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

Tesco: Phase 2 - reset investor expectations

It’s always entertaining to see good people-management at work. As with a new Government, a new management needs to persuade the stakeholders that their predicament is substantially worse than previous team were letting on, but that with a little pain, the new team and plan (usually with a catchy name) will secure recovery by the time their contracts come up for renewal. This however requires a reset (down) in expectations, which usually is accompanied by the obligatory ‘kitchen sink’ job, followed by selected acquisitions with plenty of fair value adjustments that if handled correctly can often be written back to deliver the required ‘recovery’, albeit sometimes to below the original start point.

So far, we have had the ‘predecessor-trashing’ and now with the Dec 9 pre-announcement, we are being softened up for the reset in expectations. Management have given markets just one number (under £1.4bn for FY15 trading profit) and it is a bad one, suggesting a near -75% YoY collapse in H2 FY15. What we are not being permitted to see at this stage are the components of this performance; ie how much from a further deterioration in UK like-for-like sales or whether significant provisions and charges have been levied against this period that may not be recurring. Without these, markets will not be able to gauge properly the depth of the underlying margin trough or the businesses capacity to recover. For this (hopefully), investors will have to still await the planned announcement on the 8 January. By then, investor expectations ought to have tanked and markets will be grateful to suck up any plan that offers recovery even if to a substantially lower margin base than hoped for only a few months previously.