Where next for Tesco Plc? – 06 May 2015

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 226.80
52 Week High 320.75 52 Week Low 155.40 P/E H 23.5
P/E (F) 29.2 Dividend Yield % TBC Dividend Cover TBC
CEO: David Lewis CFO: Alan Stewart Price Target 145.00


Tesco shares begin to give back Q1 gains as full year update unnerves investors

Since our last update in January Tesco shares have made a valiant effort at recovery from the depths reached during the final quarter of 2014, mostly as a result of optimism generated by the turnaround plan that management presented to investors shortly after Christmas.

However, late April saw the group announce its largest ever annual loss when reporting results for 2014, with much of the red ink being due to a £7 billion impairment charge for the period. This news has now prompted the shares to pull back sharply from their earlier highs.

Today we update our outlook for Tesco Plc in order to reflect the information contained within the full year report, before explaining why we believe that there may still be more pain to come for Tesco shareholders in 2015 and beyond.

Tesco Plc Share Price / Daily Intervals



Highlights from the full year results update: Impairment charge results in record loss

The most pertinent point in Tesco’s results update was without doubt the £7 billion impairment to its asset base, as this was the ultimate driver behind a 50% fall in the value of shareholder’s equity during the period (£14 billion down to £7 billion).

The impairment charge reflects the lower value of the group’s store network which has arisen as a direct result of current industry conditions. While such a write down was the prudent and right thing to do on the part of management, it does also offer an added benefit to the board in that it will not be difficult for them to generate some form of paper growth from this point onward, given that the current year’s performance will be measured after starting from a particularly low base.

As a result, our core concern is that even though such growth would be synthetic in nature it may overshadow or mask the true extent of the challenges that the group still faces, and this could lead investors to buy into what would effectively be a false recovery.


Tesco’s reduction in trading profit for 2014 is the “new normal” for the group

Despite that most of the recent headlines regarding Tesco have been centred on the record loss reported by the group for last year, this was not the only development during the period that investors would do well to consider.

This is because the group also recorded a steep drop in trading profits for the 2014 ( £3.3 billion down to £1.4 billion). While trading profit is not really representative of the group’s actual financial performance, it does go some way toward highlighting the effect that the current operating environment is having upon the earnings capacity of Tesco’s traditional grocery business in the UK and overseas.

We wrote previously about how we viewed 50% of the H1 reduction in Tesco’s bottom line ( -90%) as “here to stay” and we note today that the full year result for Tesco is roughly in line with this expectation, if not representative of a slightly larger deterioration than our earlier analysis projected.

Given that management do not expect industry conditions to ease by any notable measure in the near future, we reiterate today that the reduced level of operating profits is where we believe investors should expect the “new normal” to be.

The factors underlying this “new normal” include heavy discounting in stores, an expansion of the balance sheet and a further increase in both operating & administrative costs.


Tesco Group operating & strategy review

On a more positive note, Tesco saw growth in transaction volumes reach its highest level since 2011 during the second half of 2014, despite that its market share is still in decline. This suggests to us that the group’s remaining customer base is probably quite happy to maintain shopping budgets at their pre-existing levels, as opposed to cutting back on total expenditure.

While any form of growth is positive for Tesco at present, we take the recent spending behaviour of the customer base as a partial indication that there may be another problem that is at least in part responsible for the recent customer exodus at the group. 

We believe this problem is management’s failure to demonstrate value for money at the stores, in addition to competitiveness. The ability to illustrate value for money will be important for the recovery at Tesco as it is difficult to imagine that there has been any improvement in consumer perceptions of quality within the stores since the onset of the “horse meat scandal”.

In support of this view we note the subsequent lack of real reform to the brand and its product ranges in the aftermath of the scandal, while despite that many companies were implicated, Tesco was widely perceived as the most high profile and unexpected of offenders. Furthermore, even though almost all of the big four have been affected by customer defections since the end of 2012, the extent of attrition at Tesco has been much more severe than at any other retailer.

This resonates with us when considering the fact that, on the whole, the retailers who were involved in the scandal have suffered much more so from customer attrition than those who were not implicated in the scandal at all.

It is also a particularly pertinent point to make that the two “big four” retailers who were implicated in the HM scandal were already the big four’s most competitively priced retailers and they have both lost considerable ground to the competition since this time, despite large scale efforts to become even more competitive.

