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Trouble at Tesco

As Tesco reveals its UK recovery strategy, we ask whether it's time to pop the shares in your basket. John Hughman reports
April 20, 2012

Few industries are more competitive - some would say more cut-throat - than grocery. What we put on our plates is an emotive subject, and for the past two decades the battle for the hearts, minds and, of course, wallets of UK shoppers has raged fiercely. This 'Trolley War' has seen an ever greater proportion of household shopping budgets consolidated by just a few suppliers, as smaller traders have fallen by the wayside or been gobbled up.

IC TIP: Hold at 335p

No company has been more instrumental, or more successful, in this transformation than Tesco. Since taking over from Sainsbury's as the UK's largest food retailer back in 1993, it has grown its market share from 17 to 30 per cent, a level of dominance that has meant it has consistently been the most profitable grocer in the industry, with trading profit margins in excess of 6 per cent - and the most expansive, reinvesting profits in a land-grab at home and overseas.

Time to buy?

That Tesco has for so long seemed so indomitable explains why its shares fell so heavily after it warned in January that it had misjudged its Christmas sales pitch, and that profit growth this year and next would be well below analysts' expectations. The industry Goliath wasn't supposed to be fallible.

Since then, debate has raged. Does the subdued share price represent the buying opportunity of a lifetime, because Tesco has the financial muscle and market position to bounce back stronger than ever? It's often said, though, that nothing is more dangerous than a wounded animal, which means that competitors should perhaps be more fearful of Tesco now than ever. And with the knives out for Tesco, many believe now is the perfect time to tuck into the shares, not least veteran investor Warren Buffett, who took advantage of the 16 per cent dip in Tesco's share price to take his holding above 5 per cent. Buffett also owns a holding in Tesco's US equivalent Wal Mart, for similar reasons - that the sheer scale of these retail monsters gives them a buying power competitors simply cannot match. Philip Clarke spoke at length about the power of its distribution network in non-food.

REASONS TO BUY TESCOREASONS TO SELL TESCO

■ Huge property portfolio

■ Fast-growing overseas profits

■ Dominant share of UK market

■ Warren Buffett owns a massive stake

■ Progress in the US business

■ Underperforming businesses have been closed

■ Largest small store portfolio of major grocers

■ Underinvestment in stores and staff will be expensive to put right

■ Too many hypermarkets

■ Overdiverisifed

■ Too many underperforming international investments

■ UK rivals much improved

■ Major UK shareholders selling

■ Management upheaval

Or is the rehabilitation ahead likely to be more arduous than the bulls think, meaning shareholders can expect little in the way of returns for years to come? Certainly, there is much to improve in the UK, still the engine of group profitability accounting for two-thirds of total trading profits. Annual like-for-like sales growth has slipped steadily from nearly 6 per cent in 2007 to zero last year. UK trading profits fell by a percentage point to £2.48bn, enough of a decline to offset strong profit growth in its international businesses.

Along with many analysts, we at the IC have been inclined to sit on the fence and see what the company had to say in its strategic review, which it delivered alongside its full-year results on Wednesday 18 April.

Introducing discipline

As it happens, there wasn't much in the grand strategy announcement that we didn't know already, bar the cost. Tesco said that it would allocate £1bn to improve the UK store experience in the coming year, reiterating its earlier announced investment in 8,000 new staff members to deliver improved customer service, alongside better ranges and quality, at better prices, and supported by clearer marketing.

It will also refocus investment, improving its existing stores rather than ploughing hell for leather into new ones. So 400 stores, a quarter of its UK total, will be refreshed in the current financial year, while new UK space will be nearly 40 per cent lower than last year, reducing capital expenditure from £3.8bn in 2011-12 to £3.3bn this year - including £400m of the £1bn improvement expenditure, the remainder coming from the P&L. Although Mr Clarke stressed that Tesco would not be abandoning its hypermarket format, the new focus will be on opening smaller 'Express' stores and, as finance director Laurie McIlwee points out, delivering "more sustainable growth that focuses on getting more out of the business that we currently have".

That should come as a comfort to investors, who have grown increasingly concerned that what Mr Clarke describes as "planting new flags" has seen capital discipline slip. Notably, veteran fund manager Neil Woodford recently revealed that he had sold his entire position in Tesco, on the basis that "investment decisions in recent years have not created the value that they should have" and that "Tesco needs to become a more cash-generative, less capital-intensive business". Tesco has, it appears, been listening, reiterating its target of improving return on capital employed (ROCE) to 14.6 per cent by 2015, from the somewhat lacklustre 13.3 per cent reported in 2012.

Reconnecting with customers

While the newly found capital discipline should give investors comfort that dividend growth may accelerate from the rather soggy 2.1 per cent hike in 2012, it's less clear how quickly they will reverse the recent weakness in UK trading. As chief executive Philip Clarke admits, "too heavy a load has been placed on the UK to support the group… we've been taking more out of the group than we've been putting in, and that's not sustainable".

