Tesco (TSCO) reported first-half results that were slightly ahead of expectations on the top line, but negative expense leverage was greater than we expected and Tesco’s new management team offered few details about its turnaround strategy, outlook for the dividend, or commitment to an investment-grade credit rating during its conference call. As a result of lower near-term profit margins, we may lower our £2.70 fair value estimate modestly, but we still think that Tesco’s shares are undervalued.
The current market price implies that Tesco’s sales will be roughly flat over the next decade and that its group trading margin will average around 3%; we believe that there is a material nonzero probability that this scenario plays out, but also that the market pricing this scenario into the stock leaves room for upside. If like-for-like sales growth trends stabilise or improve, which we think will occur as market conditions normalize, Tesco should be able to leverage this growth.
That said, we recommend Tesco shares only to investors with a high tolerance for risk, because even a successful turnaround could take several years, and future dividend cuts could occur, justifying investors' low expectations for this no-moat grocer. Tesco still commands a massive 28% market share in the United Kingdom, more than 10 percentage points higher than its next largest competitor, but the company faces an uphill battle to change its image.
Consumers continue to migrate to no-frills discounters, because they believe that these banners offer good value for the prices they charge. Tesco’s large hypermarket stores, which are built on volume, have been disproportionately affected by these trends, leaving Tesco in a difficult spot even though its online sales continue to grow by double digits and its convenience store like-for-like sales were up a little less than 1%.
These trends were evident in Tesco’s results, as Tesco’s U.K. like-for-like sales declined 4.6% excluding petrol. Tesco management believes that its sales declined in line with the overall market, although the firm lost market share to the discounters Aldi and Lidl. The market as a whole is in a deflationary period, a trend that we’ve expected to occur given that food inflation has outpaced wage growth and square footage growth has outpaced population growth over the past few years; we think these factors have made competition unusually intense, and we think that competitive pressures may ease slightly once these discrepancies normalize. U.K. trading margin fell to about 2%, largely because of the drop in sales and modestly higher costs; pricing had little to do with the decline in trading profit, and we think the firm can sustain a U.K. trading margin about 3% over the long term if it drives positive sales growth.
On the international front, Tesco continued to face challenges as well. Asia segment LFL sales declined 4.1%, while Europe segment LFL sales declined 1.8%. Pressures in the Europe segment were driven by weak performance in Ireland, where discounters are also challenging Tesco’s business, and trading margin declined to about 1.8%. Asia has been hurt by difficult market conditions, as political unrest in Thailand, protests against Western businesses in Malaysia, and legally enforced Sunday closures in Korea have affected results. That said, Tesco’s Trading margin in Asia came in at about 5.4%, and we think the company should be able to maintain this margin as it builds its scale in the region.
Tesco did provide more details about accounting statements that were announced earlier in the month. After conducting an investigation, the company estimates that historical profits were misstated £263 million; £118 million related to first-half profits and £145 million related to periods before fiscal 2014/15. At this point, the investigation conducted by Deloitte is complete, although we may consider changing our stewardship rating if questionable accounting practices continue under the new management team’s tenure.
