Christmas might not have been a washout, but that’s not enough to inject any more cheer into investors. Festive sales were 7.9 per cent higher for Tesco, saving the UK’s largest supermarket chain from a profit warning. But the market is more focused on what is coming.
Higher prices were behind the increase in sales, actual volumes fell. Figures from Kantar had already revealed that grocery prices were running just over 14 per cent ahead of December 2021. To no one’s surprise, customers have continued to trade down, both in terms of the amount they are buying and ditching branded items for the no-frills version. Why does that matter? Higher-priced branded goods deliver a higher cash margin, own-label items are relied upon to push volumes up, points out the brokerage Shore Capital. The latter has not done enough heavy lifting. That’s a double punch to the bottom line.
There were clearer positives. Tesco might have continued to lose custom to the discounters but taking more share from the three mainstream rivals more than made up the slack, Ken Murphy, the chief executive, said. Online sales in the UK also returned to growth over Christmas after sliding post-pandemic. Just how much of that is down to customers wanting to avoid the crowds over the festive rush will become clearer over the next quarter.
The upshot? Adjusted operating profits for the retail business are still on track to come in at £2.4 billion to £2.5 billion over the 12 months to the end of February. That guidance includes belt-tightening among consumers after Christmas, too. That is below profits of £2.6 billion last year, a fall caused by higher wage and logistics costs and lapping the booming sales when consumers were locked down.
As for inflation, it has not peaked, believes Murphy. He expects prices to top-out around the middle of this year. Tesco’s hands have been tied in terms of how much of the pain of higher costs they can pass through to consumers by raising prices, without losing share. The adjusted margin at the full-year is on course to come in at about the 3.9 per cent recorded over the six months to August, Imran Nawaz, the finance chief, said, which would be below the 4.4 per cent recorded last year.
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The market is more tightly focused on what happens this year, when the impact of higher interest rates gets a tighter grip on household finances and more mortgages are due for refinancing. Analysts seem bullish enough, expecting adjusted operating profit to edge higher to £2.6 billion over the 12 months to the end of February next year.
If the outlook for sales volumes seems highly uncertain, that has not been reflected in the Tesco valuation. An enterprise value of six times forecast earnings before interest, tax and other charges is broadly in line with the stock’s ten-year average, so not exactly cheap.
If there is one thing investors can seize upon it is a strong level of free cashflow, expected to come in at £1.8 billion this year. The cash being generated by the core retail business has been enough to reduce debt, which stood at £10 billion, or roughly 2.5 times adjusted profits, at the end of August, as well as funding a £750 million share buyback programme that is still continuing. That return is in addition to paying a generous dividend, which is forecast by analysts at Shore Capital to total 10.4p this year and next, which would equate to a yield of 4.2 per cent at the current share price.
What will truly lift the shares out of their fug? Signs that sales volumes are recovering, which have a better chance of materialising towards the back-end of this year. Pulling off a two-year cost savings target of about £1 billion by the end of February next year will help.
ADVICE Hold
WHY The shares are not cheap considering the uncertainty over sales volumes this year
Dechra Pharmaceuticals
The pandemic pumped up many stocks undeserving of plaudits, such as the online grocer Ocado or the 2021 IPO catastrophe, Deliveroo. The veterinary medicine specialist Dechra Pharmaceuticals does not fall into the dud camp, but it has suffered as the boom in spending on pets has subsided.
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Flaunting a peak forward p/e ratio of 46 in the face of raging inflation, hardly helps. Since this time last year the share price has fallen by a third, representing a more reasonable earnings multiple of 21. The shares are cheaper for a reason. Revenue growth has slowed, at just 1 per cent over the past six months once acquisitions are stripped out, down from 8 per cent during the same period in 2021. Then there is the impact of higher wage and raw materials costs. Underlying operating profit is expected to be £191 million this year, 10 per cent higher than last year, but less than half the annual rate clocked up in 2020 and 2021.
There are tentative signs of improvement in revenue, including better growth during the second quarter. Price increases put through at the start of the year will also make themselves felt, as will the South Korean business, which was out of action while a new distribution partner was found.
But the premium, long baked into the shares, reflective of greater scale and a long-term record of higher growth, has also been eroded. That is less easy to justify. The FTSE 250 group’s stellar run was amplified, rather than sparked, by the twin-engine of a rise in consumer savings and pet ownership during the pandemic. Investors have got behind the stock for good reason. In the five years before the pandemic, revenue grew by an annual compound rate of 20 per cent, while earnings rose at a rate of 25 per cent.
That has been achieved by carving out a niche, prescription-only drugs business primarily for dogs, cats and horses that has helped to differentiate Dechra from large companies focused on mass-market products such as flea and worming treatments, as well as bolt-on acquisitions.
That has not been at the expense of the balance sheet either, with a leverage multiple of around one.
ADVICE Buy
WHY Share price weakness looks like an opportunity
over the medium term
