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


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