Stock of the Week: Tesco

Post-It Note With fears of a second national lockdown growing and memories of panic-buying in

Post-It Note
Post-It Note

With fears of a second national lockdown growing and memories of panic-buying in March still fresh, it’s no surprise that our Twitter followers have chosen supermarket Tesco (TSCO) as the stock of the week by a large margin. Supermarkets became a lifeline for stuck-at-home shoppers in the pandemic and that has boosted their bottom lines in a tough year for retail in general.

Tesco’s recent half-year results underlines the stark difference between the pandemic winners and losers – pre-tax profits were up nearly 30% on 2019 at £551 million amid a 69% surge in online orders. Britain’s largest supermarket also surprised investors in a year of slashed dividends by raising its payout by 20% and the stock is now yielding over 4%.

Unlike smaller rival Ocado (OCDO), whose shares have doubled this year, the boom in supermarket spending has not translated into share price gains for Tesco. The company’s shares recovered sharply from the March crash but this year the price is down 16% since January. According to Morningstar analyst Ioannis Pontikis, Tesco shares at 214p are trading below their fair value of 249p. Apart from booming food sales, investors are still anxious about stiff competition from rivals, whether the sales boost this year is shortlived, and weak sales growth in Tesco stores in Europe. Tesco shares have never reclaimed the highs near 500p reached before the financial crisis, and an accounting scandal in 2014 dented investor enthusiasm for what was once a stock market star.

Beware the Discounters

Tesco has maintained its position as the UK’s largest supermarket for many years, and according to Kantar’s recent figures its market share is nearly 27%, with next nearest rivals Sainsbury’s and Asda on 14% each. A merger between the numbers two and three would have challenged Tesco’s dominance, but the UK competition authorities scuppered the deal. But Morningstar analysts do not assign Tesco an economic moat (if it had one it would be high up on our list of top FTSE dividend payers).

Competition in the retail market is the main reason why it doesn’t have a sustainable advantage over rivals: all of the big-name supermarkets are under threat from discounters such as Aldi and Lidl, whose appeal to cost-conscious shoppers is likely to grow in tough economic times. Combined, Aldi and Lidl have a market share of 14.9%, which would make them the UK’s joint second largest supermarket. And while the UK’s Big Four supermarkets are looking to reduce their physical space, Aldi and Lidl are planning further store openings.

Tesco’s large size may be less of advantage in the future, Pontikis says: “A large source of UK grocers’ competitive advantage in bargaining power over suppliers is gradually wearing down as the mega-shops and large supermarkets lose their appeal with UK consumers.” Going forward, bigger may not be better in terms of retail space, as shoppers prefer to buy locally or go online rather than drive to a large out-of-town shopping centre.

He also thinks the boost from pandemic panic buying is likely to fade for the rest of this year and big supermarkets will have to rely more on promotions – especially in the run-up to Christmas – to keep fickle shoppers coming back.

Among Morningstar-rated funds, Tesco makes up over 4% of Silver-rated JOHCM UK Equity Income fund and over 3% of Merian UK Alpha, which has a Morningstar Analyst Rating of Bronze.

 

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