Tesco appears to be on an unstoppable march towards victory in the battle of the supermarkets. This week it announced profits of overmore than £2bn for last year – a record for a UK retailer.
The chain’s share price has responded in kind, up 26 per cent since March 2004, outperforming both its sector and the FTSE All-Share. Most analysts had a buy recommendation on the stock a year ago, and continue to do so now. But when the consensus is so overwhelmingly bullish, should investors be wary?
Tesco appears at times to do everything right. Whereas competitors like J Sainsbury or Wm Morrison (which bought Safeway in March 2004) are struggling, Tesco, with a nearly 30 per cent share of the domestic supermarket grocery sector, just goes from strength to strength.
In the year to February 26, while the rest of the UK market stagnated, Tesco produced like-for-like sales growth of 7.5 per cent. Total underlying group profit rose 20.5 per cent to £2.03bn, on sales of £37.1bn.
Through a mixture of profit growth, working capital improvements and property sale and leasebacks, Tesco also raised its return on capital employed (the amount what it earns on the amount invested in the business) from 10.2 per cent to 11.5 per cent, an impressive achievement in a mature industry.
Merrill Lynch, the company’s broker, is forecasting a further 15 per cent rise in profit next year.
Analysts laud Tesco’s business model where economies of scale are invested in lower prices, which drive sales, whose growth in turn enables further price cuts. And they believe that Tesco has scope to grow and to improve returns further.
Tesco itself says it expects its UK growth to slow next year, although strong non-food sales and an acceleration in international revenue growth should help to mitigate this.
Its expansion outside the UK generated £370m underlying profit in the year to February 26, up by a fifth on the year before.
Claudie Casimir, analyst at Oddo, says ina research note out this week that he sees nothing to worry about. “2004 performances were very respectable with double-digit growth for all items on the income statement, which is remarkable for the sector.”
Jaime Vazquez, analyst at JP Morgan, argues that whereas the UK is a mature market for its rivals, for Tesco it is a growth market. He was bullish on the stock last year, and has had an overweight recommendation since June 2003. “This time last year the main risk to our view was the recovery of Sainsbury and the Morrison acquisition of Safeway,” he says. “The risk turned out to be an opportunity.”
He believes the risks to his view stem from “rather intangible factors, such as the (potentially excessive) self-confidence of management (who could be tempted to use their equity valuation as currency for a big-splash takeover) and the possibility that Tesco will one day face the kind of public opinion backlash as seen with Wal-Mart in the US.”
Oddo’s Casimir is similarly sanguine about the risks to his buy recommendation. “Even though Tesco will not be able to escape scot-free from tougher competition and slower consumer spending in the UK in 2005, and will therefore have to look increasingly abroad for growth – thereby creating new risks on the stock – the group’s strong positioning in its domestic market should allow it to continue outperforming peers, and the risk of upset is limited in the short term.”
David McCarthy, at Citigroup Smith Barney, in research published this week, identifies some potential risks to his positive view. One is the threat from the UK’s number two player, Wal-Mart/Asda, although he believes Tesco is well-positioned to deal with this challenge. Second, he feels Tesco may find it more difficult to take market share from the merged business of Safeway and Morrison than it didin the past from Safeway. And the chain’s growing of its international business means that it is subject to exchange rate fluctuations and more volatile economies that are more volatile than the UK.
The fact that analysts feel there are so few risks to their positive view suggests the stock may be vulnerable to surprises: an unexpected acquisition such as Matalan, the non-food retailer?; an unforeseen change in management? The bullish consensus is also reflected in the stock’s valuation, which is not cheap on eight times earnings before interest, tax, depreciation and amortisation, and a 2005 price earnings ratio of 17, compared with a sector multiple of about 14 times.
Nevertheless, the consensus was right this time last year. And even if the shares go up only slightly, as Tesco’s own ads say: “Every little helps.”
