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Tesco Plc H1 Results Update – 24 October 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 168.00
52 Week High 376.00 52 Week Low 165.00 P/E (F) 7.2
Dividend Yield % -TBC-?? Dividend Cover CEO: David Lewis
CFO: Alan Stewart Previous Price Target 175.00 Current Price Target   145.00

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1st Half Operational and Reported Financial Highlights

  • Improper accounting was a larger and longer lived problem than previous guidance suggested 
  • Potential for financial penalties stemming from FCA (UKLA) investigation
  • Cleaning out the closet – 8 senior managers suspended while CEO, CFO and Chairman have all departed within 6 months
  • Profit for the period collapses 99.3% leaving just £6 million in earnings attributable to ordinary equity holders for the first half – less than 1.0 pence earnings per share
  • Board signs off to pay out 16.5 X earnings per share as interim dividend
  • Almost all reported numbers heading south – market share, revenues, trading profits, margins, earnings per share, dividends and dividend cover
  • Tesco’s administrative cost base is hideous – rises 13.7% during H1 when compared with 1 year ago
  • Balance sheet remains in ill health – short term borrowings increase by 88.9% in 1 year and 55.7% in H1 2014 alone
  • Concluding remarks: The lunatics were let loose from the asylum for too long a period and now, the new management team faces a race against time to right a capsized ship.

 

Tesco Plc Share Price // Hourly Intervals

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Tesco Plc Share Price // Monthly Intervals

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Accounting Update – Deloitte findings and FCA investigation

After notifying investors of a pending investigation by the FCA into its accounting procedures, Tesco confirmed the full extent of the damage this Thursday. After commissioning an independent investigation by Deloitte, the auditor appears to have found that the “overstatement” of profits was more than just a minor error.

This was because, in addition to recognising income that was not yet earned, Tesco has also been repeatedly late to recognise accrued costs in its financial statements. The findings of Deloitte’s investigation make clear that more than being just a one off problem to have arisen as a result of being without a CFO for five months; an understatement here and an overstatement there is a practice that has prevailed at Tesco for much longer.

On this note, the auditor concluded that the full liability resulting from the scandal was slightly larger than first suggested, with the actual balance coming in at £263 million instead of the anticipated £250 million.

Reinforcing the point above, just £118 million of this amount is thought to relate to the first half of 2014, while the remainder has been attributed to the 2012/13 and 2013/14 financial years.

As a result of the scandal, eight senior managers have now been suspended from the business pending further investigation. This is while the Chairman, Richard Broadbent, belatedly announced on Thursday that he too will be stepping down as soon as a replacement for him can be found.

The chairman’s departure means that within a period of six months, 8 directors including the three most prominent officers of the company (CEO, CFO & Chair) have all departed, either voluntarily or after an elbow’s invitation.

In addition to high level departures, the FCA is now looking into the matter with a view to uncovering whether or not the related events occurred as a result of plain incompetence, or something more untoward. The implication of this and the matter at large is that, despite an already poor performance of the group in recent periods,  the average investor’s appraisal of Tesco’s future prospects is probably still over-generous.

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Definition of a Catastrophe: Tesco’s H1 Results

In line with our expectations, the sales decline continued at Tesco during the first half, with group wide revenue reported as having fallen by 4.5%. In addition to this top line deterioration, gross profits in the income statement were also hit hard by a reduction of 45.6%; which reflects the impact of earlier price cuts upon the business’s earnings potential.

As would be expected, with such a gulf between the decline of revenues and base profits, Tesco’s margins were also reported as having caved in to pressure during the period. Here, the group trading profit margin fell by 38.3% down to just 3.04% in a straight line, while in the UK the decline was much steeper at 52.0%, down to just 2.34%.

Given the operational and strategic challenges facing Tesco, reduced margins are a concern to us as they present a risk to the group’s ability to cut prices further and invest in product or brand development at a time when it is critical for it to do so.  

What’s more is that the bad news does not end with the numbers on the front page. This is as when looking into the depths of the half year report, to the financial statements at the back, the true cost to shareholders of 2014’s first half is then revealed.

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Tesco shareholders walk away with just £6 million for the first half as profit for the period falls by 99.3%

The most notable point that we make today is that, as is so often the case, the figures on the front page of the half year update belie the true extent of the damage caused by events during the period.

While the group reported its performance on the basis of trading profits, a measure not too dissimilar to gross profits, it omitted all details about its operational cost performance, real terms earnings per share and how it intends to cover the interim dividend of 1.16 pence per share that was approved by the board in late August.

On this note, Tesco’s profit for the period (real earnings attributable to equity holders) fell from £820 million in the first half of 2013, down to just £6 million for the first half of 2014; representing a reduction of 99.3%. This provides diluted earnings per share from continuing and discontinued operations of 0.07 pence.

To be clear, that is less than one tenth of a penny, which means that the board has signed off on an interim dividend payment that is 16.5 X greater than the group’s raw earnings.

While we acknowledge that if these earnings figures are adjusted to strip out charges for discontinued operations, then EPS will have been somewhat higher at 0.93 pence; neither of these measures is sufficient to cover the dividend payment which is scheduled for December.

In addition to this, we calculate that the recent interactions between revenues, gross profits and costs will mean that the upper bound for full year earnings performance is likely to be in the region of 6 – 8 pence per share in 2014.

This is while for the subsequent year, without any significant improvement in sales volumes or an alternative reduction in costs; we see the upper bound for EPS rising by only a small measure to 13.5 pence.

