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Small Caps vs Large Caps: Are McColl’s Retail Group plc & Conviviality Retail plc Better Investments Than Tesco PLC?

Britain’s supermarkets are going through a rough time, as they face intensifying competition from the German discounters, online supermarkets and more upmarket outfits like M&S and Waitrose. The rapid shift in the way consumers shop for their groceries have quite simply left the incumbent supermarkets behind.

Convenience stores set to increase market share

Convenience stores are the unsung heroes of the UK grocery market, as revenues for the sector are growing even as overall spending in the market is declining. IGD, a research and training charity in the foods industry, expects convenience store sales in the UK will grow from £35.6 billion to £46.2 million by 2018.

Convenience store chains, including McColl’s (LSE: MCLS) and Conviviality Retail (LON:CVR), are set to benefit from a significant slice of the growing market.

But, the incumbent supermarkets are fighting back hard, by offering significant price cuts across their product lines and making substantial cost savings. The resulting food deflation that these discounts are making will undoubtedly lead to downward pricing pressure across the sector. Even as convenience stores grab a bigger slice of the market, their margins will likely become squeezed.

McColl’s Retail Group

McColl’s is probably the most attractive of the three. Earnings is set to grow modestly over the next few years, and it shares carry a forward P/E of 10.9, with an indicative dividend yield of 5.8%.

Strong operating cash flows and the proceeds of its recent IPO have enabled McColl’s to accelerate its new stores expansion and convert existing stores to its premium format.

So far, margins have held up to pricing pressures, with gross margins falling to 24.2% in the 2014, from 24.3% in 2013. Like-for-like sales grew 0.7% in 2014, with total revenues growing 6.1%.

McColl’s is also the biggest operator of post offices, with 451 branches. The company is looking to integrate more of them into their stores, which should improve customer experiences.

On a more negative note, Christmas trading has been more difficult than expected, as competition from supermarkets intensified. Like-for-like sales in the six weeks leading to 11 January, 2015 actually fell by 0.9%, but overall sales still grew by 4.7%.

Conviviality Retail Group

Conviviality has a greater focus on off-license convenience stores, with its Bargain Booze and Wine Rack brands. Its recent trading update has been slightly more downbeat, with revenues falling 2.5% in the first four months of 2015.

Much more work needs to be done to improve older underperforming stores, as like-for-like sales fell 1.7%. But, the timetabling of new store openings in the second half of this year should abate the poor start to the year.

Conviviality’s sizeable franchise network means its business is more asset-light, which enables it to open new stores at a faster pace. The company also benefit from a net cash position of £10 million. Conviviality has a forward P/E of 12.8 and an indicative dividend yield of 5.5%.

Tesco

Tesco’s (LSE: TSCO) financial performance is in poor shape, with total revenue falling 1.3% for its 2015 financial year. Like-for-like sales, excluding fuel, fell 3.3%, with underlying earnings per share down 71% to 9.42 pence.

Although the decline in like-for-like sales in the UK seems to be slowing down, margins have fallen by more than three-quarters, leaving trading margins just above 1%. With slowing investment in convenience stores in an effort to conserve cash, growth should be very limited in the medium term. Yet, the company trades at a forward P/E of 23.2, based on analysts expectations for EPS of 9.10 pence.

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Jack Tang has no position in any shares mentioned. The Motley Fool UK owns shares of Tesco. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.