Tesco – After the Kitchen Sink

Everyone has heard the bad news but what does it mean and how much of it has been discounted by the recent share price from the low of 155p?

The biggest item to be seen in the last set of preliminary figures reported by the company for the year to February 2015 is the exceptional charge which features in full scale in the statutory accounts (i.e. those complying with English company law, which have to include the bath water, the baby and the kitchen sink).

It amounted to a reported £7 billion and consisted largely, I suspect, of writing down the value of assets. Property was the biggest item of “impairment” (polite accountancy speak for loss of market value) at £4.7 billion. A minor part of it looks as though operational costs rose as a result, including a reported £416 million of restructuring cost. The logic of the write downs relates to the poorer operational conditions in the business and the industry which have lead to lower commercial values for them. The important thing is that it does not in principle represent a loss of cash or a loss of outlets. Tesco will continue to be a business with more than three thousand outlets with which to maintain and increase its dominant market share.

Forty two outlets have been, or are in the process of being closed because in the management’s belief, they cannot be made sufficiently profitable or usefully cash generative. It is a marginal number and it is what happens in the rest of them that will be crucial to Tesco’s future. Anyone who has shopped in Tesco in recent years will no doubt have found it to be a far from wholly agreeable experience. There were frequently too few staff and too many of them seemed to regard their paying customers as much more than an inconvenience, to be challenged with those stacking trolleys which too often seemed to be propelled like dodgem cars at the fair. It always struck me as evidence of some managerial malaise within the company, along with the presence of group think.

The company now seems to be addressing such neglect of basic retailing by better training of more staff. To further enhance convenience, the company will make sure of better availability of the best selling lines (something which, by implication, does not seem to have happened sufficiently in the past). The company are now ensuring that the pricing of individual items is as smart and as timely as a guards regiment army drill parade. No more sloppiness of leaving basic item prices at a premium to those charged by discounters – the tube of toothpaste that was left selling at 40% more than the next place etc. Such basic retailing sloppiness is to be protected from targeted discounted sniping.

In short, it was not that the Aldi and Lidl discounters were simply skilfully charging less; it was also a case of Tesco seemingly making the task easier for them. David Lewis (sorry Dave that I prefer to call you David out of respect) seems to have come to the conclusion that there is nothing wrong with the basic model that more oiling and managerial maintenance will not put right. It is employing the old management approach of the Royal Navy to keep things ship shape in the Bristol manner.

The new management is also improving cost efficiency by closures and reorganisation. The head office has been moved and head office teams remodelled to be hopefully more flexible and responsive. It is also doing things to increase cash generation including property swaps with British Land, changing the pension scheme from defined benefit to defined contribution and discontinuing dividends; selling business’s which are no longer core and reducing capital spend from £2.7 billion the year before last to a capped figure of £1 billion. Clearly, the company has much employment for cash; something reflected in a massive rise in working capital and a reported negative free cash figure of minus £1.3 billion.

It is very difficult to work out anything like a routine valuation for Tesco in the midst of this internal revolution. There is some evidence of small initial success with improvements in Q4 retail “like for like” sales in UK retailing and customer numbers, range of customer purchases and volume figures. The company still has substantial business interests in Asia and central Europe, from its earlier world empire building days; a speculative burgeoning empire into which UK retail cash was poured, instead of the UK business that produced it. With the lack lustre US “Fresh ‘n’ Easy” business sold off, we shall probably hear more of sales in Europe, which has performed disappointingly. Much time and treasure was poured into world conquest while the home UK retail business was left seemingly to fail gradually by lack of oversight and to provide the cash for overseas expansion. That era has come to an end.

With a reported statutory operating loss of £5.8 billion there is a positive “underlying” reported earnings per share of 9.4p, which values the shares at 24 times underlying earnings. Although retail sale revenue is cheaply valued at 330p for each 100p of share price investment, it is a sales figure which has been returning too small a net return and which is lower than that found elsewhere.

It is going to take time and much cash to turn this tanker around. So I do not think you need to chase these shares at the moment following these nightmare historic results. Psychologically, the market needed bad results of this kind to prove that the right medicine was been administered. Normally that suggests a share price rise out of a collective market sense of relief. But that seems to have been discounted in the strong share performance of recent months. With dividends cut and dividend paying relegated to the least of management’s priorities for the duration of the war against failure, the shares look as though they have gone far enough for the time being and should not be chased for the moment. Scared short term funds should look for better short term rewards.