A view on Tesco

Thursday, 22nd October 2015 10:45 - by David Harbage

This article is one in a series, written in response to a request from readers, taking a look at big companies in the news. Tesco announced a major strategic and financial transaction on Monday last week, with the disposal of its Korean business Homeplus for £4.24 billion.

This move to shore up its balance sheet (which had debt of £21.7 billion as at its year end of 28 February 2015) essentially encapsulates the current state of the UK’s largest retailer. After two decades of near inexorable growth – in floor space, by product and geography – overtaking J Sainsbury in the early 1990s to become the UK’s dominant retailer, a debt encumbered Tesco is having to come to terms with the greater competitive threat posed by newcomers to the domestic grocery trade (notably via Aldi and Lidl) ‘on the ground’ and the burgeoning non-food online retailers (too numerous to mention, but ranging from Amazon to Zara).

The business, led by Sir Terence Leahy from 1997 to 2011, was an innovator in many areas (for instance its Clubcard which provided customers with loyalty rewards in exchange for gathering critical information on spending behaviour); he was renowned for appreciating ‘the detail in retail’ facilitated, no doubt, by visiting a store every week. Investors at the time believed that Tesco had created a near virtual circle of progressive prosperity, as greater market share (in excess of one third of the UK’s grocery industry) meant greater pricing power - over its suppliers, and relative to its supermarket peers – leading to higher turnover and higher profits. These were reinvested, in conjunction with higher borrowing, in ever larger stores, increasingly encompassing a non-food proposition, and into expanding overseas (notably in Asia, Central or East Europe and the United States). Entry into the latter – a tempting market, but often considered to be the death knell of many British companies – turned out to be that ‘step too far’ for Tesco.  

The world was changing fast, (and still is, ever faster) and in particular by the internet - which provided a major opportunity for consumers ‘to shop around’ in a new way, both in comparing prices and in having groceries and other goods delivered. Coinciding with Philip Clarke’s tenure as chief executive officer (CEO) from 2011 to 2014, a number of issues surfaced to challenge Tesco’s growth and apparent supremacy. With the advent of online shopping, overcoming the need to visit a supermarket, Tesco saw its share of non-food retailing fall (for example, it was a market leader in electrical in 2011) and its longer term plans to increase its floor space (especially via the biggest superstores) were put on hold. Critics, wise with the benefit of hindsight, accused the management of complacency or lack of vision in appreciating the changing dynamics within the industry. Investors agitated for more rapid and aggressive change, which persuaded Tesco to appoint an outsider to take the company forward: David Lewis, from Unilever, becoming CEO in September 2014 at the age of 49.

This is a big job as Tesco faces considerable challenges. In particular, the explicit need to address the level of debt – which exceeds the worth of its assets - on a balance sheet bearing an increasingly geared appearance.    Exiting underperforming stores along with other property and, post the disposal of what was a very profitable (and therefore readily saleable) business in Korea, other assets are likely to ‘come under the hammer’. In particular, and in addition to more existing supermarkets, these feature its Dunnhumby data analytics (Clubcard) division which was thought to be worth £2 billion – but has only attracted bids of closer to £700 million to date.

Within the announcement of trading results for the year ended 28 February 2015, the dividend was slashed (from a pay-out of 14.76 pence, in the year to 22 February 2014, to 1.16p via no final payment), capital expenditure was reduced to less than £1 billion and previous plans to build 49 stores (producing a write-down of £925 million in respect of ‘work in progress’) were cancelled.  Although making a £1.4 billion trading profit (in line with market expectations), a £7 billion write-down (dominated by £3.8 billion impairment to reflect fairer worth of its stores), resulted in a statutory pre-tax loss in excess of £6.3 billion. Previous accounting irregularities have prejudiced many analysts’ views - and this complicated business is closely scrutinised for any signs of irregular practice – notably that described as a ‘commercial income adjustment’: overstated profits of £208 million from previous years have been identified and rebooked. Finally a £270 million annual contribution was made towards addressing a £3.9 billion pension deficit (which was up from £2.7 billion in the previous year).

Against a backdrop of negligible inflation across much of its offering, but higher business rates and rents (which applies where the company sold, and leased back properties, in its higher growth past) and wages (with the proposed ‘living wage’ set to increasingly impact over the next three years), Tesco is having to ‘run hard to stand still’. Current trading remains very difficult, with like-for-like revenue growth negative, as discounters continuing to eat into its market share and profit margins in the UK, Ireland and in central/eastern Europe. Countering this, the company are addressing costs with renewed vigour and across a wide range of initiatives – from moving out of its Cheshunt head office to exiting peripheral areas or slowing the rollout of others (like the Harris & Hoole coffee shops), closing 43 unprofitable stores to reducing middle management. In addition a reassessment of their core business model, featuring further price cuts on essential products, greater staff presence on the shop floor (Tesco report a net 4,652 increase in the headcount over the past half year) and a focus on the top 1,000 product lines (improve availability, set lower more stable prices), is underway.     

Investors will be asking themselves if the current share price reflects the downwardly adjusted expectations of analysts and institutions, by reference to the stock market’s valuation. Tesco shares have fallen from 435 pence five years ago to 181 pence at the time of writing, not far off the 168 pence low seen in December 2014. The current consensus of more than 20 ‘Sell side’ brokers anticipates a further 14% fall in earnings per share in the current year (to 8.07 pence, implying an earnings multiple of 22.5 times – almost twice that of the FTSE100 index), before seeing an improvement in the year to February 2017 when profits are seen recovering and EPS of 11.2p (equating to a PE ratio of 16.2x) is forecast. However the focus on conserving cash will see a negligible dividend payment this year and only 2.56 pence is anticipated in 2017. If big fund managers are sitting on the side lines awaiting evidence of a turnaround, the broking community are a little more positive: current published opinion suggests 9 Buy recommendations, 8 Hold or neutral views and 3 outright Sells.

The writer retains significant doubts about both the food retailing and general retailing industries, given the strong competitive pressures and lack of inflation. Although being the biggest does bring some benefits of scale, Tesco’s huge network of physical stores represent a high operational overhead putting pressure on an already fully laden balance sheet. Sometimes likened to an ocean going liner which cannot readily change direction, size – and the subsequent lack of flexibility – can bring its own problems. Accordingly, until the company can be seen to regain control of its own destiny (having reduced its net debt and stabilised its position in the market place, best illustrated by delivering positive like-for-like sales growth), Tesco shares will struggle to justify a premium rating (as is currently afforded) and this observer will watch developments with keen interest – but ‘keep his powder dry’ – shopping, rather than investing, in Tesco. 

See the latest share price for Tesco

Written by David Harbage for lse.co.uk on the 12th September 2015

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.