Is Tesco in value territory yet?

John Hughman

After several lacklustre updates at the end of 2011 - and more recent figures from industry research group Nielsen which showed that Tesco had lost ground to rivals over Christmas - no one expected the retail giant's January trading statement to be particularly good. But not many expected it to be as grim as it was, a bona fide profit warning that saw the shares slump to their largest daily fall in living memory.

Such falls are almost unheard of among blue-chip shares, especially ones that are still on course to make £3.5bn of pre-tax profits in the year ahead. More worrying was the fact that after an initial heavy drop Tesco shares continued to slide throughout the day as investors digested the news, and then fell another 2 per cent on Friday and 1.5 per cent on Monday as even the glimmest slither of reassurance from analysts from management of analysts failed to materialise. The fear, it seems, is that something is very wrong, and Tesco's admission that it would have to invest heavily to right its course was hardly reassurance that there was no need to panic.

Not that retail investors seem overly concerned, with many citing the mantra that when everyone is fearful is the time to get greedy. Comments on our site suggest that many saw the fall as a fabulous BP-like buying opportunity not to be missed - and trading stats from Barclays Stockbrokers support that anecdotal evidence. “Despite the drop in value, sentiment from traders towards Tesco was almost overwhelmingly positive, with the vast majority of Barclays Stockbrokers clients taking the opportunity to purchase the stock at a price that was perceived to be good value. Of the deals placed in Tesco yesterday by Barclays Stockbrokers clients, an unprecedented 96% were buys," said Paul Inkster, Co-Head of Product at Barclays Stockbrokers, noting that Tesco had been its top traded share on the busiest trading day of the year so far.

Big cleanup ahead for Tesco

But that the shares fell so heavily despite such high levels of retail interest suggest that the professionals, conversely, must be selling. As retail investors were keen to point out, Warren Buffet is NOT likely to have been among the sellers, but that's only because he doesn't have to. Berkshire Hathaway - which has built up an 3.6 per cent stake in Tesco - is so awash with cash that they could afford to sit on a losing position for years in the knowledge that it will come right one day, as Tesco surely will.

Most private investors don't have that luxury, though, and I'm sorry, but a 4.4 per cent yield doesn't compensate for the possibility of further capital erosion. Carrefour's shares have lost 45 per cent of their value in the last year - Tesco may not be as broken as the French grocer, but it's not immune to further problems either, especially as its large non-food business means it's more exposed to cyclical pressures than at any point in its history.

Certainly few of the analysts covering the stock, many of who had reiterated their buy advice in the run up to Christmas, had the resolve to stick to their guns after Tesco admitted that it wouldn't see any profit growth in 2012/13, and certainly not until CEO Philip Clark reveals in April the change of tack he'll be implementing to put right the strategy mistakes he'd admitted to making this year. All are agreed that while last Thursday's statement left us in no doubt that Tesco needed fixing, it gave no detail on exactly what this would involve. And although Tesco, as broker Espirito Santo points out, won't want to drip feed bad news to the market in the coming months, there's too much that remains uncertain to guarantee it won't. Questions that still need answers include:

- What does Tesco need to invest to improve performance in its UK business?

- Will Tesco's actions result in a grocery price war in the UK?

- Will competitors scale back opening programmes, or take advantage of Tesco's retreat?

- Is Tesco permanently sacrificing margin, and will this lead to permanently lower levels of industry profitability?

- Will UK problems impinge upon its ability to invest in overseas expansion?

Tesco is at a precarious moment, which may signal the transition from growth to ex-growth, and that's likely to make many investors and analysts reassess the way in which they value the business. Here's what some of them think:

Clive Black, Shore Capital (HOLD from BUY)

"We did not anticipate a material change to 2012/13 guidance from Tesco with its Christmas & New Year trading statement, [but] we do not expect Tesco UK to commence an all-out price war in the UK. We make this point for a number of reasons, not least of which is that we do not believe that Tesco UK’s perception from a price perspective is particularly poor. The approach that is being adopted by Tesco UK management therefore involves a considerable amount of non-price investment to try and improve the sales performance of the business. These improvements to the UK business are designed to appeal to a broader range of shoppers than just those that are driven by price/value and involve, to our minds, quite a considerable increase in labour participation. We therefore expect to see a stronger fresh food proposition, better service at check-outs, improved availability and merchandising in fresh and chilled food and enhanced category presentation and management in areas such as health & beauty and apparel.

We believe that the output from its ongoing initiatives will take time to come through if it does at all. Accordingly, there will have to be a period of watch and wait, which has implications for the movement (or lack of it) in the Tesco share price in forthcoming months. Accordingly, we cut our stance to HOLD. We still believe in Tesco’s business model and assert that a credible investment thesis persists; had we not, our recommendation would have been downgraded further."