The below graphic highlights the change in market share at the industry’s leading names since the close of 2012, with the bottom bars representing end 2012 market share and those above representing each group’s respective position at the close of Q1 2015.

Kantar WordlPanel Chart highlighting changes in market share within UK grocery sector



Industry Review: Pain for the UK grocery sector as a whole may be beginning to subside

The most notable event for the industry as a whole during the first quarter was a report released in February by retail analysts Kantar WorldPanel.

Here the group detailed a minor increase in sales at Tesco during the 12 weeks leading up to the report’s compilation, although it also highlighted that the group’s market share was still falling, with the most recent figures marking it down to 28.4%.  

J Sainsbury also experienced a fall in sales during the 12 weeks leading up to the period when the February report was published, with the exact reduction being in the region of 1%, while its market share fell by 0.4% for the 12 months leading up to March 2015.

Price inflation in the grocery retailing sector was also reported to have fallen for 17 consecutive periods, with average store selling prices during the 12 weeks leading up to the report’s compilation believed to have declined by -1.2%.

However, despite what must seem like an ever present cloud of doom and gloom overhanging the sector, there may still be some hope for the big four in 2015. This is because the same Kantar Worldpanel report also highlighted that sales growth at the discounters was beginning to slow, with one analyst commenting that the sub sector will probably find it difficult to maintain their earlier rate of expansion throughout the 2015 year.

This could mark the beginning of a period of relative stabilisation for the UK grocery sector, although we will need to see conclusive evidence of a positive effect upon activity at Tesco in order for us to upgrade our view of the company.


Balance sheet

In relation to the balance sheet, short term borrowings were a total of 4.9% higher at the close of the year which is much less than the considerable jump that we saw during the first half, although almost equally disconcerting given the challenges that the group will face along the road ahead.

We attribute the lower current borrowings to a mid year form of balance sheet restructuring, as the cash flow statement indicates that the group borrowed close to £5 billion of new capital during the year, although total liabilities for the group were a mere £1.4 billion higher at the close of the period.

From this we assume that the group borrowed heavily in capital markets to clear off shorter term debts at the expense of its longer term liability structure.

Speaking of the devil, longer term borrowings for the group were 14.4% higher at the close of the year as outstanding balances on the non current side of the balance sheet expanded from just over £9 billion at the close of 2013, to £10.65 billion for 2014.

Given management’s write-down to shareholders equity in 2014 these movements in debt have now impacted upon a number of key ratios, beginning with debt/equity which was pushed up by just over 100% from 0.8 X equity, to 1.8 X equity, while gearing also rose from 44% to 64% at the close of 2014. 

These figures present serious issues for Tesco management and for Tesco shareholders, most notably because higher levels of gearing will make it much more difficult for the group to reduce costs and maintain, or improve its credit profile.

In addition to this, we also note that the true level of gearing is actually somewhat higher than the above analysis suggests as gearing and debt to equity ratios take into account only traditional borrowings alone, while ignoring other forms of financial liabilities. If these additional liabilities, such as unfunded pensions and lease agreements on non-performing stores, are taken into account then the true level of indebtedness for Tesco is actually much higher than the headline ratios suggest.

With this in mind it comes as no surprise that management prefer to focus on less than ideal balance sheet KPI’s’ like net debt when reporting to investors and as a result, we reiterate our 2014 assertion that Tesco Plc is over-leveraged by any definition of the term.


Cash flow

Cash flow is another area in which management will face challenges over the coming periods. This is because in the everyday running of the business, Tesco currently consumes 3 X the level of cash that it is able to generate from operations.

This would be a problematic scenario for even the most prosperous of companies so given the current market conditions, Tesco’s cash flow predicament is also a cause for concern.

As a result of this deficiency in cash generation, the group suffered a net decrease in cash and cash equivalents for the 2014 period and if it hadn’t been for existing reserves and the issuance of £4.8 billion in new debt during the year, the existing £717 million decrease would have been much larger.  


Looking on the bright side management do appear to be aware of the true scale of the challenge they are likely to face along the road ahead, even if they don’t overtly advertise to investors just how large these challenges actually are. 

This is evidenced by the fact that the board has already come to the decision that dividends will be almost non-existent until the problems surrounding cash flow and overall indebtedness have been sufficiently addressed.

