What Tesco’s faltering turnaround means for the shares

Just a few short years ago, Tesco (TSCO) was the golden boy of British retailing.

It seemed completely secure in its dominance of the UK market. Having moved beyond food retail, it was sucking business from almost every part of the high street, from book sales to cheap laptops.

It had big plans for going on to conquer the US. It wouldn’t be easy, but if anyone could do it, Tesco could.

Investors grew used to the company beating the market’s expectations with almost every set of results it released.

The fact that all of this seems like ancient history now, shows just how far Tesco’s star has fallen. Yesterday, the company reported its first fall in profits since 1994.

Is there any sign of a return to the glory days?

Throwing money at the UK is not working


It’ll take longer than six months to see if Tesco’s turnaround plan for its UK business is working. But the initial signs are not good.

Tesco is going to spend £1 billion on freshening up its stores, putting more staff in them, changing its product ranges and cutting prices. So far this has kept sales from existing stores (like-for-like sales) where they were a year ago. But it has cost Tesco a lot of money – UK profits are down 12.4%.

Tesco is trying to fight a lot of problems at the same time. It has lost the goodwill of many customers in the face of fierce competition from its rivals. These customers may never return.

But the deeper problem is that food retail in the UK is a dire market to be in just now. There are too many supermarkets chasing too little money.

Take Sainsbury’s as another example. It’s throwing everything it has at customers in terms of quality and price, and it is still only growing its same store sales by less than inflation.

Tesco’s business model was set up for a different age: an age of easy credit that allowed it and its customers to borrow big and spend big. Those days have gone.

Tesco is now left with lots of big hypermarkets that were meant to sell electrical and other non-food items that people are now either cutting back on or buying over the internet. Trying to get these big, out of town stores to pay their way could be very difficult, and act as a drag on profits for years to come.

And Tesco’s international business is now struggling

Tesco bulls have always pointed to the growth potential in its international business. Yet just when Tesco needed this business to be firing on all cylinders, it is now facing tough times.

Tesco’s businesses in Malaysia, Thailand, Slovakia and Poland are doing relatively well, although underlying sales growth is still very modest. But life everywhere else has become a lot more difficult.

European profits fell by over a quarter as cash-strapped consumers in weak economies struggle to make ends meet. VAT rises in the Czech Republic have made matters worse, while sales of general merchandise are a lot lower than a year ago. Tesco’s exposure to austerity-ridden Central Europe is a big problem that will probably get worse before it gets better.

Asian profits, meanwhile, are stagnant. Korea – Tesco’s core Asian market – has been hit by legislation which requires big supermarkets to be closed on two Sundays every month. With Sundays usually accounting for 20% of total sales, this new law looks set to cost Tesco around £100m in lost profits this year.

The market in China is suffering from excess capacity as too many supermarkets have been built. Investing more money there does not look sensible.

Then we get to Tesco’s disastrous American adventure, Fresh & Easy. This business lost £72m during the last six months which represents virtually no progress on the losses made a year ago. We doubt whether this business will ever make money. It’s proved to be a very expensive mistake on Tesco’s part, and one they should end as quickly as possible.

Tesco’s finances need to be closely watched

There’s more to Tesco’s finances than meets the eye. While trading profits fell by 10.5%, net trading cash flow fell by nearly 40% as Tesco pumped more cash into its pension scheme and had a harder time squeezing its suppliers.

But what’s more disturbing is the large amounts of hidden debt, which we’ve talked about before. In short, Tesco tells you that it has £7.2bn of net debt (debt less cash), yet it keeps selling supermarkets and renting them back (known in the trade as ‘sale and leaseback’).

A decade ago, Tesco owned virtually all of its stores. Now its has to make minimum future rent payments on stores that it has sold – that are not on its balance sheet – of £17.3bn. So Tesco’s finances are a lot less healthy than most people think.

We’re not saying for a minute that Tesco is in danger of going bust. But if you are expecting rapid dividend increases – or indeed any dividend increases at all – then yesterday was a wake up call.

Management decided to maintain the existing dividend payout. Despite being well covered by profits, you need cash to pay dividends. If profits and cash flow continue to fall then what was once seen as unthinkable may come to pass – a Tesco dividend cut.

