Questor share tip: Tesco dodges profit warning

Sell shares as sales fall in all markets and management stick to strategy, says Questor

Tesco
340p-1½
Questor says SELL

THERE was plenty of back-pedalling in the City yesterday as Tesco reported yet another decline in sales but avoided the ignominy of a profit warning. Investors may be left scratching their heads as to quite how this is possible, but on closer inspection it has more to do with the theatrical arts than financial reporting.

Enter stage left, the house brokers. Deutsche Bank and Barclays churn out the regular and detailed analysis for Tesco, which includes sales and earnings forecasts for the future. One of the key valuation points for a share price is the future underlying earnings. Last Monday, Deutsche Bank issued a preview of Tesco’s numbers in which its analysts cut forecast earnings by 3pc and claimed the deterioration in trading across all markets was “unlikely to surprise the market”.

Well, the market was surprised. Tesco shares were down 2pc the next day when the markets opened. Enter stage right, Barclays. On Tuesday, its scribblers repeated the mood music by cutting earnings forecasts for the next two years by 3pc. The stage was well and truly set.

Yesterday it was Tesco’s turn to make its entrance on to the stage, unveiling sales down 1.5pc. Surely this would be met with uproar in the cheap seats? Well, no actually. Any disquiet was drowned out by claims from brokers that results were “in line with expectations” or “ahead of expectations”. Well, this is all true but only because they had all been so resoundingly low-balled the week before.

One could argue this whole episode has been a triumph of carefully lowering the market’s expectations without causing a panic, which to some extent is true. But where does it leave long-term investors in Tesco who, if they took yesterday’s update at face value, believe everything is on track?

Tesco is still the biggest supermarket in the sector, with a 29pc market share – almost twice that of closest rival Asda on 17pc – and that dominance gives it pricing power. The company is also top dog when it comes to profit margins, at 5.2pc – ahead of Morrisons on 4.8pc and Sainsbury’s on 3.2pc. Combined, this means that Tesco still has the option of lowering prices to fight back and halt its market-share declines.

So far, it has chosen not to do this. Questor thinks Tesco’s management is wedded to defending its margin as a strategy. Phil Clarke, chief executive, said this wasn’t true and that the group was happy with margins in the region of 4.8pc to 5.5pc. But the group has just reinvested in its range of upmarket foods and bought restaurant chain Giraffe so it can put them in its stores to entice shoppers. This doesn’t look like a company about to embark on a price war to regain market share.

Tesco has been a solid dividend stock. At the interim stage, the dividend was held and now offers a forecast yield of 4.3pc. However, the dividend has been held for the past two years, and that equates to a decline of about 3pc a year in real terms. With profits falling, the forecast dividend cover is also reduced, which decreases the chance of a meaningful return to growth.

Finally, the overseas growth is proving very painful. The company has exited the US and reorganised China, but sales fell in every one of the overseas regions in the third quarter. In Asia – a region supposed to be the great growth market – sales declines are accelerating. The only glimmer of hope was in Europe, where sales are still falling but at a slower rate than before.

Tesco is a retail giant with a dominant market position, giving it options to fight back. But, in the medium term, Questor has concerns that management seem myopically focused on margin and distracted by restaurant chains and coffee shops. In the short term, it seems likely that earnings forecasts will continue to be under pressure.

Since Questor said sell, the shares have fallen 5pc against the FTSE 100, which has risen 1pc, so there was little in yesterday’s update to change that recommendation, despite the play acting. Sell.

Watch Questor Editor John Ficenec discuss shares to profit from the Santa Claus share rally in December: