Tesco shares (LON:TSCO) have had a relatively upbeat reaction over the past week on the back of a solid Q1 trading update. As the stock closes in on its 5-year high of 397p, this begs the question of whether the shares are still worth buying.
Sunny Update
Britain’s biggest supermarket had quite a stellar quarter, as group sales increased 3.7% to £17.85 billion. More promisingly, the company saw positive sales growth across all its retail divisions – the first time in more than a year.
This strong momentum was primarily driven by Tesco’s UK and ROI divisions, where their collective sales rose by 5.4% to £15.39 billion. This was down to the grocer building further momentum in its UK (+0.44% to 28.0%) and ROI (+0.22% to 23.3%) market shares. Particularly, Tesco’s premium Finest line did magnificently well in the UK, with sales up an ever-impressive 18.0%, on top of last year’s already splendid 12.5%.
Central Europe’s sales also finally turned positive, as sales grew 3.5% to £997 million. This came after a year that was bogged down by tough comps and unfavourable FX from a strong pound. Still, Q1 sales would’ve been higher had it not been for the same reasons, which pulled growth down from 5.8%. On the flip side, fuel sales continued to suffer with a 10.5% decrease to £1.47 billion, as petrol prices fell back to 2021 levels.
That said, the biggest surprise was Tesco’s wholesale division at large, Booker. The arm recorded a 3.5% increment in sales to £2.31 billion, as its core retail (+5.4%) and core catering (+7.3%) sub-divisions outperformed, due to sunny weather encouraging more eating out activity. This managed to offset the continued weakness in tobacco (-9.0%) and Best Food Logistics (-0.8%), although the latter’s decline has become less negative.
Thus, management reiterated its FY26 guidance, with expectations for EBIT to come in between £2.70 billion and £3.00 billion. While this is still a reduction as compared to last year’s £3.13 billion, this is largely seen as a relatively conservative set of guidance by analysts alike. There’s some optimism surrounding the possibility that the figure due in 10 months’ time could come in higher than the current consensus of £2.93 billion.
Fine Margins
Having said that, there’s an argument to be made that the market pricing in a fall in Tesco’s EBIT is relatively reasonable, especially given the current macroeconomic environment. After all, the firm is contending with a massive headwind of costs that include around £430 million of wage hikes via national insurance contributions and higher living wages, food inflation, and elevated price competition from its peers.
Nonetheless, the group has some levers to pull to offset some of these cost hikes via its £500m Save to Invest programme. For one, Tesco’s market share growth should aid its sales volumes. This should help to keep margins more robust. Additionally, higher-margin items such as Finest food lines and non-food sales like clothing are now making up a bigger portion of customers’ baskets.
Moreover, while certain commodity prices such as proteins and seed oils are re-inflating in price, overall food prices should disinflate as the year progresses, as other commodities such as wheat, rice, and sugar prices now back down. Plus, much of the recent increases in grocery inflation may be attributable to supermarkets passing on the spikes in labour costs onto consumers.
The only worry moving forward, though, are the tough comps Tesco faces. With the likes of ASDA and Morrisons lowering their debt pile over the past year, price competition is becoming more intense, as these supermarkets can now afford to invest more in lower prices. As such, Tesco may have to invest in more promotions in order to grow its market share and volumes at the expense of margins, subsequently.
An indication of this may have come in last week’s update, as net switching gains were not featured for the first time since Tesco’s FY23 results. Therefore, this could be a sign that customer attraction is becoming more of a challenge. That being said, CFO Imran Nawaz did mention that quite a substantial number of promotions (around 32.0%) are still being funded by suppliers, which is a positive from a margin standpoint.
Still Under Promotion?
It’s certainly a huge positive to see Tesco managing to grow its market share despite the hotter competition in recent months. The FTSE 100 stalwart’s food volume growth, together with its excellent cost controls give reason to believe that margins can even remain steady this year, provided the market continues to price rationally, and that price competition doesn’t heat up even more.
As a matter of fact, the margin story can be supported by two main pillars. The first is the higher margins coming from F&F and other non-food items. With Tesco’s toys segment now having moved to a commission model, CEO Ken Murphy has reported better profitability. The second is Booker – with its core catering and core retail businesses which command higher margins – now boasting impressive growth rates.
Nevertheless, there’s some caution to note. Most prominently, the UK’s macroeconomic outlook doesn’t look particularly promising. April’s GDP showed a larger-than-forecasted contraction (-0.3% vs -0.1%), with the unemployment rate (4.6%) now at its highest rate in almost 4 years. In fact, the board has cited unemployment as the key metric to monitor on how consumer spending may evolve throughout FY26.
However, assuming April was a blip due to businesses front-loading imports to avoid President Trump’s imminent tariffs, and that the unemployment rate will revert back down after the initial national insurance shock, Tesco looks to be in a prime position to keep pushing ahead with further growth. Either way, Murphy thinks the consumer remains still healthy, backed by the fact that real wage growth is still positive.
But from a valuation perspective, Tesco shares look appealing. Provided the UK economy doesn’t worsen, FY26 EPS could end up being flat Y/Y, or even come in a tinge higher than FY25’s 27.38p, aided by the £1.45 billion worth of share buybacks. On that basis, the stock has a forward P/E of 14.6 – lower than the sector average of 19.0. This leaves room for some upside to complement a decent forward dividend yield of 3.8%.
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