Investability Bulletin 13/04/22: Trouble at the Tills

Tesco’s soft outlook suggests much pain in store for the grocery sector

Photo by Anna Gru

Along with everyone else, we’ve been keeping a very close eye on food prices lately. UK food price inflation hit 5.9% in March, but the ascent started well before the impact of the Ukraine conflict on certain agricultural commodities. The US administration is rather disingenuously blaming all the current inflationary woes on the so-called “Putin Price Hike™”. But they’re right in as much as Putin’s special operation means the worst of the pain is surely still to come.

Look across to the US, which revealed inflation figures at a 40 year high of 8.5% this week, and the picture is arguably worse (for now) – a nation that produces 85% of its own food still saw the price of it rise by 8.8%. By contrast the UK produces just 54% of its food – if commodity markets tighten further, competition for imports surely means even higher prices, especially as the cost of agricultural inputs such as fertiliser and diesel are rising too. Local farmers I’ve spoken to are as nervous about costs as they are excited at the elevated prices they can get for their produce.

The most pressing issue is, of course, whether the poorest in society will go hungry. Even before the currently inflation spike around 5m people were living in food insecure households, while a more recent study suggested that a million adults a day are going without eating. I’ve heard suggestions that such data is leftist propaganda – but rising food bank usage suggests otherwise.

Putting my capitalist hat back on, this is of course very bad news for anyone in the business of making or selling food – consumers will only be able to bear so many price increases given the soaring costs of everything else, too.  Energy prices alone are 28% higher than they were a year ago, and the petrol/diesel price has flirted with all-time highs, if indeed you can get it at all.

We are already seeing the effects in the figures of the UK grocery sector, with recent data from research group Kantar showing that year-on-year UK grocery sales fell 6.3% in the 12 weeks to 20th March. It laid the blame the door of the post-pandemic reopening, suggesting that more people were eating out again, or buying food on the go from convenience outlets, which isn’t included in the figures.

It certainly makes sense that we’re seeing a normalising of shopping trends as the pandemic recedes and is supported by trading news from the grocers themselves. Tesco’s full year figures showed online sales fall 14.6% in its second half, reversing a 2.3% rise in the first as shoppers returned to stores. And convenience retail swung from a 5% drop in the first half to a 4% increase in the second.  A trading update from Ocado in mid-March revealed a 5.7% drop in retail sales as basket sizes dropped 15%, the obvious implication being that it’s delivering higher numbers of orders at a lower value, and an inevitable squeeze on its already barely perceptible profit margins.

Ocado’s shares are the worst performer in the FTSE 100 over the past year, down nearly 48% after another 4.8% drop today in the wake of the latest inflation figures and an admission from Tesco that it would see a profit hit next year as the cost-of-living squeeze worsens. Tesco’s shares have done better over the year, up 11% over the year, but it too has suffered a heavy fall today, down 4.5%.

In fact, Tesco’s latest numbers are actually very good – underlying retail operating profits up 35.8% to £2.65bn on the back of solid sales growth, particularly in general merchandise and clothing. Cash flow has been hugely strong, too, with retail FCF hitting £2.3bn thanks to the strong sales performance, lower Covid costs and a bounce back in catering sales through subsidiary Booker. That’s enabled it to pay down debt, increase the dividend (+19% y-o-y) and commit to another £750m of share buybacks over the next year. I could go on, but put simply, Tesco is operating at the top of its game, gaining market share, and is easily the best in class in the UK listed grocery sector at the moment.

That, however, still isn’t likely to be enough to overcome the challenges the sector faces this year – the battle for market share in the face of plummeting household confidence is likely to intensify, especially in its core demographic against discounters Lidl and Aldi, which Tesco now benchmarks its prices against. That means that between it and its suppliers (and yes, I’m ruing that Unilever investment), margins will be squeezed rather than risk an exodus of customers.  Tesco’s latest results suggest it is still in pole position to emerge as the sector’s winner. But it’s a sector I don’t have much of an appetite to rush into right now.

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