Tesco plc, B&M European Value Retail SA and the race to the bottom in retail

Whatever happened to equality? In Thomas Piketty’s great tome Capital in the 21st Century, the writer described how the world is rapidly being divided into those that have, and those that have not. Between those who seem to have an almost endless supply of wealth, and those who can only just get by. I think he’s right.

Understand this and you’ll understand the new consumer economy in the UK and around the world. The supermarket sector is divided between the premium retailers such as Marks & Spencer and Sainsbury, and the value retailers such as Aldi, Poundland and B&M (LSE:BME).

Tesco is in retail’s squeezed middle

And those that are in the middle, such as Tesco (LSE:TSCO), Morrisons and Asda, are being squeezed from both sides. In a deflationary world where manufacturers in China and India are churning out an endless supply of consumer products, we’re facing a race to the bottom in the low-cost sector.

What’s more, we now have too many supermarkets in this country, as retailers have found the habit of building out-of-town superstore after out-of-town superstore too difficult to give up. If every retailer is building new supermarkets, and hardly any are being closed down, is it any surprise if competition is the fiercest it has ever been?

Tesco, faced with this situation, has had to decide whether to preserve sales, or preserve earnings. It has gone for the former option. In order to maintain its sales level, it has had to cut prices, and this has meant that a company that used to make multibillion pound profits is only just breaking even.

In 2014 Tesco made £1.9bn of net profit. In 2016 this had fallen to just £216m. That’s why, even though the share price has been tumbling, the trailing P/E ratio is an expensive 27, with no dividend being paid out.

B&M is growing sales and profits… fast

Contrast this with one of the most successful value retailers of the moment, B&M. In 2014 it made a net loss of £19m. In 2016 this had turned into a net profit of £125m. And this has been accompanied by a rapid growth in sales, with £1.3bn of turnover in 2014, increasing to £2bn in 2016. B&M’s shares are on a better value trailing P/E ratio of 19, with a dividend yield of 1.54%.

Browse the aisles of B&M today and you’ll see a broad range of cheap and cheerful products that remind me of Tesco in the 1980s. Cash-strapped shoppers are accepting that these no frills products are all that they need.

Meanwhile, if you shop in Waitrose, you’ll find an incredible variety of delicious and high quality fare that caters to consumers who are happy to spend that little bit more.

That’s why I view companies like Marks & Spencer and B&M European Retail as potential buys, whereas I’ll continue to avoid Tesco and Morrisons.

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