Customers have noticed and voted with their feet, particularly the deterioration in customer service caused by what Mr Clarke describes as "running the stores too hot". According to research from JP Morgan, Tesco now employs 4.8 employees per thousand square feet, down from 6.3 in 2006 and well below more service-oriented rivals such as Morrison, which employs nearer to 7 employees to cover the equivalent space. It's no coincidence that Tesco's staffing plans are focused on the fresh food categories that Morrison heavily promotes through its Market Street format - Morrison would argue that years of investment in training cannot simply be bought in overnight, even if Tesco wants to squeeze a three-year recruitment programme into one.

Tesco is also investing heavily in a new look for its stores, which have been criticised for being too clinical, to help stem the recent slippage in its market share. According to Kantar Worldpanel figures, Tesco's UK share has now slipped from a peak of 31.8 per cent in 2007 to 29.7 per cent in February, a level not seen since 2005. But while such initiatives are sensible, Tesco is not reinventing itself in a vacuum. Competitors have found their feet and are more than capable of giving it a run for its money, in a way they could not during the years in which Tesco cemented its position as the UK's largest grocer. "Having been ruthlessly oppressed by the might of Tesco for the past decade, competitors will seize this opportunity to regain market share, thereby compounding Tesco's problems," said Mr Woodford.

Indeed, Big Price Drop did not necessarily fail because it was a bad promotion - and as Mr Clarke pointed out, it got off to a good start when it was launched in September - but because Tesco was outmanoeuvred by rivals' Christmas offers. Instead of pre-emptive price cuts, Tesco's rivals focused on price matching - which meant shoppers could relax in the relative comfort of Sainsbury's safe in the knowledge that they weren't overpaying for the privilege - or on couponing, a tactic that Tesco has now emulated.

Tesco appears to be on the back foot from a product perspective, too. The relaunch of its 'Value' range as 'Everyday Value' is designed to address some of the perceptions that it's sacrificed quality for price, but having led the market on value in years gone by, it now feels as though Tesco is chasing rivals such as Asda, with its Every Day Low Prices model and value launches from more upmarket rivals such as Waitrose. At the other end of the spectrum, budget grocers such as Aldi and Lidl are proving fierce competitors, appealing to hard-pressed families and thrifty middle classes alike with low-priced products that frequently win in blind taste tests. Analyst Dave McCarthy at Investec recently said that Tesco had lost an "emotional connection" with its customers - in a fiercely competitive industry, winning that back isn't just a matter of throwing money at the problem.

Is the problem just the UK?

Tesco remains a very different beast from its UK rivals in that it also operates overseas – as it points out, its international business delivers a level of profits greater than any of its UK peers. They're growing quickly, too. International trading profits climbed 17.7 per cent to £1.1bn, underpinned by a 22 per cent increase in Asian trading profits to £737m, and lower losses in its US business Fresh & Easy, which fell from £181m to £153m.

However, look beneath the headline figures and the international story is less appealing. International like-for-like sales growth over the full year was a slim 1.6 per cent, deteriorating over the course of the year from 2.7 per cent in the first half to 0.7 per cent in the second. As Tesco points out, that was partly the result of country-specific issues such as floods in Thailand, a £38m hit from a 'crisis tax' in economically troubled Hungary and one-off distribution issues in Central Europe.

But problems could be surfacing elsewhere. Tesco plans to reduce the number of new hypermarkets it opens in China from 19 in 2012 to 16 this year, blaming the slowing economy and the spectre of rising inflation – it had originally said it would step up the rate of openings. According to research group IGD, China overtook the US as the world's largest grocery market in 2011, but most of the benefit is going to local retailers despite the best efforts of Western retailers to add space. As for Fresh & Easy, after already gobbling up approaching £1bn of investment, break-even has been pushed out by another year to 2013-14, a disappointing surprise given recent bullish comments to the FT. Even once break-even is reached, Tesco gave no guidance on the likely level of returns it can expect from the business, but Tesco remains committed to the US.

Some analysts, though, such as Mr McCarthy, argue that international has been underperforming for some time. "Tesco has been in many of its international markets for 10-15 years and yet in many cases fails to generate a return in excess of its WACC," said Mr McCarthy, noting that investors tend to focus on the few bright spots and the one disaster, Fresh & Easy, rather than the several more middling markets. Given he's one of the few analysts that have been negative on Tesco for some time, he's worth listening to.

Tesco – the IC verdict

When all is said and done, Tesco remains a mighty business, and one that still has masses of long-term growth potential, especially overseas but also through UK services such as banking, which after a three-and-a-half-year investment is now on the cusp of a substantial rollout of new services, including mortgages and current accounts. It's certainly not going bust - turning down the dial on capex will improve cash generation, and the business is backed by a truly enormous property portfolio. At £22bn it's worth more than the estates of the UK's three largest property specialists – Land Securities, British Land and Hammerson - combined, and can be unlocked to release valuable funds, as the £349m generated from the Thailand Lotus property IPO demonstrated.

