Tesco shares go on sale as inflation bites (OTCMKTS:TSCDF)
I hadn’t planned to cover British supermarket giant Tesco (OTCQX:TSCDY) quite soon after my last piece in June, but the evolution of business and stock prices since then probably deserves to be an update. These stocks have fallen around 15% in sterling over this period, extending over 20% for USD-denominated ADRs and significantly underperforming the returns of the broader MSCI UK ETF (EWU).
Currency translation effects clearly explain much of the performance of dollar-denominated ADR – the pound sterling has fallen significantly in recent months – while the underlying weakness can be attributed to the deteriorating macroeconomic outlook for retailers in the UK and Europe, which is now beginning to trickle down into industry and company specific data. With that, the recently released results covering the first half of the company’s 2022/23 financial year were a bit of a mixed bag, with earnings falling and business conditions obviously becoming more difficult.
Notwithstanding the above, these stocks have become even more attractive given the magnitude of the sell-off, and they are currently trading at a single-digit forward P/E with an implied dividend yield of over 5%. With would-be USD investors also able to take advantage of the strong dollar to pick up cheap UK assets, Tesco now offers a compelling case for value-oriented investors. Strong purchase.
Inflation is starting to bite
As the UK’s largest grocery chain, Tesco has been dealing with the cost of living crisis and inflation for some time. These issues aren’t new, but they’ve now started to show up in earnest in industry and company-specific numbers, including the company’s latest round of financial results covering the first half of its 2023 fiscal year. .
Overall group revenue for the period was just under £28.2bn (excluding VAT and fuel sales), an increase of 3.1% year-on-year other at real exchange rates and 3.5% at constant exchange rates. That looks pretty solid, but quickly becomes less impressive given the levels of general inflation and food price inflation over the same period. UK retail sales (just under £20bn, or 72% of total retail sales excluding Booker wholesale) look particularly weak in this respect, rising by just 0, 7% year-on-year, although Booker’s performance was stronger, with like-for-like sales up 13.9% to £4.399bn, as COVID restrictions in the year previous allowed a soft composition. Group adjusted operating profit was £1.315 billion, down 9.8% year-on-year, with the company’s adjusted retail operating margin down from 78 bp to 3.9%.
The operating environment is clearly deteriorating for the business. Cost inflation eats away at operating expenses, while customers shift to own-brand products and frozen foods add pressure to revenue profit margins:
In June, we were saying that we were starting to see some small changes in customer behavior, but it was hard to disentangle them from the effects of post-pandemic normalization. We can now see tangible changes in behavior purely linked to the increase in the cost of living. Whether it’s switching to the Tesco brand to take advantage of our great prices or making more subtle changes, like switching from fresh to frozen, we can see customers prioritizing value wherever they can.
Margins are fragile and could remain so, with more sticky than expected inflation and deteriorating UK consumer finances representing the biggest risks here over the medium term. Industry data stay softNielsenIQ analysis suggesting that industry and business sales continue to lag general price inflation due to reactive customer behavior.
Not all bad news
There are, however, reasons to remain optimistic. First, not all of the softness here is due to the weakening of the macro environment. The expected post-COVID normalization explains part of this, while Tesco is deliberately slowing price increases by prioritizing its value offering against competition from hard discounters Aldi and Lidl. There is good evidence that it is working, with Tesco’s Net Promoter Score widening its lead over the remaining ‘big four’ grocers. Tesco’s overall market share also remains relatively robust, despite gains made by Aldi and Lidl.
Moreover, despite the increasingly uncertain environment, Tesco has only slightly softened its profit forecast, with the company now seeing retail-adjusted operating profit of between £2.4 billion and £2.5 billion. pound sterling. This represents the low end of previous forecasts of between £2.4bn and £2.6bn, while Tesco Bank’s adjusted operating profit forecast remains between £120m and £160m. The retail free cash flow forecast has actually been raised – with management now guiding ‘at least £1.8bn’ compared to earlier guidance of between £1.4bn and £1.8bn sterling.
Finally, Tesco’s ongoing share buyback program will support earnings per share should underlying earnings decline. Management noted that £450m of the company’s £750m takeover authorization had been used in the first half, implying there was a further £300m remaining over the six coming months. This equates to just over 2% of the current diluted shares outstanding based on the prevailing market price.
An attractive value proposition
Tesco shares are currently changing hands for just under £2.10 each in London, around 10 times estimated earnings per share for FY2023. The dividend yield is currently over 5% on a payout basis. of the previous year, which, if any, underestimates the forward yield given management’s commitment to pay a progressive dividend.
Tesco is a low-growth business by nature, given its reliance on UK Retail. The UK grocery industry is not benefiting from strong growth prospects for obvious reasons, while what little growth there is will fall disproportionately on hard discounters as they continue to gain market share – from all the more so now given the rapidly rising cost of living and deteriorating consumer finances.
Nonetheless, Tesco shares now look significantly undervalued. I still have a fair value of around £2.70 per share for retail – this being based on discounting long term low single digit annual growth in retail free cash. It is around 30% higher than the current share price and does not include the value of Tesco Bank, which contributes around 5% of the group’s operating profit and is worth around £1.5billion. in tangible net asset value. As a rough guide, I would add an additional £0.15 per share for the bank, which would bring my overall estimate of fair value to £2.85 per share and 35% above the prevailing share price.
Finally, UK assets generally look cheap for USD holders. Like most currencies, the British pound has fallen significantly against the dollar in recent quarters.
This weakness will likely persist as long as the Fed continues to raise rates, although there is medium-term upside potential for the currency when that ends. All told, this equates to a very attractive value proposition for Tesco shares, with potential investors also in a position to collect a decent dividend in the interim. Strong purchase.