Stock in focus

Tesco:BOGOF to end

John Royden, Head of Research

Who knows what BOGOF means? Well, if you worked at Tesco then you’d know it stood for Buy One Get One Free. Shares peaked at £5 back in 2007 and they now trade at £2.29; relative to the 2007 price, you can now buy one and get one free!

I think the BOGOF offer is coming to an end. To understand why, we need some historical context to Tesco’s troubles. From 2007 investors took on a growing perception that their Fresh & (not so) Easy expansion in the US was not going so well. Fresh & Easy was eventually sold in 2013. We also saw Philip Clarke (CEO, 2011 to 2014) move to an increasingly antagonistic relationship with suppliers by exerting heavy-handed purchasing tactics, which backfired in many ways. There was also a realisation that Tesco had probably got too much property space and then in 2014,an accounting scandal broke the headlines and undermined confidence yet further.

At the same time that these troubles boiled up, Aldi and Lidl realised that they could run stores with less capital expenditure (capex) and less operating cost. Same sized stores meant that Aldi and Lidl did not need architects and engineers to start from scratch every time they built a new store; they just told the builders to “do it again”. Basic shelving carrying fewer SKUs (stock keeping units), fewer checkout staff and cheaper lighting kept costs down as well. Their commercial strategy begun to blossom at around this time and take market share from Tesco, and others.

The discounters were not buying packets of cereal for less than Tesco was, they were just better at running stores.

With lower overheads and fit out costs, this meant that the discounters could charge less than Tesco and still make a similar cash profit. The discounters were not buying packets of cereal for less than Tesco was, they were just better at running stores.

In order to compete, Tesco and the other incumbents had to slash margins and become much more capex efficient. This is what Tesco achieved under Dave Lewis who took over in 2014. Tesco’s cash profit (EBITDA) margin used to be close to 8% back in 2011. Their capex margin was 6%. Today the EBITDA margin stands at 5.2% with the capex margin at 2.8%.

Tesco also had to contend with wage inflation and input cost inflation. From 2014/2015 the pound was in a bear market which pushed up the prices of imported goods and squeezed margins. But going forward, and barring a hard Brexit, I now think the pound has bottomed. Whilst some economists fancy the pound back at $1.45 by end 2020, our thinking is more that the bear market is over. This will take the pressure off Tesco’s margins. UK consumers are now enjoying real wage inflation (wage inflation > CPI inflation), so consumers should in theory start spending more and being less price sensitive.

When Dave Lewis took over, he also sought to rebuild relationships with suppliers and build trust with consumers. Market surveys, like BrandIndex and industry chat suggests that he has done both. This should let Tesco make more from its higher margin, own label goods. Lewis’s improving availability (being able to buy what you want to buy) from 80% to 95% must have helped. He has also got the company to realise that when you throw home delivery into on-line shopping, it is not so attractive compared to getting shoppers into your stores. Pricing is now less biased to promoting the on-line shop.

So you could argue that Tesco’s future looks a bit brighter. They have adjusted the business model to compete with the discounters, the stronger pound should help margins and we expect the UK consumer to spend more. And it looks as if they have finally sorted out the ill-conceived expansion into Eastern Europe (12% operating profit in FY 2018). Their operations in Thailand (15%) look as if they are now being run properly as well. In addition to merger synergies, Booker should gain ground against sub-scale and weaker competition now that the company’s talented CEO, Charlie Wilson, has recovered from his cancer operation. Booker is close to 10% of the enlarged Tesco. And another thing; if the Sainsbury/ASDA merger goes through with few forced sales of store sites, then this could make the market less competitive with fewer players.

The downside is that a poor Brexit drives slower growth and a weak pound drives more input inflation which Tesco can't pass through to customers. Any Brexit inspired disruption to the supply chain would not help them either. We also hear that the big four grocers are facing equal-pay claims from more than 30,000 shop floor staff, which solicitors Leigh Day say could cost them up to £8 billion if they lose.

When we weigh up the arguments we come to a neutral conclusion but could be persuaded to predict the end of the share BOGOF offer if the negatives retreat.

PRICE
£2.29
 
52 WEEK HIGH-LOW
£2.66—£1.87
 
NET YIELD
1.6%
 
HIST/PROS PER
20.4—16.3
 
EQUITY MARKET CAP (M)
£22,564
 
 

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