Tesco Plc – 18 June 2014
Company and Market Overview:
Tesco Plc is a grocery retailer that is headquartered 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. These 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||291.85|
|52 Week High||386.40||52 Week Low||278.50||P/E||9.1|
|Dividend Yield %||5.07||Dividend Cover||2.16||CEO:||Phillip Clarke|
Damaged brand perception and economic climate drives customers away and share price lower; strategy remains confused and under fire
The last 36 months have seen Tesco’s brand perception among core consumers decline following its involvement in a number of high profile scandals and controversies, the most notable of which was the horse meat debacle of 2013 in which the group held a centre stage role.
In addition to damaged consumer perceptions, recent years have seen household incomes remain under pressure from lacklustre economic conditions. This has driven an increase in the number of consumers which have scaled back their grocery budgets and/or sought out more cost effective alternatives to the “Big Four”, aiding the explosive growth of discount retailers in the UK. The discount (lower) segment now collectively accounts for close to 15% of the overall grocery market.
Tesco’s response, beginning in 2011, to declining fortunes has been to announce numerous high profile turnarounds, with campaigns to win back customers at the forefront of these. While the group has made efforts to counter the perception of poor quality that surround the brand, the predominant theme among each successive turnaround attempt has been price competition.
Tesco’s Big Price Drop of December 2011 was coined the “Big Price Flop” by analysts across the city as it failed to win new market share and placed margins under unnecessary pressure during a peak trading period. Just one of many attempts to win back customers, the failed campaign inevitably led to yet more promises of an eventual turnaround at the stores. In the two years since this time, both Tesco’s market share and its share price have each fallen to a decade long low.
In summary, Tesco suffers from the effects of a damaged brand, which has reduced the incentive for cost-conscious, budget and family consumers to consider shopping there. This incentive has been further eroded by the advent of discount supermarket chains that have aggressively grown their market share throughout recent years.
Another factor to have further compounded the woes of Tesco, in our view, is the recovery strategy that the group has pursued. Although management have made the improvement of quality in Tesco product lines a feature in the overall turnaround strategy, investors would have to delve deep into the detail to realise it. This is while the headline feature of group strategy going forward is, once again, price competition.
The end of the space race and current competitive environment suggests downside risks to market share, revenues and profits at Tesco over the near to medium term
Given the current competitive environment for UK-focused retail grocers, the future outlook for Tesco is far from certain. Our view for the sector overall echoes that of the wider industry in that the “space race” of recent years, which saw high streets and residential roads across the nation peppered with convenience supermarket stores (24Hr metro), is now over.
Changing economic conditions, an unfavorable medium term outlook for “family finances” and the growing number of specialist discount outlets each suggest that the growth experienced by supermarket groups over the last decade will be difficult to replicate going forward.
In our view, competitive pressures created by the advent of discount retailing are here to stay. While it is not possible to predict the exact geography of the future grocery market landscape, we do see increasing competition driving those existing chains that are unable to differentiate themselves on quality, toward an era of lower revenues, reduced margins and lower profits.
This is as in order to survive without a differentiation strategy, we see a number of the larger chains being driven toward the discount price model over time (Tesco, Asda, WM Morrison). Such a development we believe will deepen the existing divide between both higher and lower segments of the grocery market, with those consumers not willing to downgrade their shopping basket being driven toward more premium brands such as Waitrose, while the discount and budget retailers compete for those who are more easily influenced by prices.
In relation to Tesco, the group’s frequent reversion to price competition, while sweeping under the carpet serious actions on quality improvement, leave it vulnerable to a blind stroll along the above path.
Further from here, any decisive and concerted effort to improve merchandise quality and perception at the group would be likely to require time before it yields results. Consequently, our initial outlook for earnings at the group over the near to medium term is negative.
Nevertheless, Tesco remains the largest retailer in Britain and enjoys significant financial resources. As a result and from a longer-term perspective, we do not see a recovery to some form of prominence as outside of the realm of possibility. The question that remains more difficult to answer seeks to discover just what a revived, and once again dominant, Tesco Plc will look like.
Tesco Bank and other redeeming features
Although significant challenges continue to threaten group performance, Tesco does have some redeeming features. Management have made substantial investment to improve both the customer experience as well as operational performance.
So far, much of the financial investment has been focused upon redesigning store formats and increasing the in-store headcount at larger outlets in order to improve service levels. In addition to financial investment, poorer performing stores have been earmarked for downsizing while management explore the option of increasing allocated space to concessions.
Further from here, 2013/2014 results from Tesco Bank (TB) were encouraging, with trading profit increasing by 2.1%. During the 2013/2014 year, the income from Tesco Bank accounted for just under 0.5% of group revenues and 5.82% of overall trading profits. This was while customer deposits stood at £6.1 billion and total customer numbers at 7 million.
