Will Tesco survive Brexit?

Tesco (LON:TSCO) used to be a rather dull stock. It was seen as a defensive play with a generous yield and had the potential to expand abroad in Asia and the US. Today, its business is anything but dull. A new management team is in the process of changing the company so that it is once more a UK-focused grocer. It is also taking on discount operators with a new strategy which has thus far been well-received by its customers. However, it now faces its biggest challenge: how to survive Brexit.

Brexit could be a headache for Tesco

The main problem with Brexit is that nobody can say for certain what its impact will be. However, the Bank of England’s forecasts are a good place to start and they paint a tough outlook for the UK economy. For instance, unemployment is forecast to rise by over 50 basis points to 5.6%. This could cause consumer spending to come under pressure, since even those individuals who do not lose their jobs may rein in their spending as fears surrounding job losses intensify.

One effect of this could be a return to a situation where customers trade down within the food retail sector. This was popular in the credit crunch when shoppers became more price conscious. With Aldi and Lidl having larger estates than eight years ago, they are more easily accessible for a greater number of shoppers. Therefore, Tesco could lose customers to its cheaper rivals.

Further, Brexit has thus far caused inflation to rise. This week saw it hit 1% for the first time since November 2014. Although this is well below the Bank of England’s 3% target, it is a sign that a weak pound will be felt by shoppers since it makes imported goods more expensive. While Tesco and Unilever (LON:ULVR) were able to agree on pricing recently, the episode showed that Tesco may be forced to either pass on higher costs to shoppers or else absorb them itself. If it passes them on to customers, it could encourage greater numbers of customer to trade down to Aldi and Lidl. If Tesco absorbs them itself then its financial performance could suffer.

In terms of the longer term prospects for inflation, the Bank of England has stated that higher levels of inflation may be a necessary evil in order for it to maintain a loose monetary policy. The central bank could attempt to dampen inflationary pressures through higher interest rates, but this would be likely to exacerbate a slowing GDP growth figure. Therefore, higher inflation is likely and Tesco may struggle to come to terms with it.

Tesco’s strategy

The strategy adopted by Tesco’s new management team has been viewed as successful so far. Its decision to concentrate on being a grocer rather than a conglomerate makes sense in my view. Tesco had become bloated, inefficient and lacked the focus of its rivals in a highly competitive food retail space. However, its decision to dispose of international operations in favour of being a UK-focused retailer may prove to have been the wrong decision.

At a time when a number of FTSE 350 companies are benefiting from a weaker pound, Tesco’s UK focus will mean it misses out to a large extent. A loose monetary policy seems to be here to stay over the medium term, so the pound could weaken further.

The full impact of Brexit is not yet known. It may not be known for a number of years. This could cause investors to de-rate companies which lack geographical diversification since they will mean higher risk for the investor. Under Tesco’s new strategy, it will be included in that list and its shares may fail to trade at their intrinsic value.

Financial strength

One area where Tesco has made improvements is its financial standing. Excluding Tesco Bank, Tesco’s net debt has fallen by £758 million to £4.4 billion in the last six months. This puts Tesco on a more stable financial footing for the long term. Additionally, net operating cash flow covered capital expenditure to leave free cash flow of £414 million in the first half of the current year. This will provide Tesco with the scope to restart dividends over the short to medium term.

Tesco will also improve the efficiency of its distribution system and operate a simpler store model. Both of these changes should help to create a leaner and more productive business. Although there is still some way to go before Tesco returns to financial health, it is nevertheless in a better position than it has been for a number of years to face the risks associated with Brexit.

An uncertain outlook

Tesco’s P/E ratio of 60 is of little use in deciding if the company offers good value for money. That’s because it is forecast to increase EPS by 162% in the 2017 financial year and then by 35% in the 2018 financial year. This means that Tesco has a prospective P/E ratio using 2018’s forecast EPS of 21. Beyond 2018, Tesco is aiming to increase its operating margin up to 4%. It will do this through cost savings of around £1.5 billion.

This may be achievable, but cost reductions could be offset by the negative effects of Brexit. Therefore, in my view Tesco’s valuation prices in a positive outlook for the company, when the reality could be very different thanks in part to the risk from Brexit. Challenges such as higher inflation, higher unemployment, a more price conscious consumer and an increasing lack of geographical diversity could count against Tesco over the medium term.

In my opinion, Tesco’s valuation is too high given the risks it faces. I don’t doubt that it will survive Brexit. However, I think it lacks a sufficient margin of safety to prosper as an investment over the medium term.