The Economist Intelligence Unit also makes the simple case that because of Tesco's ubiquity in the UK, many shoppers will continue to shop there on the basis of convenience alone. That means its market share won't be overtaken any time soon. The grocer still takes £1 in every £8 spent on the UK high street, and a 2 per cent slip in market share over five years isn't really much of an encroachment into Tesco's dominance – in terms of the sheer numbers, it's hard to see Asda or Sainsbury catching up, not least because the competition commission is hardly likely to rubberstamp any mergers that would create another supermarket as large as Tesco. Rivals are also unlikely to embark on the kind of unfettered space expansion that allowed Tesco to become so dominant in the mid 1990s (Tesco added nearly three times as much space as Sainsbury over the past two decades) – planning approvals are more difficult to come by, while investors are much more focused on capital returns, which are initially lowered by new space.

Yet the next few years will be a period of transition, which could see the share price continue to bump along at the current low level. Mr Clarke says that management "knows what is wrong and knows how to fix it". But the cost of righting the business is substantial, and means that trading margins have been substantially rebased from the long-term average of around 6 per cent to nearer 5 per cent. What's more, given the competitive backdrop there's every possibility that Tesco may need to invest more in pricing than it has so far anticipated. We're also concerned, like Invesco's Neil Woodford, that Tesco is now a much more cyclical business than the grocer of old, as it has increased the amount of non-food merchandise it sells. Mr Clarke's appeared to admit that he had delayed addressing UK problems in the mistaken belief that an economic recovery was on the way – a huge planned expansion of its online non-food business is equally at the mercy of a recovery that does not come, in an environment where heavyweight rivals such as Amazon are happy to operate with wafer-thin margins.

Our final concern rests with the recent management upheaval, especially the unexpected departure of former UK chief executive Richard Brasher, a 25-year Tesco veteran. We'd agree with the assessment analyst Nick Bubb made at the time: "It is not a good sign when the CEO of a huge global group like Tesco tries to micro-manage the UK business," he said, asking whether Mr Clarke would assume control of, say, the banking business if it, too, started to struggle. Far from becoming less centralised – a frequently cited reason for the apparent complacency that has seen Tesco lose its way of late – Mr Clarke runs the risk of grabbing on to too much control as a result of the so-called brain drain many warned of when he took over the business. Given the number of moving parts in the business, that's a worry.

Ord price: 335pMarket value: £26.9bn
Touch: 334-335p12-month high: 423p   low: 310p
Dividend yield: 4%PE ratio: 9
Net asset value: 222pNet debt: 47%

Year to 25 FebTurnover (£bn)Pre-tax profit (£bn)Earnings per share (p)Dividend per share (p)
200847.32.82710.9
200953.52.8827.112
201056.93.1829.313.1
201160.53.6434.414.5
201264.53.8436.814.76
% change7572
Last IC view: Hold, 330p, 12 Jan 2012 Ex-div: 25 AprPayment: 6 Jul

WHAT THE ANALYSTS SAY:

Clive Black, Shore Capital

All in all, Tesco's update provides a safety net of sorts to the current share price, assuming no further disappointment. However, the business performance has to improve, as evidenced by a 1.6 per cent decline in UK ex-fuel like-for-like (LFL) sales in Q4 2011-12 and the market needs to see that improvement. Such progress can be expected to take time to come through – there is a lot of things listed 'to do' and doing them will by definition take time. Accordingly, we are not minded to change our hold stance on the share at this juncture.

Richard Cathcart, Espirito Santo

The initial results from Tesco's 16 trial stores (subsequently rolled out to 200 stores) look underwhelming to us, with a like-for-like improvement of just 1.2 per cent versus the control group. This improvement takes Tesco back to levels of like-for-like sales growth on a par with the competition, so it looks as though the changes made so far are not enough to take Tesco back to a level of outperformance. At first glance, this statement does not change our view that it could take longer for an improvement in performance to show through in the UK but for now we think management has some time to work on the issues.

Philip Dorgan, Panmure Gordon

This statement should reassure the market that Tesco has a coherent plan for UK recovery, and that greater focus on financial management should drive cash generation and higher group returns. From what we see in the stores, we think that it has a good chance of success. However, as always, execution is key. Turning the UK around is all about doing 1,000 things 1 per cent better, the devil being in the detail, not in the Powerpoint presentation. We remain buyers, with a target price of 440p.

Freddie George, Seymour Pierce

Our view is that Tesco is still a strong business with an unassailable market-leading position in the UK that has temporarily come off the rails. Management, in our view, should not change its strategy significantly either in the UK or overseas. It makes sense to invest more in service and in the ranges, particularly in fresh produce, but we do not believe management should be forced into selling overseas operations or its banks subsidiary. Nevertheless it is hard to see anything other than pedestrian earnings growth from the company over the next three years. UK profits are unlikely to grow while the company has to invest in its proposition to defend market share and overseas, which still only accounts for around 25 per cent of operating profits, will not significantly move the dial. We downgrade our target price from 400p to 350p. Hold.