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Tesco continues to struggle

Today Tesco issued a profit warning, where the company slashed its full year 2014 EBIT outlook. Due to the challenging operating environment and continuing OPEX investments in UK, Tesco´s EBIT will be 2.4-2.5 billion pounds, while the consensus was expecting EBIT of 3 billion pounds. Tesco also slashed its dividend by 75 % as the new management wants more financial flexibility to finish the turnaround program. Even though Tesco´s development has been disappointing, we still see clear value in the company´s different parts and believe that the new CEO is the right man to bring out this value.

Tesco´s new CEO Dave Lewis will start his job on Monday. We would not be surprised if Tesco would announce more writedowns during the H214 as he continues to go through the company´s operations. We take a positive stance towards the new CEO as his track-record from Unilever is impressive. Even though he does not have a previous experience from retail, we put more weight on his management abilities that Tesco is currently lacking.

Tesco´s problems can be dividend in two; home and abroad. In home (UK) Tesco has been struggling with sliding market share and competitive pressure from discounters (Aldi & Lidl). In order to defend its market share, Tesco has been slashing prices and increased OPEX to lure more shoppers. This has reflected negatively on company´s margins and the trading profit in the UK has come down notably. We believe that Tesco is currently roughly half way in its turnaround in UK; many of the actions Tesco has taken will yield results with a lag. Due to the massive scale advantages of the company, we are confident that the new management will be able to complete the turnaround process and end the slide in the market share.

Other problem has been operations abroad, where Tesco has been struggling in various markets. During the past year or so Tesco has been tackling these problems aggressively and it has divested its businesses in USA and Japan as well as merged its business in China with a China´s largest retailer. We still expect Tesco to exit its business in Turkey during FY14. After the exit in Turkey, the table should be clear and Tesco can start to focus to grow in its profitable markets (Thailand, Korea, Malaysia, Ireland etc).

Tesco´s share price has nosedived after we initially purchased the share and it has been one of our worst investments. Although we are disappointed, we still have faith in the company and especially in the new management. The current valuation has been pushed to an extremely low level and with a cautious market estimates the P/E ratio for upcoming years is around 10x. It is worth to notice that company´s true earnings power is clearly greater than what the consensus is currently forecasting. If the turnaround is successful there should be notable earnings leverage. We are currently considering to increase our position in Tesco as we see its risk/reward ratio of the share attractive.

We own shares in Tesco.


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