Can Tesco Recover its Crown? By James Faulkner

When businesses lose sight of their core strengths in an attempt to be all things to all men, this is usually a recipe for disaster. In many cases, Tesco (TSCO) is a classic case of corporate overstretch, but it is also one which has been exacerbated by what appears to be a structural shift in its marketplace, precipitated by the growth of discounters Aldi and Lidl, and magnified by the impact of the recent recession and ensuing squeeze on household incomes.

Although almost universally praised as one of Britain’s best businessmen during his tenure, ex-CEO Terry Leahy certainly played a major role in laying the foundations for many of Tesco’s problems, not least of which was an ill-fated foray into the notoriously competitive US grocery market, and pursuing international expansion seemingly as an end in itself rather than a means to an end.

For a while, this empire-building went largely uncriticised. And as star UK fund manager Terry Smith has pointed out, although sales, profits and earnings rose year after year, returns on capital were getting lower and lower. In short, Tesco had lost the plot. So when discounters like Aldi and Lidl stepped up investment in the UK, they found a market ripe for the taking.

Several profit warnings later, Tesco is still reeling from an accountancy scandal (always a significant possibility at a company facing structural problems), a credit downgrade and a swathing dividend cut. That said, the shares – after having hit lows of 165p after December’s profit warning – have been trading strongly after the Christmas trading update and the announcement of CEO Dave Lewis’s restructuring plans.

What investors need to know is whether this is the beginnings of a recovery of merely a dead cat bounce.

The Christmas trading statement, released on 8th January, was actually the most positive update from Tesco for some time. While group sales fell by 3.8% during the third quarter as a whole, Christmas trading materially improved and beat market expectations, with UK like-for-like sales just 0.3% lower. There were also some particular bright spots, including a 12.9% rise in grocery home shopping, a 22% rise in online general merchandise sales (including a whopping 52.4% increase in clothing online), positive fresh food volumes for the first time in five years, and a 4.9% increase in Tesco Express sales. Tesco management framed the update thusly:

“We are seeing the benefits of listening to our customers. The investments we are making in service, availability and selectively in price are already resulting in a better shopping experience. A broad-based improvement has built gradually through the third quarter, leading to a strong Christmas trading performance.”

Lewis also used the trading update as a platform to outline the direction for travel in terms of dealing with its structural problems. The main points included a restructuring of central overheads, simplification of store management structures and increased working-hour flexibility, delivering savings of c.£250 million per year at a one-off cost of £300 million; flat investment in payroll, the introduction of a flexible benefits package for store colleagues and a turnaround-based bonus for all colleagues; a decision to consolidate head office locations, closing Cheshunt in 2016 and making Welwyn Garden City the UK and Group centre; the closure of 43 unprofitable stores; and an initiative to set lower prices on some of the nation’s favourite brands.

While this is clearly just the beginning, Lewis has shown that he is prepared to make major decisions – decisions that admit and address past failures (one of the key benefits of hiring an external candidate!).

The direction of travel looks clear

The closure of underperforming stores and the reduction in capex will help stabilise and (eventually) drive up returns on capital and operating performance in a market that is clearly facing oversaturation (at least in terms of hyperstore capacity), whilst also helping to deleverage the balance sheet (there was £7.5 billion net debt as at August 2014). There will also be decisions to be made regarding other possible divestments of non-core assets, such as Tesco bank, Giraffe, dunnhumby and possibly some of the various overseas assets. In the process, Tesco will be able to refocus its attention on its core UK offering and get back to doing what it used to do best – provide value for money.

The closure of the Cheshunt office is clearly aimed at signalling an overhaul of the corporate culture at Tesco, and the fact that Lewis has no past history at Tesco leaves him better placed to instil this than the hapless Phil Clarke. In this vein, we like the fact that Matt Davies, another external appointment, now occupies the position of CEO UK & Ireland (the second most important office in the group). Davies was CEO of Pets at Home before its buyout by KKR in 2010, and more recently was at the helm of struggling bike and car parts retailer Halfords, where is is generally seen to have done a good job of putting the firm back onto an even keel. With Davies in position at the core UK business, Lewis will have more time to spare taking control of the balance sheet and group strategy, and the market will be looking on with interest and expectation as this management partnership takes root.

The UK grocery market is where Tesco’s fate will be decided. Here it is worth noting that the outlook for the consumer is looking a lot better. Most analysts expect wage growth to pick up over the coming year, whilst inflation is set to average around 0% by some estimates. This should reduce the pressure on consumers to ‘trade down’, thereby diminishing the allure of the discounters. At the same time, Tesco will be working hard to win those customers back. In the vanguard of Tesco’s counter-attack is lower prices on branded favourites, which seems to square the circle of the ‘quality’ and ‘value’ proposition that Tesco wants to convey. This is also where Tesco’s scale and buying power could give it an advantage over rivals, and the move hits both discounters (who have highlighted the price gap between branded products and their own ‘generic’ labels) as well as the other supermarkets, who will find it difficult to respond on the same scale. Again, there is much more to be done here, but the move nevertheless indicates the direction of travel.

So should investors bag Tesco in the expectation of a recovery?

Tesco’s position is salvageable, and I would even go so far as to say that I believe Lewis and Davies will succeed in turning the ship around. That said, huge ships like Tesco take a lot of time to alter course, so investors will have to be patient. Encouragement may be drawn from the experience of Carrefour across the Channel. Just like Tesco, Carrefour had become complacent and things came to a head in 2011 when Carrefour’s dividend was slashed in half. A new broom came in and promptly exited underperforming international markets and cut costs. Several years later, and the Carrefour share price has more than doubled from its lows. What’s more, all this was achieved in the midst of a stagnant European economy, whereas Tesco has the benefit of a relatively buoyant UK backdrop.

How can we value Tesco?

With earnings looking pretty meaningless at this stage, one measure investors could look at is price-to-book, which is the market capitalisation divided by total shareholders’ equity (net assets). Tesco is currently trading on a price-to-book of 1.25, which is low versus historic trends but still high versus peers, which currently trade around parity with book value. Nevertheless, with a significant amount of book value tied up in real estate, this does provide a measure of downside protection from current prices. So what’s the upside? Broker Shore Capital suggests that to reach a share price of c.300p (on a 12x P/E rating) would require c.25p EPS. The broker estimates EPS of c.8p for FY16 and c.17p for FY18, albeit with low visibility.

My take is that just as Tesco’s fall from grace was dramatic and took people somewhat by surprise, so shall its recovery do the same. Lewis and Co. have only begun to scratch the surface and there is a huge amount of work to be done, but they have demonstrated that they understand Tesco’s problems (in stark contrast to previous management) and the sheer scale of Tesco presents a myriad of opportunities. My inkling is that those willing to take a long-term punt will be rewarded.