TSCDF - Tesco Is Enjoying A Rare Moment

2023-12-16 09:23:21 ET

Summary

• Tesco's share price has hit a 52-week high, outperforming the FTSE 100 by a third.
• The company has achieved impressive sales and profit growth, generating strong cash flows.
• Tesco's market share continues to expand, surpassing its competitors.

Inflation has been kind to Tesco (TSCDF) (TSCDY) over the past two years, and rising interest rates did not do it much harm neither. While the FTSE 100 remained at standstill over the past year, Tesco’s share price has hit a 52-week high on the 14 December 2023, rising by a third. Tesco’s shareholders cannot be blamed if they ask to be pinched – overperforming the index by that magnitude is often reserved for the innovative, groundbreaking businesses, rather than for a mere mortal grocery business.

But is reality not a dream; this sleepy, traditional business that is focused on the mature and highly competitive UK market has achieved the unthinkable; growing sales by 9% and adjusted operating profits by 14% in the first financial half of 2023 , ending August. Critics would hate to admit it, but Tesco’s management seem to be doing something right – at last.

Financial performance is solid across all fronts

Tesco’s UK like-to-like food sales grew by a solid 10.6% in the first financial half of 2023/24 – pulled down by consistent deflation in clothing and home items that reach negative 4.8% to average an overall like-to-like growth rate of 8.7%. Tesco does not disclose the division between value and volume sales growth – the company only reported that “volumes stronger than expected” in the UK market in the first half of the financial year.

Not only is Tesco growing sales and profitability nicely, but it is also generating strong underlying cash flows. GBP 2.6 billion of operating cash flows, to be exact, in H1, coupled with GBP 1.4 billion of free cash flows. Low levels of capex for this maturing business, coupled with persistent positive working capital cash contribution – typical for a grocery business – underpin strong cash generation that is likely to remain so in the foreseeable future. This provides support to maintain and grow the attractive 3.8% dividend yield (5% if you invested a year ago).

Tesco’s credit rating should be better; a BBB- rating is on the knife-edge of an investment grade, leaving no room for slip-ups. Tesco’s net debt to retail operating cash flow of 3.7x does not help, but that is the nature of such asset-heavy business.

Leading market position is not only maintained; it is expanding

In the quarter ending the 4 ^th of September 2023, Tesco expanded its market share by 30 basis points, versus 14 basis points for Sainsbury, and compared to a drop of 39% basis points for Asda and 51 basis points for Morrisons. It is truly amazing that such a mammoth company that already enjoys a leading position with 27% market share can still grow its market share more.

Strong growth will shave off, but in a soft landing

With interest rates as high as they are, and the UK economy in limbo, it is only natural that Tesco’s growth levels will converge closer to those of the wider economy – at some point. After all, Tesco’s products are a core part of inflation, and consumer spending, parameters.

It is widely agreed nowadays that the inflation has peaked in early 2023, and is now travelling south. According to the UK’s Office of National Statistics , CPI increased by 4.6% in the 12 months to October 2023, down from 6.7% in September. On a monthly basis, CPI did not change in October 2023, compared with a rise of 2.0% in October 2022. Inflation of food and non-alcoholic beverages stagnated in October 2023, growing by a trickle of 0.1%. In its notes for interest rate decision on the 14 ^th of December 2023, the Bank of England noted that: “ Contacts of the Bank’s Agents anticipated further declines in food price inflation ”. The Bank of England still noted, however, that “ Inflation expectations for the year ahead had remained at elevated levels. ”, meaning that the recent slowdown in grocery prices does not mean that price growth is done and dusted. Consumer Confidence measures were also significantly higher in November 2023 than in November 2022, giving Tesco’s laggard clothing and home segment a potential lift, especially in the Christmas peak season.

Future growth needs a long-term outlook

While investors must be delighted to pocket generous short-term returns, long-term investors must wonder whether Tesco’s leadership have thought through the company’s long-term future. The strategic priorities of Tesco, as outlined in its annual report , lack ambition and innovation. Growing online sales, growing convenience stores and being a cost attractive retailer are all hardly creative options for long-term growth. The leadership of Tesco must do better than this.

Tesco, as well as Sainsbury’s and Walmart, have been bitten before by international expansions, and by acquiring non-core businesses. So it is understandable if Tesco’s leadership are wary of burning their fingers (and their performance-based compensation) in wild ventures. But there must be a mid-way but taking wild risks and between taking none at all. I am not sure if the current management team have what it takes – future new leadership should have such mandate.

Valuation is still tempting

Despite the share price reaching 52-week highs, as I write this article, Tesco is still not an overvalued investment. A P/E ratio of almost 14.5x might not seem particularly cheap, but its UK peer Sainsbury’s is trading at a whopping 35x, and US cousin Walmart is trading at 25x. Tesco does cheap in comparison, but a further discount in price would entice value shoppers even more.

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