The Business Of

Tesco | What Are Their Costs?

Morning All!

So yesterday we looked at How Tesco Makes Money - and saw that cigarettes, coca-cola and chocolates are some of the most popular products for shoppers at UK supermarkets.

Today we’ll be seeing what costs are needed to operate this UK retailing giant. So without further ado…

Beware: Razorrrrr Thin Margins

One of the main things that investors look for in companies/industries is strong margins. As we explore more business models, we’ll see several companies that do exhibit high margins. For example, industries like asset management and luxury fashion have strong and sustainable margins. And we’ll see companies in these industries boast EBIT (Earnings Before Interest and Tax) margins of 30% and higher. Now, I hope you're ready - but let's look at Tesco...

Tesco's EBIT margin for 2022 was 4.6%.

And this wasn't just a one-off. If we look at the chart below showing margins since 2015, 4.6% is actually the highest its been since then! The company's operating margin has averaged just 3.1% over the last 8 years. So, whilst strong, sustainable margins are a brilliant trait for a business to have, not all successful businesses have strong margins (just ask Tesco, or Amazon for that matter!)

Tesco in their reports just lump all their costs under 'Cost of Sales'. But they do tell us that the main expenses and so let's dive into these.

(i) Purchasing Costs

Okay, so we established in the previous section that the bulk of Tesco's revenues come from selling cigarettes, fruit, vegetables, meat, fizzy drinks, etc. However, the second part of the puzzle is - how much are Tesco paying brands/companies to purchase their cigarettes, fruit, veg, meat, fizzy drinks, etc? The answer here is actually in the selling price.

As an example, let's look at chicken! Tesco buys an extraordinary 3 million fresh chickens every week! Their biggest supplier of chicken is Avara Foods. On the company’s website (here), there’s a brilliant illustration of how their supply chain process works. But to make it very simple… Avara receives hens from specialist breeders/farms. They then take the eggs laid from these hens, and wait for these eggs to hatch. After hatching, they raise the birds in large, open, climate-controlled houses before processing these birds. Upon processing, these chickens are then packed into the products that we see in supermarkets - thighs, breasts, fillets, etc. As I said, that’s a very simple way of explaining it!

Now if we look at the screenshot below, we can see Tesco selling 1kg of chicken for £6.70.

What would they have paid Avara Foods for this 1kg of chicken? Well, unless you worked at Avara Foods, there is no way of telling for sure as these contracts are confidential! But let's estimate that it's around 2/3 of the selling price, so £4.46. This means that Tesco mark-up the chicken by 50% (6.70/4.46 = 1.5). Tesco's gross margin for this product would be ~33% ((6.70-4.46))/6.70). Now, this markup is going to vary by supplier. For a brand like Coca-Cola, one of Tesco's biggest suppliers, the mark-up will likely be a lot less, maybe 15-20%. Meaning that if a Coke can is sold for £1.20, Tesco would likely purchase this from Coke for £1.

These agreements however, are based on negotiation and sometimes suppliers and supermarkets can find no middle ground. We saw this in 2022 where the supplier, Heinz wanted Tesco to pay them a much higher price for their products than the year before. Tesco didn't want this because it would mean either (i) a lower gross margin for Tesco or (ii) a higher price that their customers would have to pay (if Tesco increased the price they sold Heinz products at). As Tesco and Heinz didn't come to an agreement, Heinz's products were taken off shelves!

However, one party must have compromised because Heinz baked beans and tomato ketchup is now back in Tesco stores... phew!

After the agreements with suppliers have been made, there is a second part of purchasing. And that is - where do Tesco store the purchased products? Well, if you've ever been driving down the motorway and seen these giant structures (bottom left), with the big Tesco signs, you've just driven past all the purchases!

Tesco needs these massive warehouses because so much food and drink needs to be refrigerated/frozen. But also, from central hubs like these warehouses, the right amount of stock (food, drinks, cigarettes, etc) can be shipped to the individual Tesco stores in the region. Whilst the energy costs for operating these warehouses are incredibly high (unfortunately, I couldn’t find accurate figures), they are on the way down, with Tesco looking for ways to improve their energy efficiency.

(ii) Getting It To Customers

Once products have been bought from suppliers and stored in the warehouses, the next step is actually getting it to consumers. This usually happens in two ways - via lorries and via rail. Tesco has over 5,000 vehicles (lorries and trailers) in their commercial fleet and also invests in rail freight. During the lorry driver crisis, Tesco credited their use of rail freight as helping getting products in their stores. The main costs associated with lorry transport is the fuel cost and driver cost.

Once products are agreed and then transported to stores, there is one further cost for Tesco related to 'getting it to customers'. And that is marketing costs. Some companies need marketing for people to become aware of the company. For example, a startup will need to invest in marketing so customers can hear about their products. However, why do Tesco need marketing - everyone already knows about them?! The reason Tesco invest in marketing is because, whilst customers know about them... they also know about Sainsbury's, Morrisons, and their competitors. Tesco need to remind customers about their offering and make their brand first in people's minds. Hence, we often see marketing campaigns - like the ones below - on our TVs and mobile phones.

(iii) Store Costs

Okay, so nearly there! Products have been agreed and purchased from suppliers. We've stored them in warehouses. Then transported them to stores. We've advertised the brand to customers. Now, we need to help customers actually buy the products when they come to the stores! And for this, we need employees!

From Tesco's reports we can see that the company had 231,223 full-time employees in 2022. And the total amount they paid on salaries and social security costs was £6.9bn. This indicates that the average employee at Tesco makes £29,854. However, this number is actually being too optimistic. Because within those 231,233 employees we've got the CEOs and directors who earn far more. And there's also plenty of non-full-time employees who also take some of that £6.9bn. So the average full-time employee probably actually earns closer to £20-25k.

The other major store cost for Tesco is rent and this is an expense the company has been very keen to bring down over the last decade. As of 2022, Tesco owned 58% of their properties in UK&ROI. For these properties that Tesco own, they don’t need to pay rent. However, for the other 42%, they have to pay rent in order to use the stores. As the chart shows, Tesco have been keen to own more of their properties over time so they can save on rental costs.

22nd Feb 2023

Nigel Jacob CFA