While the bank has been operating for some time now already, the first half of the 2014 calendar year saw TB take the biggest step toward placing itself on an even playing field with the “big six” UK banks when it launched its very first PCA (personal current account). As the largest net contributor to profits at UK retail banks, a personal current account offering has the potential to accelerate growth at the Tesco Bank, enabling it to make an increased contribution to earnings at the group level over the months and years ahead.
As promising as it may sound, further success at the financial services arm is far from guaranteed. Switching activity in the UK is notoriously low, despite regulatory changes, while competition for new accounts remains fierce. In addition to this, recent surveys suggest that a degree of scepticism exists among consumers as to whether or not a supermarket is any more trustworthy than the bruised and battered high street banks when it comes to personal finances. (Personal Banking Market Assessment, Keynote, 2012).
Nevertheless, if the group is able to maintain the current momentum in growth then the potential impact upon earnings would be notable and wholly positive for the longer term.
Financial performance, dividend and valuation
While Tesco Bank posted some positive numbers for the 2013/2014 year, performance at the group level was less than impressive. During the period, sales revenue increased by a meagre 0.3% while profits slumped by 6% simultaneously; reflecting lower margins in the wake of heightened competition and customer defections following the horse meat scandal of summer 2013.
In response to the decline in profits, Standard and Poor’s downgraded the outlook over Tesco’s investment grade credit rating from stable to negative, reflecting unease among observers over the group’s ability to withstand a greater increase in competitive pressures. Net balance sheet debt for the period remained flat at £6.6 billion.
In relation to dividends, the pay-out for 2013/2014 also remained flat with the year before at 14.76 pence per share, which equates to a yield of just over 5% based upon today’s trading price. The existing dividend is covered a healthy 2.1 X over by earnings, which leaves the pay-out in little danger of being reduced over the near term.
Despite this, we do not anticipate a noteworthy increase in cash returns to shareholders in the immediate future, given ongoing competitive headwinds and the consequent pressure upon earnings.
From a valuation perspective, Tesco shares currently trade on a multiple of 9.1 X 2013 earnings, which is broadly in line with J. Sainsbury and reflects a substantial premium to the slightly more beleaguered WM Morrison Plc. This, we feel, is slightly on the expensive side given the challenges faced by the group and the advantages that J Sainsbury (quality perception, customer demographic, customer loyalty) enjoys in comparison.
The biggest risk facing Tesco investors at present is that the group is unable to stem an exodus of customers over the medium to longer term, and that this further compounds existing pressures upon earnings.
Should this become reality, more and more investors could be driven away from the shares, resulting in a sustained period of price weakness. As things stand, competition within the industry has shown no inclination toward slowing and as a result, we continue to see downside risks to Tesco’s performance over the near term. For these reasons, the risks attached to Tesco shares are high.
In summary Tesco Plc remains Britain’s largest retailer. The group’s significant financial resources see it well equipped to re-engineer a sustainable future for its business, after a tumultuous 36 months of trading, although significant challenges remain along the road ahead.
Competition within the UK grocery market continues to grow fiercer and this trend has shown no sign of abating. The group’s options are to either go head to head with the emerging discount retailers in an all-out price war, until one prevails; which if carried out over a sustained period could impede upon the group’s ability to recover lost margins.
The other option for Tesco is an attempt to differentiate itself, through an emphasis on quality, from the competition that is currently eroding its market share. Given the Tesco’s role in the horse meat scandal of 2013, valid questions have been raised by consumers over quality standards at Tesco, which has left a larger question mark over the group’s ability to successfully pursue a differentiation strategy in the current environment.
As a result, the spearhead of management’s turnaround campaign is likely to remain price competition, which poses near, medium and long-term risks to margins.
Ultimately, we feel that Tesco will grow over time to develop a significant footprint in the discount retailing space, under either its existing brand or a separate subsidiary. This is while promising developments in the financial services arm have the potential to make progressive and meaningful contributions to group earnings over the months and years ahead.
In relation to price targets and price action, we expect Tesco shares to trade with a bias toward the downside over the near – medium term. At best, we see any upside as likely to remain capped at 316.00 pence, while our central view in relation to price action is that a further leg downward to the 250.00 pence mark occurs during the months ahead.
Past here, further moves in the share price are likely to evolve as a response to developments within Tesco’s competitive environment and information emerging from earnings reports. As a result, we will endeavour to keep all of our members up to date with progress at Tesco. The next major event for the group (scheduled) is the release of interim results on 01 October 2014.
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