Questor share tip: Sell Tesco until it gets back to its roots

The old retail maxim of "pile it high, sell it cheap" has been lost in translation, investors should sell shares until the company returns to its roots, says Questor

Tesco
293.8p+7.5
Questor says SELL

WOULD now be a good time to buy shares in Tesco on the cheap and bank a healthy income of 5pc-plus? The nation’s biggest retailer is offering a dividend yield well ahead of the miserly rates on offer at the high street banks, and despite a drop in both sales and profits, the shares – up 4pc – were one of the leading risers in the FTSE 100. So has Tesco reached the bottom?

While it’s tempting to think so, Questor is not convinced. On closer examination the strategy doesn’t appear to have meaningfully altered course. There are very clear challenges facing Tesco in the form of competition from discounters and falling real incomes across the nation, yet management appear unable or unwilling to adapt to this new reality.

Alongside the annual results Philip Clarke, chief executive, said the grocer is responding to the challenging trading by focusing on providing the “most compelling offer for customers”. He went further and detailed the strategy as “sharper prices” and will invest £200m by cutting the price of items such as butter and peppers. The company will also “significantly” reduce investment in Europe, and focus on more profitable Asian markets. There will also be reductions on fuel prices through rewards points.

The £200m in price cuts doesn’t really sound like enough when compared to rival Morrison’s pledge to invest £1bn in lower grocery bills. There is always the concern that while Tesco says it is reducing the prices of onions, carrots and chicken by as much as 24pc, the company has so much data on our shopping habits it can retain its share of our weekly spend by adjusting prices elsewhere. Questor can’t be the only one who has noticed the ever rising weekly spend, whatever is in the basket.

This isn’t mere conjecture, it is supported by the resilience in Tesco’s profit margin. The UK trading profit margin reduced only by 0.18pc, to 5.03pc, during the year ended February 2014. Tesco retains one of the highest retail profit margins of the UK supermarkets, and well ahead of rival Sainsbury’s at 3.47pc.

The reduced investment in Europe is welcome, but Tesco could and should go so much further. The company has said total investment spend will be reduced from £2.7bn last year to not more than £2.5bn in the year ahead, a reduction of just 7pc.

Tesco can afford to make big price cuts as it is still profitable and highly cash generative. The company increased the amount of cash it makes from operations to £3.2bn, from £2.8bn a year earlier. The majority of that cash, or about £2.8bn last year, was spent on property investment and new technology. On Questor’s estimates Tesco needs to spend about £1bn a year to ensure the quality of the stores doesn’t decline, that frees up about £1.5bn for price reductions if it really wanted.

This is a maddening situation for shareholders. Tesco shares have now gone sideways for almost a decade, and since the start of 2012 they have fallen by 27pc while the FTSE 100 has risen 22pc. What’s more, the dividend has been held for the past three years, which means it is steadily being eroded by rampant inflation in real terms.

Declining real incomes are nothing new and have been a trend since 2008, and other retailers have fared much better than Tesco.

Jack Cohen, Tesco’s founder, had a simple strategy of “pile it high, sell it cheap”. The modern Tesco seems to be “spread it over a wide area, with a frappuccino and a croissant, and maybe a meal as well, and then offer 15pc discount on your next visit”. Tesco needs to get back to its roots.

Questor has been nothing if not consistent with its views on Tesco. When we first recommended selling the shares at 358p, on October 2 last year, it was classed as a contrarian view. When we repeated the warning on December 5 they had slipped to 340p, and we echoed those views a month ago with the shares down to 303.7p. As Questor has repeatedly said, there has been no fundamental change in strategy since last October. On that basis the recommendation remains unchanged. Sell.