Tesco (LSE:TSCO) reported a 3% increase in revenues compared to a year ago. The stock is down 26% over the last 12 months, so should I buy Tesco shares?
Competition
Tesco is the UK’s largest supermarket, with over 3,000 stores and a market share of around 27%. But it can be difficult to find attractive investments in the retail space.
When I look for companies to invest in, I try to find businesses that can see off competitors. In other words, I look for something that keeps customers coming back.
This can be hard for a retail business. Even if I shop at one supermarket this week, that doesn’t prevent me from going somewhere else next week.
Tesco has one way of trying to incentivise customers to return, though. This is its Clubcard programme.
The Tesco Clubcard programme has more than 19m members (I’m one of them). That’s a lot of people who have an incentive to shop at Tesco rather than anywhere else.
So does this mean that Tesco has the kind of competitive advantage I look for in a stock to buy? The company’s most recent earnings report indicates to me that it doesn’t think it does.
Earnings
As a result of low switching costs, supermarkets are keen to try and convince shoppers that they offer the best value. They do this by freezing prices and matching offers from competitors.
Competition for the lowest prices typically means that margins are generally low. Tesco, for example, has an average net margin of just 3.5% over the last five years.
The point of something like a Clubcard system, in my view, is that it gets Tesco out of having to compete on price. It gives customers a reason to shop at Tesco even if its prices aren’t the lowest.
Tesco’s earnings report, however, indicates to me that it’s caught up in the struggle for the lowest prices along with everyone else. And that concerns me as an investor.
In order to compete with other supermarkets, Tesco has been holding down prices. This has succeeded to a point – customers are continuing to shop there and revenues were higher than expected.
The trouble is, holding down prices has resulted in lower margins and lower profits. As a result, management forecasted that profits would come in towards the lower end of the anticipated range.
If I were a Tesco shareholder, I would see this as bad news. I’d be looking for the company’s Clubcard system to help maintain higher margins than competitors, which doesn’t seem to be happening.
A stock to buy
I don’t think that Tesco is a bad business by any stretch of the imagination. I’m sure its shareholders will do well – and I hope that they do.
For me, though, when I ask myself what the company’s protection against competitors is, I don’t have a good enough answer. That’s why I don’t anticipate buying Tesco shares.