Given the size of its problems, it was always going to take a long time to turn Tesco around. But its latest results show no real sign of significant improvement on this front at all. And with markets generally tough both in the UK and overseas, it’s hard to see where any pick-up is going to come from.

So what should you do if you hold the shares? Well, it’s not unreasonable to give the management team some time to sort things out. It’s increasingly clear that they need to do something. If Tesco were to announce it was getting out of America then the shares would probably bounce on the news.

And what if you don’t own them? Assuming an unchanged dividend, the shares yield 4.5% at the current share price of 326p. If trading doesn’t pick up soon, there’s no reason why the shares couldn’t fall further, to yield 5% or 5.5% on a lower share price. If the shares were 50p lower, we might be tempted to buy a few. Since they are not, we see no reason to buy now.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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20 Responses

  1. 04/10/2012, terry wrote

    Tesco needs to take into account the public’s memory,I speak to lots of people every week,they don’t shop there ,mostly for one reason,surprisingly,What Tesco did to them/friends,by holding up payments until small companys went bust,or breaking legally binding agreements for short term gains or calling suppliers the night before and cutting the agreed price. That’s why I stopped using them.

  2. 04/10/2012, Nick Fury wrote

    They also reneged on their 4 X Tesco Clubcard points deal, which was a shambles last year as they changed it to 3 X and they have now since restored it to 4 X again, but in the meantime lost many customers. In general they lost respect for their customers and many left to shop at cheaper supermarkets…in a similar way to Lloyds bank did a few years ago and they still have’t recovered those disullusioned customers back, who they felt they didn’t need their deposits due to all the free investment banking money…which has run dry now. They all deserve what’s happening to them now; no customer care or respect, uncompetitive in all of their products, they should really have been left to go under, as per financial ‘natural selection’.

  3. 04/10/2012, anam biskut bokul wrote

    asda all the way BRAP BRAP

  4. 04/10/2012, Adnan wrote

    As an investor I would rather avoid Tesco shares. For the past 12 years Tesco share price ‘ hardly ‘ moved when compared to some companies such as Tullow Oil or Dragon Oil. One needs not talk much but facts and figures speak out what every investor has in mind when come to investment for long term. Thanks

  5. 04/10/2012, Tim W wrote

    An illuminating overview of the current state of Tesco, thanks.

    Not sure about this though: “With Sundays usually accounting for 20% of total sales, this new law looks set to cost Tesco around £100m in lost profits this year.” People still eat food even when the shops are closed, the loss of sales on Sunday will be taken up elsewhere. Yes, potentially at smaller retailers that are allowed to be open on Sundays or maybe people will do the weekly shop on Saturday instead…

    Just be careful with use of statistics like this.

  6. 04/10/2012, Julian R wrote

    When a European company decides it is time to conquer the US, it is usually time to sell its shares: Marks and Spencer, Midland Bank, Daimler-Benz, Tesco… Always the same story, always a company riding high, a board whose egos have got too large

  7. 04/10/2012, jr 1987 wrote

    i hate tesco, i know so many suppliers who have been pushed to the brink of bankruptcy and beyond by there non fair deal making

  8. 04/10/2012, jrj90620 wrote

    I live in the geographic center of So California.I can’t speak about what Tesco is doing elsewhere but can tell you that their Fresh & Easy chain wasn’t well thought out.They opened 2 stores in my area.Lucky me.One just closed last month.Tesco obviously didn’t do their homework.This area is becoming hispanic/asian immigrant dominated and Fresh & Easy doesn’t appeal to these people.Many other “white peoples” chains have closed stores here,while hispanic and asian markets have grown.I expect our other Fresh & Easy location to close,also.

  9. 04/10/2012, Roger wrote

    Let business be business, I stoped shopping at TESCO simply because its price/quality ratio is not good. I think Sainsburys and ASDA are doing OK right now. If price is dearer, quality must go up, and vice versa.

  10. 05/10/2012, Mike Gee. wrote

    I can’t seem to find Asda or the German supermarkets on our shares index? May be we should be supporting British instead of knocking them. This may help the country back on it’s feet and more money in our pockets.

