No-moat Tesco (TSCO) reported a £1.4 billion trading profit in fiscal 2014/15, but nearly £7 billion in one-time charges weighed on reported results. Most of the £7 billion in charges was driven by noncash impairments of property and joint ventures.
Investors should only consider Tesco if they have a high tolerance for risk
The group’s trading profit was in line with our expectation and management’s previous guidance, although it looks as though achieving £1.4 billion in trading profit in 2015/16 could be a challenge.
We had expected Tesco’s sales momentum to continue into next year, and also anticipated that positive like-for-like sales growth could drive profit growth.
With this outlook appearing too rosy for a base case, we may lower our £2.70 fair value estimate modestly.
We do believe that Tesco can drive profit growth once market trends normalise, but it’s highly uncertain when that might occur, and as such, we think that investors should consider investing in Tesco only if they have a long time horizon and a high tolerance for risk.
The most encouraging aspect of Tesco’s results was the fact that fourth-quarter like-for-like sales trends improved in the United Kingdom. Traffic and volume increases suggest that consumers are making more trips and buying more at Tesco, which we view positively given that the company has cut prices to better compete against discounters.
However, with deflationary pressures affecting the market, Tesco’s additional price investments, and numerous changes being implemented at Tesco simultaneously, we remain cautious about the near-term outlook for like-for-like sales growth.
Tesco cut its capital expenditures budget in half to about £1 billion, as the firm doesn’t expect to add material square footage this year. Capital expenditures could run below deprecation for the next few years, but we don’t think that these capital expenditure levels are sustainable, and we think that they will tick higher over the medium term.
Tesco now estimates that its property is worth £23 billion, which is considerably lower than the £34.1 billion estimate at the end of last year. We’ve advised, and continue advising, against using Tesco’s property value as an estimate for a floor for the firm’s valuation, as the firm is overexposed to the hypermarket format, which could very well be in secular decline in the U.K.
The firm also intends to contribute £270 million per year to make up for a pension deficit of nearly £3.9 billion, which increased by £1.2 billion after the company reviewed its actuarial assumptions and lowered the discount rate it uses to value these liabilities. All else equal, this change could represent a 3% detraction from our fair value. With the firm intent on reinvesting in the business and bolstering its balance sheet, we believe that Tesco’s dividend will remain below historical levels for quite some time.
