Last week may just have marked a historic low-point in Tesco's (TSCO) trading history. Friday's profit warning was the second in only five weeks and brought with it news - though widely expected – that the interim dividend would be slashed by 75 per cent to 1.16p a share. The embattled chief executive, Philip Clarke, stepped down a month sooner than expected, too, with new boss David Lewis placed in charge of the UK's biggest supermarket as of 1 September.
Trading profit for the current financial year is now expected to reach £2.45bn to £2.5bn, between a quarter and a third lower than last year and up to a fifth lower than City forecasts. Profits in the first six months of the year will come in around the £1.1bn level, down from £1.58bn in 2013. Mike Dennis, an analyst for Cantor Fitzgerald, says this implies that Tesco's UK trading profit in the first half could be down by as much as a quarter to £850m, on sales of £21bn, with the UK trading margin 118 basis points lower year on year at 4 per cent.
The company also announced a £400m reduction in capital spending for the full-year to no more than £2.1bn, which will see it cut funding for IT projects and store refits. Tesco chairman Sir Richard Broadbent said these actions had "not been taken lightly".
The news is pretty dire, but not unexpected. Tesco is still reeling from a series of mistakes over the past six years, many of which former chief executive Philip Clarke arguably inherited. It's fair to say that Tesco took its eye off the ball, focusing on peripheral activities, such as its Giraffe restaurant chain and digital streaming products, as well as on conquering the world of food retail, rather than on its home turf. Taking for granted its dominant position in the UK core grocery market was perhaps the biggest mistake of all.
Now, Tesco seems to be following the same strategy as Sainsbury (SBRY) did in 2005 when former boss Justin King took the helm and 'kitchen sinked' full-year numbers, halving both dividends and margins. Mr Dennis says the big question is how low the UK trading margin might go. A margin of 2.5 per cent would cost £700m to £800m, equal to all of Sainsbury's trading profit, he points out, adding that there are also substantial opportunities for cost saving across the UK's £10bn-plus cost base.
"Tesco needs to find more than £500m of annual cost savings and reduce UK staff numbers by 10 per cent and refocus the business formats on driving cash profit growth," he says. "An £800m reduction in total dividend to 4.76p from 14.76p and £500m cost base reduction would give Tesco £1.3bn of extra cash to reinvest in price and put its main competitors in considerable margin pain."
Indeed, should Tesco cut prices, that could have serious implications for its competitors, not least Morrison (MRW) and, to a lesser degree, Sainsbury. Mr Dennis reckons it could also force the discounters back to the loss-making position they endured in 2009. That would be good news, given the fast growth of Aldi and Lidl, who both maintained their record high shares of the UK grocery market at the last count - 4.8 per cent and 3.6 per cent, respectively - in the 12 weeks to 17 August. The figures from Kantar Worldpanel also show that, with the exception of Asda, the big four are feeling the squeeze. Sainsbury suffered a small drop in its share of the UK supermarket till spend to 16.4 per cent from 16.5 per cent, but Tesco's market share dropped more dramatically, to 28.8 per cent from 30.2 per cent, while Morrison dipped to 11 per cent from 11.3 per cent.
So what next? Well, Tesco's next trading update is likely to contain more gloom, with poor like-for-like sales figures and dreadful margins, says Espirito Santo analyst Rickin Thakrar. "Ultimately, this race to the bottom will impact all players until they realise that a five-player market cannot support seven combatants," he says, alluding to Sainsbury, Morrison, Asda, Tesco, Waitrose, Aldi and Lidl. He reckons the current cut to the dividend and capital spend will only be offset by earnings pressure, so Tesco must go further, spending more to improve stores and prices. This could imply a UK margin of 2 per cent, but the resulting sales uplift would eventually help to repay some of that investment.
Tesco has to get the basics right: price, presentation and quality. So far, it's failing on all three fronts. We think Mr Lewis stands a good chance of success given that, as an outsider, he'll be able to make tough, unpopular decisions. But this journey will be long and hard; Tesco is still a massive beast, lumbered with a huge, and struggling, overseas business as well as multiple peripheral ones. Expect a lot of rationalisation and exits from loss-making ventures. As we've said before, we're negative on the supermarkets and believe the sector is one to avoid, having sold both Morrison and Tesco last year and downgraded Sainsbury to a hold. We reiterate that view and think investors would do better putting their money elsewhere - for now. But, if you still hold on to shares in Tesco, it's probably still worth selling out, particularly given the dividend cut.
