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OPINION

Five reasons not to buy Tesco

Five reasons not to buy Tesco
October 19, 2016
Five reasons not to buy Tesco

Between a dollar and a discounter

The grocer shook off its tussle with Unilever (ULVR) fairly easily. Some of the early comment has criticised the consumer goods giant for a public relations failure in a relatively small (for it) but high-profile market, and lauded Tesco for sticking up for the consumer. But it remains to be seen what compromises were made by each side.

There will be pressure on supermarkets to increase prices in an inflationary environment. Yes, this could push up gross margins, depending on the pain split with the suppliers, but it could also risk market share. "It would likely result in a loss of customer traffic to more competitive operators," JPMorgan Cazenove analyst Borja Olcese has argued.

 

Share of bricks and clicks

The march of Aldi and Lidl has been well documented, even if recent data suggest it may be slowing. These discounters have already made good in-roads that will make it harder for Tesco to grow the top line, while at the bottom line analysts think the cost advantages of the newer players will tell with the rising minimum wage.

Online sales make up 6.9 per cent of UK packaged goods sales, according to data provider Kantar Worldpanel, compared with 1.4 per cent in the US. While the majority of the overall spend of even regular online shoppers is at a physical store, experts argue that growing early market share is crucial. Tesco's recent decision to improve the profitability of its online grocery business at the expense of growing sales could prove regrettably short-termist.

 

The pension

The widening accounting deficit in Tesco's pension provision was described by Shore Capital analyst Clive Black as a "body blow to the overall aspiration of Tesco to structurally deleverage". The accounting deficit at the half-year was £5.9bn, equal to Tesco shareholders' equity and pushing back hopes of a returning dividend. When the company's pension assets and liabilities are calculated as at March 2017, a bigger deficit may require higher contributions, but we won't find out until the following year. Bears add the hidden liabilities in Tesco's sale-and-leaseback arrangements to reasons not to buy into the 'improving balance sheet' argument.

 

The margins

Tesco plans to deliver a 3.5-4 per cent operating profit margin by the 2020 financial year. It is clear on how it will reduce costs, although changes to shift patterns are already finding resistance. But the other side of the equation is sales growth over that medium term, which faces headwinds: the discounters' greater market share, the arrival of Amazon, and underinvestment in its store estate, as evaluated by SharePad's Phil Oakley for this title in September.

 

The valuation

For a margin recovery story, price-to-earnings measures make less sense. Tesco is a case in point, with its shares close to 30 times expected adjusted earnings. Brokers supportive of the stock prefer enterprise value-to-sales as a valuation metric. But even on this basis, the shares are matched with the global peer average at 0.42 times, according to Capital IQ data.

Our conclusion has been that any recovery is priced in. But given Tesco's challenges, it comes as little surprise that the balance of the analysis is towards the downside: of the 22 analysts whose recommendations are picked up by Bloomberg, 10 say sell, seven say hold and five buy. It pays to be right rather than popular, but a fair amount has to go the grocer's way to support its shares' rally.