Tesco shares what to expect from it 8217 s Q1 update

Batten down the hatches. At 7am (BST) tomorrow, Britain’s biggest retailer, Tesco, reports to the market on how it fared in the 13 weeks to May 24th, its fiscal first quarter.

Market expectations are low, somewhat depressed and expecting the worst. On the one side, this gives rise to the potential that any beat on sales could inspire bargain hunting and a boost to the firms share price. But the issue here is there is a degree of validity to depressed expectations.

What are we expecting?

Tesco is expected to report a further deterioration in its quarterly sales decline. For Q1, like-for-like sales (including VAT and fuel) in the UK is expected to fall by between -3.5% and -4.1%, having slumped -3.5% in the fourth quarter of 2013. This could be its worst quarterly sales decline for over a decade as the retailer battles against rising competition from discount retailers, disruptions caused from store refits and a slowdown in sector growth.

If we get a sales decline of -4% or worse (and I think that’s a real possibility), tomorrow could be a disastrous day for Tesco. Shares have started to trade back around the 300p level having hit their lowest levels in a decade in April. We could see yet more falls should Tesco fail to calm investor fears that Philip Clarke and the Tesco board is losing its turnaround battle. We could be looking at the 275p-280p area.

Tesco UK in the eye of the storm

Whilst Tesco is the worlds’ third largest retailer, behind Wal-mart and Carrefour, it’s the UK that is its core market. Last year, 66% of the groups’ total profits came from trading in the UK, whilst 68% of sales came within the UK. So, if the company struggles in the UK, it makes a real impact.

“The problem with Tesco is it just doesn’t know what it is anymore.”

Consumers know what Asda, Aldi and Lidl stand for – low value, discount shopping. They know that Waitrose stands for high value, quality grocery shopping. So what does Tesco stand for?

Since February the firm has announced a series of aggressive price cuts totalling a £200m investment (yet another restricting investment) to attract footfall back to its stores. So does this mean they want to re-brand as low value? Consumers simply don’t know.

And, when put up against a backdrop of a divorce between UK economic growth and UK wage growth (three- month wage growth is 1.7% vs inflation of 1.8%), a lack of transparency over what consumers will get shopping at Tesco, and structural issues in the UK grocery sector (see below), this becomes a huge problem.

UK grocery sector facing a structural correction

Research from Kantar Worldpanel this week showed that the UK grocery market grew 1.7% in the last quarter (similar reporting dates to Tesco Q1). That may seem ok but, in reality, it’s the slowest pace of growth in the UK grocery market for 11 years and at the heart of this is a growing price war amongst retailers and slow wage growth.

At the same time – fed largely by price cuts – grocery inflation also slowed to 1.2% (marking its eighth consecutive slow down) and is now at its lowest level since May 2010. Low price inflation – especially that which is driven by a price war – cuts profit margins for retailers and, without the increase in volume to counter, this is troubling.

Even more concerning is the fact that there seems to be no end to the growing price war. Morrisons (who Kantar believe suffered a -3.9% decline in sales last quarter) have embarked on an aggressive price cut plan to target lost footfall to Aldi, Lidl and Asda, which has somewhat clouded Tesco’s own price cuts. There’s a sense that there could be much more to come in the form of price cuts and, without knowing where the bottom may be, this could hamper grocery inflation and profit margins further.

And what does that mean? More profit warnings. I worry we could even see another one from Tesco in this Q1 update.

Tesco shares fell to a ten-year low in April

Philip Clarkes’ job is under pressure

Make no mistake, the pressure is on Philip Clarke, and if their Q1 results come out with the tone expected, his job will be under threat. They are now into the second year of Clarke’s ‘building a better Tesco’ turnaround plan but the market has failed to see any traction that inspires confidence that Tesco can deliver a return to consistent quarterly sales growth and earnings, let alone demonstrate that a corner has been turned.

Clarke may well counter any negative sentiment with talk of a long-term strategy that takes time to deliver as well as the impact of store re-fits in hurting sales in the near term. Yet patience amongst shareholders must be running thin. With shares hitting their lowest in a decade recently and forward 12 months price to earnings of 11.35 compared to a sector ratio of 15.02, Tesco’s largest shareholders could start to bang on Clarke’s door more potently should they become unconvinced the firm’s strategy has what it takes to recover lost ground.

So, on to tomorrow for what looks to be a hugely interesting day.