EUR 850.00 For Business Accounts Only

Morningstar | Mixed Results for Tesco in First Half With Asia Weakness Weighing on Margins; Shares Fairly Valued

No-moat Tesco reported half-year results with group like-for-like sales up 2.2%, in line with our expectations, but EBIT disappointed due to continued weakness in Asia. Management reiterated guidance on synergies and margin targets and announced a dividend of GBX 1.67 per share (67% up). We intend to lower our fiscal 2019 operating margin forecast for the Asia segment and hike our Booker top-line forecasts, as the business benefits from access to Tesco's buying capabilities. As such, we don’t expect a material change to our fair value estimate. Shares are fairly valued.

From its high of GBX 266 on Aug. 6, Tesco's share price has declined more than 20%, including today's 9% drop, erasing its sector-beating year-to-date return. At the time of writing, the stock is trading at GBX 214, 7% lower than our GBX 230 fair value estimate. Although we see valid reasons for the market's reaction today, weakness is coming from noncore areas of the business, which in our view are fixable in the medium term.

More specifically, LFL sales in Asia and Central Europe declined 7% and 1.5%, respectively. EBIT in Asia declined almost 30% in the first half despite sales being in line, which Tesco attributed to price cuts, volume deleverage, and continuous negotiations with suppliers on promotions. Management expects this to continue into the second half but made it clear on the call that this is not a permanent rebase of margins in the region, though they didn't provide more clarity on timing.

On the positive side, we were satisfied with Tesco's core business in the U.K. and Ireland, which increased LFL sales at a healthy rate (2.5% and 3.1%) and delivered cost savings as expected. We think Tesco is the best-positioned Big Four grocer in the U.K., given its channel exposure and strategic decision to grow in the dynamic wholesale market through its Booker acquisition. The latter continues to grow rapidly, with new contract wins propelling top-line growth in the first half (14.7% LFL).

Tesco also recently introduced its new discount store format, Jack's, with two stores being already operational and a target of 10-15 total stores to be opened by next year. Overall capital spending is around GBP 20 million-GBP 25 million, and performance will be the key driver of any future expansion plans. Although the new banner will imitate all aspects of the typical hard-discounter format (70% private-label, shops smaller than 1,400 square metres, shelf-ready packaging, no-frills stores, lean staff structures), Tesco has stated that a key differentiating aspect of Jack's offering is that 80% of food and drink products in the store are produced in Britain.

Time will tell whether this new experiment deployed by yet another U.K. grocer (after a failed attempt from J Sainsbury back in 2014, with the introduction of Netto) to combat discounters (Aldi, Lidl) will succeed, but we think that investors should restrain themselves from reading too much into this for several reasons: 1) Aldi and Lidl are actively looking to source more British produce, with fresh meat, eggs, milk, and butter already being supplied by British producers; 2) the new banner would require considerable capital investments if it is to have a meaningful impact--capital-light expansion is not likely, in our opinion, as it is still unclear what impact the utilization of excess space in Tesco's hypermarkets and supermarkets (concessions, attached shops) will have on Tesco's core business; and 3) Tesco's management already have a lot on their plates, with the Booker integration and execution of fiscal 2020 targets being the most important, and we doubt that an operationally more complex company such as Tesco would be able to compete effectively against hard discounters merely by imitating their business models.

On the contrary, we believe that Tesco's core strengths are sourced from its scale on food, which can leverage through its recently acquired Booker business into the high-growth and less competitive wholesale market (caterers and wholesale convenience). Booker's double-digit top-line growth since the integration is evidence of that potential, and we view this direction as the only way for Tesco to grow profitably in the U.K. and stand out from the pack.