Why Analysts Downgraded Tesco

After disappointing financial results, and a misreporting of company profits, supermarket giant Tesco has lost its advantage over its retailer peers and seen the share price plummet

Ken Perkins 6 October, 2014 | 1:04PM
Facebook Twitter LinkedIn

We are lowering our fair value estimate for Tesco (TSCO) to £2.70 per share from £3 to reflect lower short- and medium-term sales growth due to competitive price matching in the U.K. Our updated fair value estimate implies a forward price/earnings of 13 times, enterprise value/earnings before tax of 12 times, and a free cash flow yield of 10%.

The biggest driver of our fair value estimate is our assumption that Tesco can generate low-single-digit like-for-like sales growth and sustain a trading margin just under 4.5% over the longer term. In the recent past, Tesco has struggled to grow both sales and maintain its margin; U.K. like for like sales have declined in each of the past two years, and trading margins have contracted from 6% to less than 5%. While we've been concerned about the impact of increasing competition on Tesco's margins, the impact of competition on margins has been greater and faster than we originally expected.

We now forecast Tesco’s like-for-like sales to decrease by a mid-single-digit percentage this year and a low-single-digit percentage next year due to price investments and declining traffic and volumes. However, we think significantly lower prices should help to spur volume growth over a two-year plus time horizon; like-for-like sales growth should then trend in the right direction. Overall, we expect growth will return to a low-single-digit rate, essentially due to population growth and modest increase in average ticket, over the long term. We also expect Tesco to increase its total square footage by a low- to mid-single-digit percentage annually over the next 10 years, with a majority of the growth driven by store expansion in Europe and Asia. These assumptions drive our 2.5% annual revenue growth forecast for the company as a whole.

We also estimate that trading profit margin falls to around 4% this year due to operating deleverage on negative like-for-like sales growth. However, we think Tesco should be able to leverage future growth to bring trading margin to a low to mid-4% range; we believe Aldi’s U.K. trading profit margin is around 4.5%, a level that we think Tesco could sustain with a more competitive price architecture over the long term. Significantly lower prices should help to spur volume growth over a two-year-plus time horizon, which should begin to drive like-for-like sales growth and margins in the right direction.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Facebook Twitter LinkedIn

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Tesco PLC350.80 GBX0.63Rating

About Author

Ken Perkins  is a Morningstar equity analyst covering consumer packaged goods firms.

© Copyright 2024 Morningstar, Inc. All rights reserved.

Terms of Use        Privacy Policy        Modern Slavery Statement        Cookie Settings        Disclosures