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Edentree Opinion: Why Tesco can outlast its food retail rivals

By Ketan Patel, Fund Manager. 

An industry undergoing change

The food retail space in the UK is undergoing a period of radical transformation. Consumers increasingly buy goods and services online, including food where margins suffer significantly. This growth in online could allow new players, like Amazon, room to gain market share.

Challenge one: online

Online is the quickest-growing channel in UK food retail, achieving sales growth in the low teens, but still makes up only 6% of grocery sales in the UK. Despite this, the UK has the world’s most advanced online market accounting for half of the total global sales.

Tesco has been the leader in online and originally offered home delivery for £1, which did not cover the additional costs incurred, but did entice customers to try the service. Tesco subsequently increased this and also offer a delivery subscription service which creates a level of stickiness with customers.

Challenge two: amazon

While the market knew that Amazon had the potential to be a significant food retail threat, its lack of operations in this area prompted many to believe this was a decade away or more.

However, its recent purchase of Whole Foods has turned this assumption on its head. Amazon appears to be following Alibaba’s Asian model, where they bought four physical retailers to enhance their online service. A key risk is that, given Amazon’s scale, they can afford to operate at much lower margins than traditional food retailers to steal some market share.

Challenge three: changing store preferences

Should online grow as significantly as some predict, it will alter store networks, dividing them into conveniently located stores, online-fulfilment and destination stores. In the future, larger stores will become more fresh-food oriented as dry, durable goods are standardised and easiest to fulfil online.

Convenience stores have higher margins as their customer base is determined by location rather than price competitiveness as with hypermarkets. However, this trend is now introducing multiple stores to single streets, invoking consumer choice and potentially making competitive pricing a factor.

Tesco: size matters

Presuming Tesco’s planned takeover of wholesale operator Booker goes ahead, the company will have operations in the growing area of wholesale to cafes, restaurants and convenience stores. Further down the line, the combined Tesco/Booker entity could expand wholesale operations internationally as there are not many large players in this area.

This does not entirely mitigate the large proportion of Tesco stores that are in the declining hypermarket format and that the discounter threat is still real. Should Amazon buy a competitor it could become Tesco’s key rival.

However, given it has the highest market share by far in the sector and a strong online food offering already, it stands a better chance against such competition, although this could impact margins.

Tesco has the best opportunity out of the food retailers to achieve a sustainable 3.5%-4% margin with their volume, efficiencies and Booker deal. However, these margins will never reach the 6% levels once seen.

 

Ketan joined EdenTree in 2003. He began his career on the equity derivatives desk at JP Morgan, before moving to Insight Investment as a Global Healthcare Analyst. Ketan is a co-manager on the Amity UK and UK Equity Growth Fund. He has been a CFA Charterholder since 2009 and holds post-graduate degrees in both Geography and Economics from the University of London.