Tesco moves to stage 2 of its 'recovery'

UK supermarkets are a bit like the beer they used to sell; bland and too many of them. Tesco however is working on that one as it culls its less profitable sites and brands (including the #4 UK brand, Carlsberg) to restore its growth and margin metrics, even it means from a lower base of revenues and margins. Tesco's interim results released yesterday therefore reflect this dynamic of what was a slight deterioration in actual UK sales growth in Q2 to -0.9% YoY vs the -0.4% posted for Q1, but having eliminated the weaker perfomers from the average meant that the Q2 like for like sales in the UK surged from -1.3% to -1.0%, to take the first half average to -1.1%. While a considerable improvement on the prior trajectory, it was not without cost, with UK & RoI operating profits collapsing by 69% (-£377m) to only £166m and a margin down -200bps to only 0.9%. Given the profit decline of -£377m substantially exceeded the underlying revenue decline of -£226m and that the group had taken around £6.8bn of provisions last year to help pad out the bottom line this is a pretty remarkable performance. Either management is keeping its powder dry for the great cost led margin rebound just ahead of their option vestings in 2-3 year time or the apparent stabilisation in top line sales was expensively purchased out of gross margins.  While this may keep some pressure off the new management, this is no substitute for a sustainable recovery, particularly when the share price is still reaching out to well above even where consensus forecasts are anticipating in FY17.

With underlying organic sales growth still negative and the shares trading on a current year prospective operating FCF yield of possibly under 3% markets are clearly reaching out into a future where a restoration in operating margins and possibly also near market average growth rating may also be in prospect. If one were to take a fairy upbeat assessment that the group ought to be able to justify an underlying growth rating of around +4% pa (and circa 7% Op FCF yield), then we estimate that the group needs to convince markets of its capacity to restore operating margins to near peak levels of around 5%, or to over +50% above where consensus estimates are currently for FY17. We may be through the trough, but is the pace of improvement currently being delivered by either Tesco or its competitors really enough to take us to these valuation highlands within a credible investment horizon? At this stage, the group needs to a capacity for some serious over-delivery rather than merely tracking existing expectations.

A serious over-delivery against current consensus out to 2017-18 will still be needed

Welcome to the UK recovery!

Still faced with a structural deleveraging in personal and public debt, the policy response by those who ought to know better remains the same – juice the system and hope growth miraculously appears.  That’s right, the same strategy as adopted for Greece, Portugal, Spain, France etc, etc, & etc. 

After the >+10% MoM rise in asking prices for London homes published by Rightmove, another vested interest group, the Council for Mortgage Lenders issued a press release highlighting the increase in mortgage approvals from 64k in August to 67k in September. Bank of England data released on 18 October was already showing a 25% YoY increase in UK property backed loans for August.   Consumer credit meanwhile is not being restricted to just property backed loans.  The Arch-Bishop of Canterbury may not approve, but net unsecured debt is also up, rising by £411m MoM in September; a +4.4% YoY increase.   As good Keynsians know well, rising credit equates to increased consumption and therefore growth so all this must be good for the recovery!

Encouraging consumers to leverage into property ahead of a possible rise in interest rates or take on more Wonga type debt however, seems an odd basis for celebration if not supported by real income growth.  Consumer credit may be expanding to fund current consumption, but real income growth will need to be supported by re-investment by industry.  While consumers were loading up with £411m of additional unsecured credit in September, lending to SMEs fell by an almost comparable amount of -£383m.  You can’t blame the banks as they are merely responding to the environment that Governments and regulators have created, just as we saw with most other financial cock-ups from the Savings and Loans debacle to the sub-prime crash.  When you can make a property loan with a Government backed guarantee or a pay-day loan with an APR of >1000%, then why should a bank go at risk to lend to some SME with no realisable assets and a business plan you don’t understand?  

Property back loans continue to rise: +67k in Sept vs +64k in Aug

Consumer credit increases +£411m in September

SME lending however down £383m in September

Not exactly positive for real personal income growth!

Consumers therefore continuing to buy more stuff with cheap credit, but particularly vulnerable to any increase in debt servicing costs while real income growth and SME investment remain constrained.