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Stockatonia Comment: Tesco Plc Christmas Trading and Strategic Update – 8 January 2014

 

Company and Market Overview:

Tesco Plc is a grocery retailer that is head-quartered in the UK. With more than 3,000 stores, employing 500,000 people worldwide, Tesco has grown to become one of the world’s largest supermarket chains since it was established in 1947. The group is a FTSE 100 company, listed under the general retailers segment of the London Stock Exchange.

The UK grocery market is subject to fierce competition and currently dominated by the “Big Four” supermarket chains, Tesco, Sainsbury’s, Asda, and WM Morrison.

The above firms occupy what is frequently referred to as the middle segment of the market, while continental discounters hold the lower tier and the home grown, quality-focused Waitrose and Marks & Spencer attract the more affluent customers at the higher end of the income spectrum.

Index FTSE 100 Ticker TSCO.L Latest Close 209.35
52 Week High 341.58 52 Week Low 155.40 P/E H 8.9
P/E (F) 20.41 Dividend Yield % Dividend Cover
CEO: David Lewis CFO: Alan Stewart Price Target 145.00

 

Tesco remains under pressure throughout Q4; Christmas update spurs relief rally

Since our last update on Tesco Plc another profit warning has seen the shares remain under pressure throughout the final quarter of the year, reaching new lows of 155.00 pence in December; a short distance off from our most recent price target.

Despite the downward pressure during Q4, the shares received a boost this week when the group updated investors on trading during the Christmas period and the implications going forward of CEO David Lewis’s strategic review.

Although there was little in the update by way of long term game-changing measures, the lack of a collapse or catastrophe during the Christmas period prompted renewed bidding for the shares and a sigh of relief from investors. This saw the shares gain just over 15% before midday before falling back ahead of the close.   

Tesco Plc Share Price / 8 Hour Intervals

TescoJanuary

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Recent trading performance and strategic update

The cornerstone of the group’s update on Christmas trading was David Lewis’s declaration of sales figures which appeared to show the sales decline at Tesco slowing during the period. In detail, sales continued to fall over the short Christmas period albeit at a much reduced rate relative to that seen last year (0.3% for the UK & 0.6% group wide).

However, and despite the above, we caution that figures for the most recent full quarter (Q3) show the decline steepening relative to last year with like for like sales down by 4.4% against a decline of 1.5% for the same period in 2013.  Moreover, the

A further factor in the Tesco rally was a strategy update, where CEO Dave Lewis announced a number of measures designed to shore up the group’s financial position and boost performance in a number of areas.

  • Scraps final dividend for 2014
  • Proposes to cut admin / operations expenses by 30% (£497 – £559 million annually)
  • Proposes to scrap 43 under-performing stores
  • Cancels 49 planned new store projects – although 25 are still to go ahead
  • Dunhumby and Blinkbox subsidiaries are to be sold
  • Goldman Sachs looking into full or partial sale of Dunhumby which, according to some estimates; could fetch up to £2 billion
  • Cuts planned capital expenditure to £1 billion in 2015
  • Cuts prices on a large range of branded products by 25% – the race to the bottom continues
  • Cuts final salary pension scheme (£3.4 Bill deficit)
  • Hires CEO for UK Division

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Recent and likely financial performance

Following today’s update we remain 10% below the consensus when it comes to EPS estimates for 2014/15, with our own forecast being 9.00 pence per share against an industry consensus of 10.15 pence per share. This is to be expected considering that management guidance relating to the full year outlook also remains unchanged in that the group still expects 2014 earnings to be no more than £1.4 billion.

Looking ahead, if the group’s attempt to reign in costs by 30% does prove to be successful then this would doubtlessly have a positive impact upon earnings at Tesco.

Under this scenario, we calculate that our forecast for 14.00 pence EPS during the subsequent 2015 & 2016 years could potentially rise to 19.30 pence per share if management were to retain such savings. However, we caution that the if behind this is a big if.

While the above would be an ideal outcome for shareholders we believe that it is pretty unlikely and therefore, in our view; earnings are unlikely to rise much higher than our baseline forecast for the foreseeable future.

This is most notably the result of management intentions to use gains on disposals of assets as well as any cash derived from “cost” savings to fund further price cuts across the grocery business.

In short, the cost savings in terms of admin and operations expenses are likely to remain classified as costs in the future, but will just be shifted higher up the income statement to show as a different kind of cost. As a result, it is unlikely that there will be any real benefit to bottom line at Tesco, that is derived from cost savings, for quite some time to come.

In addition to this, we also caution that the group will face challenges in its attempts demonstrate savings, past the point of having to decide which stores to close and which subsidiaries to sell, due to the behaviour of its balance sheet during recent periods.  

In this regard, we wrote previously about our concern over the shift of long term liabilities into the domain of short term liabilities on the balance sheet and how this emerging trend could create further risk for shareholders in the future.

On this subject, it is interesting to note that Moody’s cut the group’s corporate credit rating today from investment grade down to junk status. The agency cited the above referenced shift in liabilities and the likelihood of further downward pressure upon margins as its core reasons for having done so.

To be more specific, the agency referenced a likely increase in repayments during the 2016-2019 period as providing a particular cause for concern, in addition to structural changes within the UK grocery industry.  

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Summary and the Takeaway

In summary, we do not view the much cheered cost saving as being likely to have any notably positive impact upon earnings over the near to medium term.  

This is mostly because the mooted 30% of savings are likely to be put toward funding further price cuts across selected ranges in the grocery business which so far, have managed to prop up revenues during the short term, but had a damaging effect upon the bottom line at the same time.

Furthermore, we see no long term benefit to earnings from both the prospective cost cuts as well as the group’s overall strategy to date.

This is because the cost cuts are likely to continue to impair the bottom line and the group’s ability to increase earnings, while excessive reductions in price expectations among the customer base could also have a long lasting effect by perpetuating further expectations of low prices in the future.

This, in our view, is an effect that would be unlikely to add any real value to the business and its earnings profile over the longer term.

In short, we view the Tesco strategy to date as a misguided attempt to become a cost leader as opposed to one which seeks to establish itself as a differentiated retailer of quality products, such as is the case with J Sainsbury. This is while we also see balance sheet risks as remaining unaddressed by the business and overlooked by shareholders.

Therefore, our conclusion and the key takeaway today is that the recent rally in the share price is short term noise, which has resulted from over excitement derived from a “not catastrophic, but just poor” trading update and some much hyped speak of asset sales.

Consequently, we view the current share price strength as unsustainable and thus, likely to succumb to further downside pressure in the future. As a result, we maintain our price target for the shares at 145.00 pence although we acknowledge that short term noise could temporarily delay TSCO.L’s arrival at this level.

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