Tesco PLC (OTCPK:TSCDF)(OTCPK:TSCDY) is probably one of Britain’s most recognisable brands. In typical UK fashion, they do half-year reporting, but we got a trading update that tells us what we need to know about the coming year. In all, performance has been great. Prices are down and loyalty benefits are up, but they are managing a trade-up effect, showing they can deliver value in a really tough market for food. Commodities matter a lot for this business, and it’s unsure what will happen. But more importantly, minimum wages matter even more, and this is driving expectations of a pretty limited profit growth, reversing some of the major profit growth spied in the H1. Still, as of the trading update, the strong operational performance improved guidance from a flat development to a slight development of a little less than 5% in operating profit.
Trading Update
Firstly, let’s focus on the facts. As of the H1, guidance showed a flat operating profit evolution. This seems weird at first, as the operating profit grew around 14% in the H1, but it makes sense in the context of Britain’s major minimum wage effect, which is going to see minimum wages grow by more than 9% and see a greater proportion of the working population qualify for it. It explains why profits will suddenly drop off in the H2.
But now the outlook has changed as of the Q3 trading update, which only contains sales information and an accompanying call.
We now expect retail adjusted operating profit of c.£2.75bn, above our previous guidance range of £2.6bn to £2.7bn
Outlook from the Tesco Trading Update PR
This is not an insignificant revision, and it come on the heels of a strong Christmas period that showed a really good performance in terms of fostering up-trading into the Finest collection of Tesco food products.
Quality is also particularly key at Christmas as customers look to trade up and treat themselves… Finest range really stood out from the crowd as a result… record Christmas for Tesco Finest, with sales up 17% and with more than 18 million customers buying from our Finest range over the period.
Ken Murphy, CEO of Tesco
Another thing that was pointed out is that the new delivery service and infrastructure saw a major pickup in customer engagement. The concern is that the business might not have been profitable yet, as it wasn’t as of recently, and that while it might have contributed in sales it may have hindered profit growth. However, it seems the segment is now profitable, and won’t be making an incremental negative contribution.
There were more positives, which is that due to the cost of living crisis in the UK, supermarket brand products saw an uptick in take-up, consistent with a downtrading environment. While Finest is a more premium brand, it is still super market label. Branded is back to growth now though, although own label products are still doing better. Part of the reason is that branded suppliers have started to get a little desperate with a long period now of supermarkets focusing on selling their own label stuff where they can more easily compete on value. Marginality is therefore improving in selling branded products, whose volumes are also recovering.
And now what you’re seeing is suppliers, branded suppliers, trying to win share back through deeper deals and more frequent deals.
Ken Murphy
It should also be mentioned that Tesco is staying behind inflation, demonstrating value and also being good for the broader UK inflation situation.
Bottom Line
Operational performance is seriously good. Managing to orchestrate an up-trading in own label products for Christmas was a great move that will cushion increases in minimum wage coming.
As for fuel costs, which account for around 10% of sales, it’s difficult to say what will happen, as it requires a clear view on oil. We think that oil will remain high or go higher in the H2 on account of the Saudis so far having taken a break with their supply cuts, making it voluntary for OPEC for now. They could start cutting again. But who knows?
On valuation, we don’t mind the Tesco 14x PE multiple, flipping it and getting around 6-7% earnings yield. We think growth is doable and totally believe in the sub-5% operating profit and related EPS growth that the company is guiding for, so a yield like that on run-rate figures is decent. We also like the mention that competitors might be laying off price competition, which signals that Tesco may win share since it’s earned more space for winning share.
But we do note the exposure to politicised issues like minimum wage. We are also unconvinced of disinflationary trends in general, particularly in the UK whose economy operates like a disadvantaged version of the US economy. Inflation is higher, and it is similarly sticky downwards. There are safer EPS growers with a 14x valuation out there that don’t have such defined risks as continued popular pressure for higher minimum wages.
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