This week, new data for UK inflation will be released. For the past three months, UK inflation has averaged 10%. This is a far cry from the 2% target set out by the Bank of England. Even with the capping of energy bills, there’s some that struggle to see inflation falling materially anytime soon.
Given the impact of grocery inflation on Tesco (LSE:TSCO), it got me thinking. If inflation does remain elevated next year, what could happen with Tesco shares?
The negative hit from inflaton
It’s important to consider how inflation has negatively impacted the supermarket in 2022. Back in June, the quarterly results noted that “we are seeing some early indications of changing customer behaviour as a result of the inflationary environment”.
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The half-year figures released in October showed that despite revenue increasing by 6.7% versus last year, operating profit dropped by 43.6%! Higher cost of sales hit the company hard. As a result, the outlook for full-year profit was revised down to the lower end of the previously expected range.
Of the three points flagged up for the lower profit, cost inflation was one of them. The strategy the business has taken is trying not to pass on price increases to customers. This helps to retain demand (with revenue increasing). But it does mean that if the customer isn’t taking the full hit on higher prices, Tesco has to. This reduces profit margins and ultimately means that profit will fall.
There’s no magic solution for companies dealing with inflation. Either you pass the price increase on and see revenue fall, or you take the hit and see costs rise.
Positives for 2023
With inflation hurting Tesco’s financial results, it’s not a huge surprise that the share price has fallen by 19.5% this year.
The firm is taking actions for next year to try and boost performance. For example, it’s focusing on improving cash flow to aid working capital. Supermarkets historically have very tight working capital given the quick level of inventory turnover. By improving cash flow, it can ease pressure on Tesco and also prevent the need to raise more debt.
Tesco has also made the largest single-year investment in employee pay recently. Even though this increases short-term costs, it should help in 2023. Higher staff rentention and better morale will drive a more efficient business.
My take on Tesco shares
It might surprise some to find out that I’m not running a mile from Tesco shares. If inflation does remain high next year, it’s likely going to force the UK into a deeper recession than expected. In that case, I think we could see the stock market tumble.
As a supermarket, Tesco sells essential goods. This is why it’s a defensive stock, one that tends to outperform the market during bad periods.
Don’t get me wrong, in this scenario the Tesco share price could still fall. But I don’t think it’ll fall as much as other stocks in the market.
Am I going to buy Tesco shares right now? I’m going to see what the October inflation figure is first and go from there. If inflation shows signs of increasing, I think I’ll add a small amount of Tesco shares to my portfolio as a defensive play.
