Tesco discount could be a bargain

Tesco shares still have some way to go to recover after last week's severe punishment.

Tesco shares still have some way to go to recover from severe punishment that followed a half-year operating profit miss last week. The stock remains 7% lower since Monday 1st October. Heaviness suggests investor views are hardening on chances that Tesco can meet key goals set two years ago. The group itself is certain that it will generate £9bn in retail cash from operations and lift group operating margin to 3.5%-4% by 2019/20. Hitting the margin target in particular has come to be seen as a key test of CEO Dave Lewis's formula for sustainable growth and, ultimately, shareholder returns. Scepticism has been rising for some time. Including last week’s price thrashing, the loss since 10th August has been about 15%.

It is possible investors have rushed to overly harsh judgement. Britain’s biggest retailer generated a 24.4% underlying operating profit rise in H1 to £933m, lifting the operating margin 29 basis points (bp) to 2.94%. That was backed by a solid 2.5% like-for-like (LFL) sales advance in the UK & Republic of Ireland division (UK & ROI) during the second quarter (up from 2.1% in Q1) taking six-month growth to 2.3%.

True, the operating result was below consensus by as much as £67m, whilst headline operating profits fell 6.5% to £819m. That was largely due to hefty profit and LFL slides in Asia (-29.1% and -9% respectively) and a £32m loss in Poland.  Still, the worst that can be said about UK & ROI, the region where the group generates c.80% of revenues, is that the operating margin excluding Booker fell 4bp between the second half of 2017 and the first half of 2018. That begs the question of whether slashing over £2bn from Tesco’s market cap last week was an over-reaction. The fall easily assumes zero operating profits between now and the 2019/20 financial year.

More to the point, it is clear investors have become more hawkish about which end of Tesco’s margin target range it might hit by that date. Whenever risks looks weighted to the lower 3.5% end, the shares face pressure. If UK sales growth remains stable (though, probably a tad softer, without the World Cup boost) Tesco’s now cheaper rating could help close its share’s gap to UK rivals. The group trades at 15.87 times 2018 forecast earnings compared Morrison’s 19 times, according to Refinitiv data. Investors will have to wait till 11th January for a Christmas update though Kantar Worldpanel’s monthly UK grocery market data are due out next week.

Figure 1 – Normalised share price chart: Tesco, WM Morrison Supermarket, J Sainsbury – 1st January-10th October 2018

Source: Refinitiv/City Index

Build your confidence risk free
Join our live webinars for the latest analysis and trading ideas. Register now

StoneX Financial Ltd (trading as “City Index”) is an execution-only service provider. This material, whether or not it states any opinions, is for general information purposes only and it does not take into account your personal circumstances or objectives. This material has been prepared using the thoughts and opinions of the author and these may change. However, City Index does not plan to provide further updates to any material once published and it is not under any obligation to keep this material up to date. This material is short term in nature and may only relate to facts and circumstances existing at a specific time or day. Nothing in this material is (or should be considered to be) financial, investment, legal, tax or other advice and no reliance should be placed on it.

No opinion given in this material constitutes a recommendation by City Index or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person. The material has not been prepared in accordance with legal requirements designed to promote the independence of investment research. Although City Index is not specifically prevented from dealing before providing this material, City Index does not seek to take advantage of the material prior to its dissemination. This material is not intended for distribution to, or use by, any person in any country or jurisdiction where such distribution or use would be contrary to local law or regulation.

For further details see our full non-independent research disclaimer and quarterly summary.