Tesco (TSCO) management provided an update on its long-term strategy, and we don't expect to make a material change to our forecasts or our £3.80 fair value estimate. Although competition remains fierce and limited customer switching costs constrain our moat rating for Tesco, we think the shares are undervalued.
We remain cautious that price cuts will be enough to turn around sales
The key takeaway from Tesco's presentation is that management is committed to doing whatever it takes to ensure that Tesco has the "most compelling offer" in the U.K. marketplace. Although this commitment is not necessarily new, the fact that management refrained from defending the sustainability of a 5.2% U.K. trading margin is a notable change from the past. Management has come under much pressure from investors calling for Tesco to cut the U.K. margin to defend itself against the onslaught of discounters Aldi and Lidl, which have steadily gained share in the recent past. Some have argued that the discounters offer products of equal/better quality than Tesco's mid-tier private label, but at lower prices, and that Tesco needs to rebase its price architecture to remain competitive.
We think management is trying to alleviate intense investor scrutiny about the margin target so the firm can focus on improving the long-term competitive position of the business. We appreciate this decision, but maintaining its goal for mid-single-digit operating income growth requires that Tesco like-for-like sales growth turn into positive territory. Given that Tesco intends to cut prices, the volume uptick will need to be fairly strong to drive profit growth higher. We remain cautious that price cuts will be enough to turn around sales, particularly in larger stores that have been under pressure. Our base case assumes Tesco's sales grow at a mere 3% annually, but that the firm is able to maintain a trading margin near 5%. If Tesco's margin falls below 5% but sales growth accelerates above our base case expectation our return on invested capital and cash flow projections should still be reasonable.
Even though management's updated strategy isn't a direct reflection of investor proposals, some of the underlying tenets have a common theme. Most notably, Tesco has already begun lowering prices by reallocating promotional spending to everyday low prices. The company believes that there is too much promotional activity in the U.K. that isn't resonating. Going forward, Tesco wants to be more strategic in its promotions while making its price competitiveness very clear through every day low price products. We think this may be Tesco's attempt extend the positive perception of Price Promise (price matching for the major grocers). Although justifiable, this strategic shift still has its risks, as it leaves open the potential for miscommunication and customer disappointment.
Tesco also lowered its capital expenditure plans by about £500 million, and now expects £2.5 billion in annual capital expenditures over the near to medium term. We think these reductions make sense, as we think the U.K. grocery market is relatively saturated and multichannel shopping is of growing importance. In addition, a good proportion of Tesco's capital expenditure will go toward refreshing stores. The company has refreshed about one third of its U.K. stores over the past few years, and intends to focus on refreshing Tesco Express convenience stores in the coming fiscal year. Over the longer term, we think Tesco's refresh capital expenditure will moderate in the U.K., but the company could begin to refresh stores in international markets at that point.
