Food retailers like Tesco (LSE:TSCO) are go-to shares for novice investors and those seeking quality defensive companies. We all need to eat regardless of whatever social, political, or economic crisis is going on outside our windows. As a result, revenues and profits at these companies typically hold up better during downturns.
But is this long-held belief starting to look more shaky? If fresh data from Which? is to be believed, the robustness of UK supermarket shares is coming under severe pressure.
My view? Tesco’s share price could be set for a painful correction. Here’s why.
What’s happened?
First let’s look at that red flag hoisted by Which? In a chilly retail report, it says that “consumer sentiment was already bad prior to the conflict in the Middle East, but it has fallen sharply in the past two months“.
As a result, its latest survey in mid-April showed “consumer confidence in the future UK economy fell to -62, the lowest level since the height of the cost of living crisis“. Just 9% of respondents think economic conditions will improve over the next year. A whopping 71% believe they’ll worsen.
So what does this mean for food retail? It’s pretty worrying, to put it mildly. Which? says that more than two-thirds of British adults have made “at least one adjustment to shopping or eating habits in the last month“.
These include:
- Buying cheaper products (43% of respondents).
- Buying more supermarket own-brand budget goods (37%).
- Buying extra items on promotion (31%).
Perhaps most alarmingly, Which? says that “15% of UK households reported going without some foods and one in 10 are skipping meals“.
What does it mean?
This is clearly bad news for Tesco, though it may be better placed to tackle this threat than its rivals.
As the UK’s largest supermarket, it has enormous scale and buying power, meaning it can get better prices from suppliers. It also has strong brand power, and a reputation for value that’s helped by promotions through its Clubcard member scheme. Finally, it has an excellent data advantage through Clubcard, enabling it to target promotions more effectively than its competitors.
Yet the threat to Tesco’s sales and margins remains severe. And in the economic current climate, the firm has limited scope to raise prices to protect its already wafer-thin profit margins (just 4.3% last year).
There’s another big worry for Tesco: if customers are cutting back on food essentials, how bad will things get for the retailer’s general merchandise lines? The FTSE 100 firm makes 5%-10% of revenues from non-grocery items.
Will Tesco shares crash?
The longer the Iran war drags on for, the worse these profits threats become. I don’t believe this is baked into the supermarket’s current valuation, leaving it in danger of a correction.
Tesco’s share price has soared 30% over the last 12 months. The result? Its shares trade on a forward price-to-earnings (P/E) ratio of 18.9, well above the 10-year average of 12-13.
Its next trading statement is due on 18 June, and any negative news could send its shares toppling. They could even slump beforehand if news on consumer spending and the broader economy worsens. While it enjoys some protections, I won’t be buying Tesco shares for my portfolio in May.
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Royston Wild has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco Plc. 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.
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