Tesco to Report as Food Prices Fall While Competition Rises

Inflation in the UK is coming down finally, but as shoppers look for relief, UK grocers can feel an extra margin pinch, with budget-focused stores like Tesco especially vulnerable.

UK Grossers Facing Margin Squeeze

Last month, food prices in the UK fell for the first time in two years, driven by intense competition among the major chains, according to the British Retail Consortium. The monthly drop of 0.1% pales compared to the 9.9% annual growth; however, it will relieve British shoppers little. It does show that grocers are facing limits to pass increased costs on to consumers, though a threat to margins. In anticipation, Tesco had already been pressuring suppliers to cut prices. Recently, major supermarkets have been cutting prices to entice customers and stave off the growing competition from discounters Aldi and Lidl, which continue to grow despite the cost-of-living crisis.

As the premier budget British supermarket, logically, Tesco faces more competition from the German discounters. But, there could be some relief from an unexpected ally: Higher interest rate costs. Lidl is facing higher borrowing costs, which could put a crimp on expansion plans, as the BOE is set to keep rates high to bring down inflation. The British unit of the German discount store also reported a loss over its last fiscal quarter, as it focused on expansion in a tight margin environment. Aldi and Lidl have forced Tesco to take more competitive action to keep prices down in the short term.

Adjusting to a New, Challenging Market

The margin compression is expressed in the summary of analysts' outlook, compiled by Tesco ahead of its earnings release on Wednesday. Headline sales are forecasted to increase this fiscal year, reflecting growing inflation, while operating profit is projected to show a much more modest expansion. That is likely to be the focus of the interim report, with how much margins will likely be impacted as Tesco tries to hold on to market share. Headline sales are seen rising 7.4% over the same period last year, driven primarily by price increases instead of volume.

As for the outlook, investors might hope for a boost to the £750M buyback already announced for this year or signs that it might be renewed. But that supposes Tesco can keep free cash flow up without too much margin compression. The company's current shareholder reward program contemplates operating income staying flat this year, and given the expected increase in operating margin in the first half, it could withstand a comparable decline in the second half and still maintain dividends and the buyback.

Tesco in Pullback After Leading Wedge

Tesco's stock price has likely formed a leading wedge pattern at 275 GBX, pending deeper corrections. Typically, they pull back 61.8% to 78.6% of the entire leg (from 245 to 275 GBX), bringing 255 and 250 in focus. Losing the latter support will increase speculation for a falling flag, exposing 245 and lower levels. If prices rise past 265 and 268 (the two wedge peaks), advancing above 275 may open the door to 285 and eventually leave a low behind.

Source: SpreadEx / TESCO

Key Takeaways

UK grocers are facing a margin squeeze as food prices in the UK fell for the first time in two years due to intense competition among major chains. Tesco has been pressuring suppliers to cut prices in anticipation of the new trend as it faces competition from discounters Aldi and Lidl. The company may find relief from higher borrowing costs for Lidl, which could hamper its expansion plans. Tesco's upcoming earnings release is expected to reflect growing inflation in headline sales but only a modest expansion in operating profit, highlighting the impact on margins. The company's ability to maintain dividends and the buyback program will depend on free cash flow amidst potential margin compression.