Tesco is still not at rock bottom
Britain's biggest retailer has warned on profits again, but is this "year zero" for Dave Lewis and his plan for Tesco?
5:32PM GMT 09 Dec 2014
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After Tesco issued its fourth profit warning of 2014, shares in Britain’s biggest retailer slumped to their lowest price in the 21st century and credit default swaps, which measure the chances of a company going bust, hit their highest since the collapse of Lehman Brothers in 2008.
A return to the levels of 2008 is revealing, because the scale of the problems facing Tesco has increasing echoes with the turmoil that engulfed the banks at the peak of the financial crisis.
Dave Lewis, who has just completed his first 100 days in charge of Tesco, tried to present the latest profit warning as a “year zero” for him and the retailer.
Lewis has effectively rebased the company by applying his own standards and strategy. This includes price cuts, more staff on the shop floor, new relationships with suppliers, and the end of measures to “artificially” boost profits at the end of a financial period, which one analyst described as “diving for the line”.
The Tesco boss believes this plan – which is costing £500m – puts the grocer in a stronger position to compete over the long-term.
According to some industry sources, it represents a back to basics approach for Tesco. In the same way that banks shifted from a reliance on controversial new financial instruments, such as credit default swaps, after the crisis of 2008, Tesco wants to focus on just selling food again. Rather than relying on clever deals with suppliers to make money – a tactic which ultimately led to a £263m accounting scandal – Lewis wants the supermarket group to focus on generating profits from what it sells to shoppers.
“Whilst the steps we are taking to achieve this are impacting short-term profitability, they are essential to restoring the health of our business,” the Tesco boss said. “We will not engage in short term actions that compromise in any way our offer for customers.”
However, the short-term impact of Lewis’ plan has rattled the City, who were already braced for bad news.
Clive Black, analyst at Shore Capital, said the new profit warning suggests that Tesco will now lose £182m in the UK for the six months between the start of September and the end of February. As a result, the company is unlikely to pay any more dividends for at least the next 18 months.
Black said: “You have to be less positive with the profit base eroding ever lower. Whilst so, I think Lewis is doing the right things. The question is just how much damage has been done to Tesco.”
He added: “We expect the profits warning, and the implication for 2016 and beyond, to further heighten speculation around the need for disposal activity and the potential for a rescue rights issue to shore up Tesco’ balance sheet.”
There could be worse news to come too. For all Lewis’s plans, Tesco remains hamstrung by the fact that it has too many supermarkets in the wrong place and the wrong size.
There have been a string of warnings recently from Mark Price, the boss of Waitrose, Sir Ian Cheshire, the outgoing boss of Kingfisher, and analysts at Goldman Sachs that supermarket retailers need to close stores and that this will be a painful process. Sir Ian warned in an interview over the weekend that it has taken a decade for B&Q to manage its over-built estate, and that it still has an average of eight years to run on its leases.
As such, there is no easy answer to Tesco’s problems. To undo this problem will take years of effort and cost billions of pounds in writedowns. That is why Tesco’s annual results in April could end up being the nadir, in financial terms at least, of its woes. Lewis and Alan Stewart, the finance director, are likely to try to kitchen-sink the results and take a brutal approach to valuing Tesco’s portfolio of property.
Last month, Sainsbury’s reported a £290m loss on the back of writedowns on its property. However, Tesco’s losses could be worse, which is worrying news for a company lumbered with £7.5bn of net debt, a pension deficit of £3.4bn and lease liabilities of more than £11bn.
With such a backdrop, Dave McCarthy, analyst at HSBC, warned that Lewis had to deliver an improvement in sales quickly.
“There will be bumps in the road, but we remain of the view that Tesco is on the right road and that focusing on the long-term needs of customers is the best way to serve long-term shareholders’ interests,” he said.
“Having said that, Tesco needs to start delivering meaningful improvements in sales sooner rather than later, or else it will have sacrificed its margin for no gain and its long-term spiral down will continue. The next few months will be very telling.”
The sense that Lewis and Tesco are walking on a tightrope was exacerbated by analysts at Espirito Santo. They compared the company’s situation to that of Sears, which was once the biggest department store chain in the US but fell into decline and eventually merged with discounter retailer Kmart in 2004.
“Tesco reminds us of the Sears situation in 2004,” Rickin Thakrar at Espirito Santo said. “We think the best case scenario for Tesco is private equity or retail interest, which could prove optimistic given Tesco’s high leverage and dwindling freehold. We think the Sears example provides a stark reminder that big companies can potentially fail despite their size.
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