Tesco (LSE: TSCO) shares recently had the distinction of falling to price levels not seen since 2016. For a company as ubiquitous as Tesco, providing goods and services that we all need, that must raise some alarm bells for me. So, what is going on?
The supermarket business is challenging
Tesco’s dominance in the grocery sector is not in dispute. But this does not shield it from the larger challenges it now faces. The competition from lower cost rivals such as Lidl and Aldi are well documented. In fact, these chains reportedly are the fastest growing supermarkets in the UK.
Tesco has said in response that it has worked aggressively to close price gaps across a range of products, as well as imposing a price freeze on more than 1,000 items until 2023.
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In my view, such efforts to maintain market share can only come at a cost to the bottom line.
Present economic conditions don’t help
While spending money on food is not necessarily considered discretionary, the present cost-of-living crises within a recessionary environment is bound to influence how much we spend. In fact, supermarkets are already suggesting that the coming Christmas period will not be “normal”. Consumer confidence is certainly impacting sales.
Such an operating environment accounts for a 64% drop in profits for Tesco in the first half of 2022, against a backdrop of rising costs, falling margins and inflationary pressures.
So, what is the upside?
I do believe that it is too early to dismiss Tesco as a potential investment for my portfolio. There is room for some optimism.
It is, despite poor trading conditions, on a more stable financial footing than many of its rivals. Its strong cash position implies it is better suited to outlast a price war. Then combine this with its enormous scale of operations and the subsequent buying power it enjoys with its suppliers.
Additionally, it has an effective loyalty system via its Clubcard membership. An impressive 20 million customers benefit from reduced prices on many products. Tesco has achieved this while also being particularly effective at capitalising on the growing online grocery business and now enjoys a 39.5% share in the UK.
Finally, the directors themselves have been buying stock in some volume. This to me indicates a vote of trust in their own company.
Potentially both a growth and an income stock
I do not know when the share price will recover, but I am assuming that most of the bad economic news has already been priced in. In the meantime, Tesco continues to maintain its policy of paying half its profits to shareholders. Presently the dividend yield sits at 5.12 % with a dividend cover of around 2.01. To my mind that could be an acceptable return while I wait patiently for the stock to perform.
