Tesco (LSE: TSCO) shares have looked fairly steady lately, but there’s one big risk that has me worried.
The supermarket chain is heavily exposed to rapid food price inflation, sparked by war-driven costs. My concern is that things could turn really nasty ahead of the company’s upcoming annual results release on 16 April.
For me, the question is simple. If input costs jump, can the company effectively pass them on without scaring off shoppers?
The big risk of inflation
Recent headlines have been focused on a looming energy shock from the war in Iran. I can see why.
One-fifth of the world’s oil passes through the Strait of Hormuz, which remains effectively shut. However, it’s not just oil that should be on investors’ minds.
The risk of a food inflation shock is growing. This part of the world is vital for other key commodities including fertiliser and urea. Prices for the latter have surged as much as 50% in recent weeks.
That might sound distant from the UK weekly shop, but fertiliser and fuel costs don’t just stay on farms. Cost increases make their way through production, processing, packaging, and transport. Eventually, they turn up in everyday staples that we purchase from the likes of Tesco.
That to me creates both an opportunity and a risk for the company. The ability to pass on costs to consumers is critical given the tight profit margins in the grocery sector.
However, it’s not easy to do, particularly with consumers already feeling the pinch. Holding back price increases could help to increase market share but at the expense of profitability.
In a sector where promotions get matched fast, it’s easy to look competitive while quietly taking a hit.
Valuation
Tesco shares are currently trading on a trailing price-to-earnings (P/E) ratio of 21 ahead of the market close on 20 March.
Arch rival J Sainsbury is sitting a touch higher at around 23.7 as I write. Both sit above the FTSE 100 average of around 18, which reflects the non-cyclical nature of their businesses.
This sort of valuation is broadly in line with the long-term average. Investors have been keen to back Tesco recently with the stock up 46% in the last 12 months to 473p.
There’s also the dividend to think about which can be valuable in uncertain times. The company has a 3% dividend yield right now. That’s less attractive than the 4.3% offered by Sainsbury’s but nothing to sneeze at.
Verdict
For me, war-driven food inflation is a huge risk. If the company can’t fully pass on cost increases to consumers then margins could get squeezed.
However, it’s not all doom and gloom. The company has gone through various other supply chain shocks and managed well.
Investors interested in knowing more should be watching the Tesco results carefully for management’s views and the company’s outlook.
And if this risk is building for Tesco, what does that say about the next earnings season across the wider UK consumer sector?
