The last big economic downturn caused the market share of discount supermarkets to swell and Britain’s Big Four grocers are keen to avoid the mistakes of the past. There are signs that Tesco is managing to balance pricing with profitability. Better sales plus cost savings in the first six months mean it now expects adjusted profits of between £2.6 billion and £2.7 billion from its retail operations this year. It had forecast profits flat on last year’s £2.4 billion.
Admittedly, food prices inflation has played a big part in lifting like-for-like sales, which were 8.4 per cent higher in the UK and Ireland. Volumes were still “marginally flat to down”, according to Ken Murphy, Tesco’s boss, adding that food inflation is easing and should continue to head south. Yet investors remain wary about how well buying power will hold up. Homeowners are still grappling with higher mortgage costs and borrowing rates are expected to stay higher for longer.
A forward price-to-earnings ratio of only 11 is near a decade low. That does not give much credit to what Clive Black, of Shore Capital, calls Tesco’s “cash-compounding” potential. Free cashflow generated from its retail business is expected to be between £1.8 billion and £2 billion for the year, better than the £1.4 billion to £1.8 billion it targets.
Keeping the pace going rests on two key things: one, pushing sales volumes forward at a decent rate, which could induce better terms from suppliers; and two, maintaining discipline on its expenditure. On the latter, Tesco has made good inroads, wiping another £260 million in the first six months from its operating costs. Easing energy costs could help later in the year. The pace and extent that sales volumes recover is a greater unknown.
The extreme level of price rises over the past 18 months is a burden on consumers’ spending. Deflation is equally damaging to profit margins. The sweet spot is between 1 per cent and 5 per cent, Black says, which neither prompts shoppers to trade down nor reduces the volume of items they buy. Grocery inflation was 9.9 per cent last month, according to the latest shop prices index published by the British Retail Consortium and NielsenIQ. But that figure was a considerable drop from the 11.5 per cent in August.
Volumes recovery will depend, too, on whether discounters can keep slashing prices. Lidl’s aggression pushed it to a loss last year. Tesco’s market share, meanwhile, edged forward to 27.2 per cent, according to the latest Kantar figures, just higher than this time last year. Higher free cash means more to put towards strengthening the balance sheet and investing in stores.
Net debt has fallen by more than a fifth to £9.9 billion since before the pandemic, now at 2.3 times adjusted earnings. That is the lower end of the target range. Capex has been raised to £1.3 billion this year, up from £1.2 billion, some of which will be put towards buying back more of its retail estate. But analysts don’t expect Tesco to blow the budget, forecasting stable spending over the next three years, at least.
A share buyback of £750 million is continuing. The question is whether the scope of returns is expanded in future years. Together with a solid dividend, cash returns are compelling enough. Analysts have forecast a payment of 11.25p a share for this year, which alone leaves the shares offering a potential dividend yield of 4.2 per cent. The prospect of more special returns might entice some investors. But if Tesco shows that it can continue to balance pricing and not be tempted to overstretch on spending, it should earn itself a higher rating from the market.
ADVICE Buy
WHY The shares look too cheap, given the strength of cash generation and the potential for more of it to be returned to shareholders
Renewi
Renewi is not defending itself from a hostile bid at full strength. Shareholders in the waste management group might be tempted to take a firm bid that emerges from Macquarie, the Australian asset manager, but not at the price on the table.
The company, which collects and recycles waste and sells it back to the market, is facing weaker demand for raw materials from some key regions — notably the Netherlands, which accounted for almost half its revenue last year. Recycling volumes have continued to decline as muted construction sector activity limits both waste collection and demand for the repurposed material.
It has reiterated targets to push forward growth, boost margins and improve the conversion of profit to cash. It also set a new goal of lifting the return on capital expenditure to 15 per cent, from 11 per cent last year. Some ambitions look more credible than others, though: a plan to lift organic growth above 5 per cent, a feat it has managed only once since the merger that created the group in 2017, is hard to put much faith in.
Investors might want to think, too, about the timing of the offer. The group is coming off a three-year capital investment programme aimed at making the sorting of materials more efficient and expanding the range that can be recycled. Investing in upgrading has been higher over the past two years, but that reflects an element of catch-up post-pandemic. Analysts expect a free cash outflow during the present financial year to give way to free cash generation next year and growth in that metric over the next two years.
Perhaps it’s no surprise that the 775p potentially on the table is hardly a knockout price for Renewi. True, it is a 52 per cent premium to the undisturbed share price on the day before Macquarie broke cover. But the shares changed hands above that price last summer.
It translates to an enterprise value of 6.8 times forecast earnings before interest, taxes and other charges, according to Investec’s analysis. That is below the sector average of 9.2 and is lower than the takeover multiples paid within the sector over the past two years. Shareholders should hold out for more.
ADVICE Hold
WHY A firm takeover bid could lift the shares higher
