Last week the market wiped out £1.5 billion of the valuations for Tesco PLC (LSE:TSCO) and J Sainsbury PLC (LSE:SBRY) due to worries that the industry will see profits squeezed amidst rising costs and changing interest rate expectations, but for investors JPMorgan sees "10 reasons to buy the dip".
The bank noted that this penalisation was despite underlying increases in forecasts for the companies and both the pair's positive post-Christmas reports in the week as well as the current market dynamics.
2025 will see the whole grocery industry pass through cost inflation onto customers, leading to higher food cost inflation – which indeed was something the retail industry warned of last week.
JPMorgan's analysts have nudged up their profit estimates by 2-4%, driven by UK food inflation assumptions that are now one percentage point higher, and sales volume estimates that are now half a percentage point higher.
The target prices for Tesco (down to 400p from 410p) and for Sainsbury's (down to 305p from 310p) offer 10% upside potential for the former and 20% upside for the latter.
"The UK grocery market should remain rational for longer, in our view," the analysts said in a note to clients, based on their assumption that "improved execution" and price positioning from the two biggest supermarkets will continue, "in sharp contrast to strategies of margin preservation/maximization at key rivals Asda/Morrison and discounters [who hold circa 40% combined market share]".
Feeding through from the industry-wide pass-through of cost inflation, Tesco and Sainsbury's should enjoy "constructive" benefits to gross margin, cash flow and capital returns than the majority of City analysts are expecting, the JPMorgan team believes.
"The recent pullback in TSCO and SBRY creates a good opportunity," they said, with shares trading on 10-12 times earnings and 9-10% free cash flow yield, a 10-20% discount to the sector.
This thesis does not apply to B&M European Value Retail SA (LSE:BME), the analysts added, as it faces "company-specific issues, in our view".
The JPM target price for B&M was cut to 320p from 349p, versus the last close price of 316p.