As the UK’s largest food retailer, Tesco (LSE: TSCO) should be one of the most defensive stocks around. As long as people need to eat, Tesco will be able to sell stuff. However, food retailing is a low-margin business, and growing competition in the sector has weighed on Tesco’s profitability for the past four years.
For example, even though City analysts are currently expecting the firm to report a pre-tax profit of £1bn for 2019, this is nothing compared to the group’s expected turnover of £59bn. These figures give a net profit margin of 1.7%.
But while Tesco’s margins are razor thin, the retailer’s suppliers are much better off.
A better business
Greencore (LSE: GNC) is one of the UK’s largest food producers, and Tesco is one of its clients. The firm manufactures convenience food such as sandwiches and sushi, along with dips and sauces. Over the past five years, the company has gone from strength to strength with revenue nearly doubling and net profit rising from £19m for 2011 to £47m for 2016.
Greencore has used its position in the market to grow both organically and through acquisitions. Its latest buy was the $745m deal to acquire US-based Peakcock Foods, which helped the firm report a 57% increase in revenue for the for the year to September 29.
Unfortunately, costs associated with this deal have weighed on profitability. According to Greencore’s full-year results release, issued today, pre-tax profit for the year fell sharply to £12.4m from £48.2m due to exceptional costs of £78.2m. Nonetheless, despite these headwinds, revenue for its UK & Ireland operations was up 12% on a pro forma basis year-on-year. Adjusted operating profit rose 2.6% to £106m as the US business posted a revenue rise of 5.9% on a pro forma basis, while operating profit was £33.3m after a loss of £2.1m last year.
Returning to growth
I believe Greencore’s year-end figures show precisely why the company is a better buy than Tesco.
As the UK’s largest retailer struggles to gain traction in a competitive market, Greencore’s size and experience is helping it continue to grow despite headwinds. After the integration of Peacock is complete, profit growth should return, and analysts have pencilled in a pre-tax profit of £148m for the year ending 30 September 2018. Based on this estimate the shares are trading at a relatively attractive forward P/E of 11.
In comparison, Tesco is currently trading at a forward P/E of 18.4, which I believe is too expensive when you take into account all of the risks now facing the business. With profit margins below 2%, the retailer does not have much room for manoeuvre if another price war kicks off in the sector.
Also, while management’s efforts to cut costs have yielded some results, it’s not clear how much more can be taken out of the cost base. If the discounters go on the offensive again, Tesco may find itself in a precarious position. For that reason, I don’t believe that it’s worth paying a premium for the shares.
Overall, considering Greencore’s position in the market and growth potential, I believe that the company is a much better buy than Tesco.
Avoid these key mistakes
Low-margin businesses like Tesco tend to be poor investments as they lack flexibility if things don't go to plan.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK owns shares of and has recommended Greencore. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.