Dave McCarthy, Evolution (previously REDUCE, recommendation under review)

"This is a bad day for Tesco and for the sector. We suspect that when investors look back, that they will view this day as the day the market recognised the fundamental changes that are taking and have taken place. Today is Tesco Thursday. We have now entered a new era of weak/negative LFLs, falling industry profits and falling industry returns. This is not going to change anytime soon and Tesco's situation is probably weaker and worse than appears from the outside. For example, to get store standards back to where they should be, could be a £500m bill, and there is still the quality and range issues to be sorted out, plus more price reinvestment. Tesco has been over-revving the engine for a long time and is now paying the price.

Right now, it is impossible to analyse and value the sector meaningfully as we do not have enough information. Tesco may have unveiled its broad strategy, but we know nothing about the revenue and capex investments, time scale, competitive response etc. All we can say is the outlook is not good, the timescale for recovery will be greater than suggested and that we are likely to see further cuts to forecasts in the future - for Tesco and the industry. This is not the end of the problem, this is the start of a new era for the industry."

Caroline Gulliver, Espirito Santo (HOLD from BUY)

"After two decades of almost uninterrupted growth and success, Tesco’s rebasing of profit expectations amounted to a recognition that it had fallen behind its UK competitors. Espirito Santo’s proprietary consumer surveys show that Tesco is not leading the sector for any measure, and quality perceptions in particular lag Sainsburys and Morrisons. Tesco is seeking to address this through increasing store staff, among other things. However, while it is clear that perceptions of Tesco are only average, our surveys show that the gap between Tesco and its UK competition is nowhere near as pronounced as the gap between Carrefour and its French competition. Hence it is possible that Tesco’s problems can be solved by the one-off, accelerated c.£400m investment and management may be able to avoid the pain of multiple profit warnings. However our industry analysis suggests it is too soon to rule out the risk of a damaging price war.

The risk is that industry profitability temporarily falls below £1 per sq ft, as it has done in the past following step-changes in pricing. That’s not to say Tesco would necessarily be the principal loser in a competitive battle but we think it’s too soon to judge the likely competitive reaction to both Tesco’s investment in its offer and deceleration of new space openings. We do not share management’s optimism that this “catch up” investment will lead to a significant improvement in LFL sales volumes and thus we assume the 100bps reduction in the UK operating margin to 5.0% to be a permanent step down in profits. We downgrade our rating to Neutral and or fair value from 480p to 335p."

Sam Hart, Charles Stanley (HOLD from ACCUMULATE)

"We had previously expected profit growth in the core UK business to be relatively anaemic, given the mature nature of the UK food retail market and Tesco's c.30% market share. It was felt, however, that it would be the "cash cow" to fund growth in the higher growth markets of Eastern / Central Europe and Asia, which in turn would drive overall earnings growth. Clearly the UK business is in much worse shape than we had realised and is going to require significant investment over the coming years, calling into question the Group's ability to drive growth overseas. Following today‟s sharp fall in the share price, the shares look inexpensive, but visibility is poor and we see low single digit growth in earnings and dividends at best over the medium term. We downgrade our recommendation from Accumulate to Hold (last recommendation was at 391p on 13 December 2011)."

Philip Dorgan, Panmure Gordon (BUY)

"The UK numbers are – once again – not good enough and we are downgrading our pre-tax profit forecasts by 15% for both FY2013 and FY2014. This raises concerns for long term growth as, ultimately, if the UK’s profits keep falling, then it will not be able to invest as much overseas, so long term growth will slow and returns will significantly undershoot targets. This is the nightmare scenario and our bear case target price of 280p comes into play.

The shares are too cheap IF Tesco can execute better in the UK, drive higher International returns and generate cash. We think that it will eventually do all of the above and that this will drive a significantly higher share price, which is underwritten by property values and a low valuation overall. That said, this is looking more and more an act of faith as every trading update passes. Finally, with every management change, it becomes less easy to be sure that the right people are in the right jobs, because track records become shorter and shorter. We remain buyers, but we are reducing our target price from 500p to 440p."

Nick Bubb, independent analyst (NR)

"Customers don’t “love” Tesco: that’s the problem, Tesco inspire respect but not loyalty and CEO Phil Clarke must envy the more secure market position held by his rivals at Sainsbury, Morrisons and Waitrose etc. At least he knows that he has to make the stores more exciting, [but while] it is encouraging that Mr Clarke wants to quickly address the “long standing issues” in the UK (that his predecessor Terry Leahy had allowed to build up?) about the quality of the shops, the staff service and the ranges, [...] the world isn’t going to stand still while Tesco try to re-position and catch up with what their rivals are doing in fresh food. The revamped Tesco Extra Dudley is said to be nothing like as good as the Morrisons experimental store in Kirkstall, for example."


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