Tesco (LSE:TSCO) shares have come under pressure in recent months. The share price tanked in late summer, and is down a considerable 17% over just three months. So is Britain most-popular supermarket in bargain territory, or should I be giving Tesco a wide berth?
Slim margins
Supermarkets tend to have fairly slim margins. And right now, that’s problematic. Inflation is above 10% and we’re experiencing a cost-of-living crisis which is impacting supermarkets’ ability to pass these costs onto customers.
UK food price inflation soared to a record annual rate of 11.6% in October as staples such as teabags, milk and sugar became more expensive along with fresh food. The annual price increase of fresh food last month was particularly high, up 13.3% year on year compared with 12.1% in September.
Yesterday, the the British Retail Consortium’s chief executive, Helen Dickinson, said that food values soared due to “the significant input cost pressures faced by retailers due to rising commodity and energy prices and a tight labour market.”
What does this mean for Tesco?
The ability to pass rising grocery costs onto customers has been exacerbated by labour shortages and rising staff costs. Competitor Aldi has raised wages three times this year.
Tesco’s profit guidance has been trimmed slightly as a result, although updated guidance remains within the low-end of the previously announced range. In October, the firm said it expects full year retail adjusted operating profit of between £2.4bn and £2.5bn as half year profits fell 65% to £413m.
Group adjusted operating profit fell 9.8% year-on-year to £1.32bn, with the firm’s retail adjusted operating margin down 78bps to 3.9%.
But it’s not all bad news. Tesco is arguably in a better place to absorb costs than hard discounters like Aldi and Lidl. Despite gains made by the two European firms, Tesco’s market share also looks pretty robust.
And then there’s falling gas prices — food stores are some of the biggest energy users in the country.
Should I buy the stock?
Despite the worsening economic conditions, the stock certainly doesn’t look unattractive right now. The company is currently trading around £2.20, equal to around 10x estimated fiscal 2023 earnings per share. That’s clearly not expensive. And the 4.9% dividend yield is a great passive income source.
While the shares may appear meaningfully undervalued, I still have concerns about the stickiness of UK inflation. Figures might look okay now, but I’m worried about margins being trimmed further should there be continued inflationary pressure.
However, I’m still interested in the sector. But by comparison, peer Sainsbury’s may be better value, with a P/E ratio closer to eight. The UK’s number two supermarket is facing all the same challenges, but is trading at more of a discount. As a result, I’m not buying Tesco shares for now.
