
Rising costs and weaker consumer spending could cause it to miss the £2.6 billion adjusted retail operating profit this year. Management has guided towards profits for that core business coming in anywhere between £2.4 billion and £2.6 billion, which even at the top end would be a slight reduction on last year.
Tesco faces pressure on both sides of the profit margin equation. Operating expenses are unsurprisingly rising, with wage and energy cost inflation increasing by roughly the same magnitude. A decision earlier this year to increase pay for shop staff and delivery drivers is expected to cost the grocer £200 million a year.
The lockdown-era sales cushion has already been removed. Elevated retail sales growth has eased since last year, at 2.3 per cent, even if the figure for this year remained ahead of the pre-pandemic level.
Selling essential items means supermarkets are better placed than fashion retailers or restaurants when consumer wallets become thinner. But they are by no means immune to the decline in real incomes, with revenue threatened not only by falling sales volumes but also customers trading down to budget ranges.
What levers does Tesco have to mitigate the margin squeeze? Cost savings are one, which includes closing meat and deli counters in 317 stores. Increasing prices is another, potentially more damaging, option. Resisting the latter could have longer-term benefits.
Since the onset of the pandemic, the discounters Aldi and Lidl have increased their market share, but Tesco has grown it by a greater proportion. The grocer increased its market lead to 27.4 per cent of the UK market, according to Kantar, against 26.8 per cent on the eve of the first lockdown.
Tesco might have one eye on the past. After the 2008 financial crisis, it was more willing to pass on higher costs to customers through price increases, widening the crack in the door for discounter grocers to creep through.
The recent shift by rivals such as Asda and Morrisons to private equity ownership, a famously impatient source of capital, could well make them less likely to compete as aggressively on prices in favour of pumping up returns. The investment bank Jefferies reduced its forecast for adjusted operating profit this financial year by 5 per cent to £2.69 billion and by 3 per cent for the next to £2.82 billion.
But by historical standards, the shares aren’t expensive. An enterprise value of 6.9 times forecast earnings before tax and other charges is some way below a decade-high of 11, recorded during the throes of its post-accounting scandal turnaround, and not too far above a ten-year low of 5.8, when said accounting scandal emerged.
The strength of cashflow last year means that the balance sheet is in good shape and shareholder cash returns shouldn’t suffer. Net debt reduced further, to £10.5 billion or 2.5 times adjusted earnings before tax and other charges. More gratifying for shareholders is that management has stuck with a plan to buy back £750 million in shares over the past 12 months, even if retail free cashflow is expected to fall back to between £1.4 billion and £1.8 billion, versus the exceptional £2.3 billion recorded last year. That’s on top of a dividend of 10.9p a share, a 19 per cent increase on the prior year and 4.2 per cent yield at the current share price. Payments for this year are expected by analysts to fall, but not by much, totalling 10.8p.
The pain to be meted out to retailers that are heavily loss-making — see Ocado — or already struggling to generate consistent sales growth — think M&S — will be more intense. At Tesco’s present valuation, most of that has already been taken by the shares.
ADVICE Buy
WHY The impact of rising inflation on profits this year looks to be accounted for in the share price
Supermarket Income REIT
Retail is a dirty word for some property funds, unsurprising given current falling rents and asset valuations. Supermarkets are unfairly lumped in by large institutions seeking to appease their own investors by cutting their exposure to the sector. As the name suggests, Supermarket Income Reit is a willing buyer.
The trust is now raising more cash to invest in a bundle of assets worth about £270 million, which it is either under exclusive or advanced talks to acquire. Retail investors can buy into the offer via the PrimaryBid platform (a minimum £250 subscription, closing by April 26), at a 3 per cent discount to yesterday’s closing share price.
The reit, which recently joined the main market and FTSE 250 index, acquires and leases a portfolio of supermarkets to the big grocers including Tesco, Sainsbury’s and Morrisons. Atrato Capital, which manages the reit, is the asset-gathering arm. The attractions of supermarket properties are clear: they are let, on long leases of ten years or more, to blue-chip tenants with strong balance sheets whose rents are linked to inflation. In fact, about 85 per cent of Supermarket Income’s income is inflation-linked, with a cap averaging about 4 per cent. The result is an inflation-linked dividend that this year is being targeted at 5.94p a share, equivalent to a yield of 4.8 per cent. Payments for last year and the first half of this year were fully covered by earnings.
The underlying value of the reit’s supermarkets has been rising, but the same is true of assets available to purchase on the broader market. Rising values naturally pose the risk of eating into returns as acquirers are forced to stump up more. But a total shareholder return of roughly 12 per cent a year since the trust’s 2017 specialist market debut should allay investor concerns that the reit is sacrificing returns for scale.
ADVICE Buy
WHY Likelihood of NAV growth and inflation-linked dividends make the small premium worth paying