As a result, the total payout for Tesco shareholders in 2014 was just the 1.16 pence interim dividend, which wasn’t covered at all by earnings because the group made a per share loss for both the first half and the full year. 

Looking ahead, we see little scope for the dividend outlook to improve in 2015 given the hit to retained earnings taken in 2014 and the humps that still lay in the road ahead. It is for these reasons that we expect any surplus income generated will in all probability, be used to pay down debt or to bolster reserves on the balance sheet.



Given that both dividends and cash flows will be either static, negative or just difficult to predict in the near to medium term future, most absolute valuation models are rendered redundant for the time being in the case of Tesco.

However, we can look at the group on a multiples basis relative to its peer group in order to gain an insight into where the group lies on the value spectrum. We do this using forward price to earnings ratios, as all of the major supermarkets which are listed in the UK reported per share losses for the 2014 year.

A brief look at consensus earnings estimates and current prices shows Tesco trading on a considerable 29.9 X 2015 EPS, with WM Morrison at 16.9 X and J Sainsbury at 12.5 X.

Using this style of analysis one could be forgiven for thinking that the market is pricing in a recovery throughout much of the sector and that J Sainsbury is either undervalued, or yet to experience its fair share of turmoil.

We disagree with this view as our belief is that the wider market is yet to fully accept the extent of deterioration which has taken place at Tesco and WM Morrison. For this reason, we prefer to view the current high multiples for both companies as a direct result of the reluctance among investors to rate the shares according to the information available.     

In regards to Tesco, we are encouraged that consensus estimates are no longer wildly optimistic as they were in the closing stages of 2014. On the contrary, we believe that the most recent round of figures to have emerged from the analyst community may actually be overly bearish.

This is because the current consensus suggests earnings per share of 7.58 pence for Tesco in 2015, which is a significant distance below our own earlier projection of roughly 14.0 pence for EPS in 2015.

Under our own projection Tesco currently trades on a multiple of 16.2X, which is broadly in line with that of the beleaguered WM Morrison, although still too high in our view. In deriving this estimate we assume that 45 – 50% of the earnings decline in 2014 will be semi permanent, as we calculate that much of this is the result of price cuts within stores and cost inflation at the administrative level, each of which will be difficult to reverse in the near term.

Given that neither of these cost pressures are likely to disappear any time soon we can safely assume that much of the earnings decline will be with us for the foreseeable future. However, we struggle to see a particular driver that could cause EPS to fall by 70% in 2015 to the projected 7.58 pence and for this reason, we are sceptical of the consensus forecast.

Regardless, Tesco remains overvalued in our view and the only ongoing question to still require an answer is the one that seeks to determine by how much the shares need to be re rated lower.


The takeaway

Looking on the bright side for Tesco, growth at the discounters appears to be slowing according to recent reports by Kantar Worldpanel, although it still remains in the double digits. This could be an indication that the group may be able to expect its market share to stabilise over the next 12 -18 months or so.

To summarise on the key points, Tesco’s capacity for earnings and growth has been severely harmed in the rout that took place during late 2013 and 2014.

Given the ongoing industry dynamics we estimate that 45-50% of the earnings decline experienced by the group in the first half will now be semi permanent. This is bad news for the dividend outlook and bad news for management when it comes to righting the balance sheet and cash flow issues that we detailed earlier in this report.

Most importantly, we still believe that the market is yet to wake up to these facts as the earnings multiples upon which Tesco currently trades,  continue to show a company that is trading at a substantial premium to its peer group. This is the case regardless of which forecasts for EPS that we use. 

Furthermore, we also note that consensus estimates for earnings in 2015 have been marked down considerably from where they were just a few short months ago, which is bad news for those seeking a case to support the current valuation.

In relation to price targets, we remain uncomfortable with an earnings multiple that is above 10-11 X as when the closets and cupboards are finally cleared across the industry, growth will either be non-existent or just plain anaemic for an extended period. 

In deriving our price target we use our own projection for EPS (14 pence) in 2015 which, when applied to a multiple of 10.5 X, gives us our pre-existing price target of 145.00 pence per share.

Therefore, to conclude today, we maintain our price target for Tesco Plc shares at 145.00 pence.

The next scheduled event of significance for Tesco will be the release of the Q1 Interim Management Statement on 26 June 2015.



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