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Tesco’s cost base and balance sheet behaviour are a cause for concern

In an environment of declining sales revenues and lower margins it is essential that management are able to take an objective view of costs. For this reason it is somewhat disturbing to note that although the group cost of sales fell by 1.25% during the first half of the year, the benefits of this were obliterated by a 13.7%  increase in administrative expenses.

In addition to the aforementioned, movements in short term debt were equally disturbing as current liabilities increased by 88.9% during the last year and by a greater pro-rata measure of 55.7% in the first half of 2014 alone.

Such movement highlights the deteriorating health of Tesco’s balance sheet as years of leveraged expansion begin to catch up with the group at what is arguably, the worst possible time.

As a result of the above, liquidity measures of Tesco’s balance sheet are also becoming a cause for concern. This is as the group current ratio at the close of August was just 0.68 X, while an acid test analysis of Tesco’s balance sheet returned a figure of just 0.52 X. Although such low liquidity coverage is not unheard of within the high volume supermarket sector, for a company in as precarious a spot as Tesco, this could soon become a problem.

This is while in relation to general leverage, the group’s overall gearing ratio currently sits at 55%, which is slightly above the higher bound of what is normally deemed an acceptable range. A layman’s translation of this and the aforementioned would be that the group is over-leveraged and has insufficient ready assets to cover its short term liabilities.

In light of the challenges facing the industry along the road ahead, in addition to reducing top line profits and rising operational costs at the company level; these findings are unlikely to help Tesco Plc investors to sleep at night. It also comes as no surprise that management are already fielding calls from analysts enquiring about the likelihood of a rights issue taking place during the coming months.

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The way out of the woods

If we were to go out on a limb and try to say something nice, then this would be that it is encouraging to see that the new Chief Executive appears to have a strategy in place for turning Tesco around, even if he is remaining relatively tight lipped about it.

However, we are yet to be convinced that he won’t repeat the same mistakes as his predecessor along the way, by investing valuable cash into non essential revamps of relatively new stores and failing to address lingering concerns among customers over the actual quality of the products on Tesco shelves. 

We have long drawn attention to the damage done by the horse-meat scandal to consumer perceptions of product quality and on this note, our view remains that turning Tesco around will require a two pronged approach that seeks not just to improve competitiveness; but also trust and consumer perceptions of the brand.

In the little detail on strategy that the incoming CEO (Dave Lewis) has been willing to divulge, he has emphasised three priorities. These are to recover competitiveness, protect and strengthen the balance sheet and to “ begin the long journey back to building trust and transparency into our business and brand”.

Given the above, we disagree with the observations of some investors that Dave Lewis is the wrong man for the job, as he appears to have the willingness to focus on some key areas where we felt executive attention was lacking under Philip Clarke. However, having said this, we add a contingent to that disagreement.

Here, we accept that Lewis is not a finance manager and have already highlighted that another critical element of the recovery process will involve getting the best from an overstretched balance sheet, in order for the business to fund the required investments.

This makes it imperative that the new CEO and the incoming CFO are both able to work effectively together as a pair, which forms our contingent. If they are able to do this, then the group is in with half a chance at remaining a key player in the UK grocery market and one of the largest employers in Britain.

However, if the two most important people within the business prove unable to work cohesively by agreeing the right strategy and supporting each other, then the whole gig is off for Tesco investors.

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Summary

With all things taken into account, it appears fair to say that the lunatics were let loose from the asylum for too long a period and now, the new management team at Tesco faces a race against time to right a capsized ship.

While we believe that the new team is in with a shot at proving successful over the longer term, the balance sheet will require a tender touch and the pace of deterioration already experienced at the group will leave little room for mistakes. On this basis, we would be very surprised if Tesco is able to see out Q1 2015 before it is forced to either make further cuts to its dividends, restructure some of its debts, or to launch an all out rights issue.

Even after such a point, and assuming that management are ultimately successful in their turnaround; shareholders will still need to adjust to the “new normal” of lower margins, lower returns on capital and lower earnings per share for quite some time to come.

In addition to this, our calculation for EPS over the remainder of 2014 and during the subsequent year suggests that existing shareholders are in for an even tougher time during the quarters ahead. Given that our own projection sees for EPS for 2015 topping out at 13.5 pence, the implied share price at this point is just 101.00 pence, based upon the current sector average of 7.5 X earnings.

Although we do not advocate that this level will be reached immediately or via a singular straight line, when we take into account the entirety of the half year update, we are left with a firm belief that the decline in Tesco’s share price is yet to run the full length of its course

In the short term, we view Tesco shares as unlikely to sustain any return toward the 200.00 pence level and as such, we would expect the stock to encounter heavy resistance at this point.

In relation to price targets, we believe that the market is yet to fully awaken to the implications of Tesco’s interim update, with a gradual realisation of the true extent of damage most likely during the months ahead. Taking into account the high risk of further adverse news flow during the coming period, we expect that the shares will continue to move southwards over the near to medium term.

For this reason, we lower our price target for Tesco Plc to 145.00 pence per share today, which implies a 6.5 X multiple of the consensus for 2014 EPS (22.4 pence) and a 15% discount the sector average.

Our reasons for assigning this target are twofold in that we believe such a discount fairly reflects the above average deterioration in Tesco’s core business, while we also remain concious that downgrades to earnings estimates during the weeks ahead will naturally lead to some level of multiple expansion and thus, the current and implied valuations are not excessively low.  

The next major event scheduled Tesco is the release of Q3 results in January, we shall endeavour to update all of our members as and when meaningful news flow emerges.

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