What Tesco's faltering turnaround means for the shares
Phil Oakley Oct 04, 2012
Just a few short years ago, Tesco (TSCO) was the golden boy of British retailing.
It seemed completely secure in its dominance of the UK market. Having moved beyond food retail, it was sucking business from almost every part of the high street, from book sales to cheap laptops.
It had big plans for going on to conquer the US. It wouldn’t be easy, but if anyone could do it, Tesco could.
Investors grew used to the company beating the market’s expectations with almost every set of results it released.
The fact that all of this seems like ancient history now, shows just how far Tesco’s star has fallen. Yesterday, the company reported its first fall in profits since 1994.
Is there any sign of a return to the glory days?
Throwing money at the UK is not working
It’ll take longer than six months to see if Tesco’s turnaround plan for its UK business is working. But the initial signs are not good.
Tesco is going to spend £1 billion on freshening up its stores, putting more staff in them, changing its product ranges and cutting prices. So far this has kept sales from existing stores (like-for-like sales) where they were a year ago. But it has cost Tesco a lot of money - UK profits are down 12.4%.
Tesco is trying to fight a lot of problems at the same time. It has lost the goodwill of many customers in the face of fierce competition from its rivals. These customers may never return.
But the deeper problem is that food retail in the UK is a dire market to be in just now. There are too many supermarkets chasing too little money.
Take Sainsbury’s as another example. It’s throwing everything it has at customers in terms of quality and price, and it is still only growing its same store sales by less than inflation.
Tesco’s business model was set up for a different age: an age of easy credit that allowed it and its customers to borrow big and spend big. Those days have gone.
Tesco is now left with lots of big hypermarkets that were meant to sell electrical and other non-food items that people are now either cutting back on or buying over the internet. Trying to get these big, out of town stores to pay their way could be very difficult, and act as a drag on profits for years to come.
And Tesco’s international business is now struggling
Tesco bulls have always pointed to the growth potential in its international business. Yet just when Tesco needed this business to be firing on all cylinders, it is now facing tough times.
Tesco’s businesses in Malaysia, Thailand, Slovakia and Poland are doing relatively well, although underlying sales growth is still very modest. But life everywhere else has become a lot more difficult.
European profits fell by over a quarter as cash-strapped consumers in weak economies struggle to make ends meet. VAT rises in the Czech Republic have made matters worse, while sales of general merchandise are a lot lower than a year ago. Tesco’s exposure to austerity-ridden Central Europe is a big problem that will probably get worse before it gets better.
Asian profits, meanwhile, are stagnant. Korea - Tesco’s core Asian market - has been hit by legislation which requires big supermarkets to be closed on two Sundays every month. With Sundays usually accounting for 20% of total sales, this new law looks set to cost Tesco around £100m in lost profits this year.
The market in China is suffering from excess capacity as too many supermarkets have been built. Investing more money there does not look sensible.
Then we get to Tesco’s disastrous American adventure, Fresh & Easy. This business lost £72m during the last six months which represents virtually no progress on the losses made a year ago. We doubt whether this business will ever make money. It’s proved to be a very expensive mistake on Tesco’s part, and one they should end as quickly as possible.
Tesco’s finances need to be closely watched
There’s more to Tesco’s finances than meets the eye. While trading profits fell by 10.5%, net trading cash flow fell by nearly 40% as Tesco pumped more cash into its pension scheme and had a harder time squeezing its suppliers.
But what’s more disturbing is the large amounts of hidden debt, which we’ve talked about before. In short, Tesco tells you that it has £7.2bn of net debt (debt less cash), yet it keeps selling supermarkets and renting them back (known in the trade as ‘sale and leaseback’).
A decade ago, Tesco owned virtually all of its stores. Now its has to make minimum future rent payments on stores that it has sold - that are not on its balance sheet - of £17.3bn. So Tesco’s finances are a lot less healthy than most people think.
We’re not saying for a minute that Tesco is in danger of going bust. But if you are expecting rapid dividend increases – or indeed any dividend increases at all – then yesterday was a wake up call.
Management decided to maintain the existing dividend payout. Despite being well covered by profits, you need cash to pay dividends. If profits and cash flow continue to fall then what was once seen as unthinkable may come to pass – a Tesco dividend cut.
Given the size of its problems, it was always going to take a long time to turn Tesco around. But its latest results show no real sign of significant improvement on this front at all. And with markets generally tough both in the UK and overseas, it’s hard to see where any pick-up is going to come from.
So what should you do if you hold the shares? Well, it’s not unreasonable to give the management team some time to sort things out. It’s increasingly clear that they need to do something. If Tesco were to announce it was getting out of America then the shares would probably bounce on the news.
And what if you don’t own them? Assuming an unchanged dividend, the shares yield 4.5% at the current share price of 326p. If trading doesn’t pick up soon, there’s no reason why the shares couldn’t fall further, to yield 5% or 5.5% on a lower share price. If the shares were 50p lower, we might be tempted to buy a few. Since they are not, we see no reason to buy now.
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