  11. 05/10/2012, Dave wrote

    Curiously, having not shopped at Tesco for some years, preferring Waitrose, Morrisons and Sains for various reasons, I know feel tempted back to see if their offering has improved. Suspect their shares will remain unloved for some time, but their rating relative to the other grocers will return one day.

  12. 05/10/2012, Nick Fury wrote

    #Mike Well said, I agree we should all stick together as a nation, but as soon as all these PLC’s started outsourcing all products away from the UK as well as with telephone centres abroad etc, they caused the cash drain in the first place, now 25 years later we have no manufacturing, no money and no jobs, M&S tried to compete with UK only goods but failed, imports should be taxed to help UK manufacturers compete. But these multi nationals control the government and call the shots and they were only interested in the short term profit; now they (and us) are suffering, because of their short sightedness. By paying minimum wage who did they think is going to afford to buy their products. It may be too late to be patriotic, unfortunately.

  13. 05/10/2012, DrD wrote

    “A decade ago, Tesco owned virtually all of its stores. Now its has to make minimum future rent payments on stores that it has sold – that are not on its balance sheet – of £17.3bn. So Tesco’s finances are a lot less healthy than most people think.”

    Sorry I’m confused by this. Surely this paragraph is covered by the P/B ratio which is there for all to see, or the ‘assets per share’ which is about 160p. Or am I missing some higher point?

    Thank you.

  14. 05/10/2012, crazy tony wrote

    re: DrD. That bit confused me too. The only incoherent part of a good article.

    Dont see a problem with store size; its a great place to pick up cheap jeans or printer ink etc etc.

    Share price still falling… looks painful for holders. You may get your 50p fall; a few more sellers after it goes x-dividend next week. Looking forward; they cannot have two bad christmasses in a row?

  15. 07/10/2012, Phil Oakley wrote

    DrD and crazy tony,

    Tesco has sold some of its stores to property companies. It is still using them but has entered into long-term rental agreements with the new owners.

    It has agreed to pay £17.3 billion of future rent payments on these stores. These stores are not assets on its balance sheet but are a liability that Tesco has agreed to pay. This liability is not on Tesco’s balance sheet because the stores have been classified as “operating leases” in the accounts.

    Had Tesco bought these stores with a mortgage. The assets and liability would be on the balance sheet. Many in the accounting and finance profession argue that these future rent liabilities are just like debt and should be disclosed on the balance sheet. If Tesco did this, I estimate that its debt would be closer to £20 billion rather than £7 billion. Its profits would not change as the rent is expensed in its income statement.

  16. 08/10/2012, DrD wrote

    Thanks Phil, that’s clearer, so you’re basically saying this is a bit of an accounting fiddle and doesn’t get covered by the P/B ratio or ‘assets per share’.

    Here is another related question. Given that MoneyWeek expect property prices to go down. Is what Tescos position so bad? I mean the alternative (e.g. Sainsburys) of owning stores which are going to go down in value is not so clever either is it? Surely it’s better to have sold the stores on a high and then rent (or buy) them back?

  17. 08/10/2012, Aff wrote

    In days gone buy if you wanted some lunch you might drive to the nearest town centre and peruse various local cafes and eateries. Now more than likely there are none left, instead you head to the edge of town where these monstrous places like Tescos exist. You look at a crap choice of sandwiches and your will to live starts ebbing away. Whenever I’m at a huge Tesco store I feel sad and spiritually drained. Like the dinosaur these things have got too big and will become extinct.

  18. 10/10/2012, Jonasdad wrote

    Re 15 above the author is saying that future rent payments on stores should be treated as debt- this is not realistic. Why not therefore include other future costs as debts? Accounting standards have long recognised the basic principle of matching costs and revenue in the same accounting period so future rental payments are not current debt.

  19. 17/10/2012, desmond wrote

    personally , I find Tesco . Staff are excellent , and value is consistently good .I am optimistic that the money spent on upgrading the shopping experience will be reflected in future profitability .Desmond

  20. 19/11/2012, Bob wrote

    If the shares went below £3.00 I would buy in. Just saying. I would be happier at £2.75.

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