Supermarket sweep: where did Tesco go wrong

5 October 2017

Supermarket sweep: where did Tesco go wrong

Tesco recently posted a strong set of half year (H1) results with a 2.2% rise in like- for- like sales and a 27% increase in underlying profits. 

Tesco recently posted a strong set of half year (H1) results with a 2.2% rise in like- for- like sales and a 27% increase in underlying profits. 

Dave Lewis, the Chief Executive, should be commended for his successful turnaround of Tesco from the dark days of the £250m accounting black hole to first half profits of £562 m.

However, the market did not reward this strong operational performance. Even the welcome return of a dividend payment, after a three year hiatus, was not enough to stop Tesco’s share price declining by 3.2% on the back of their H1 results announcement. So why did Tesco’s stellar results not translate into increased shareholder value?

Supermarket giants 

Intense competition in the UK food retail market can be cited as a main factor in the negative outlook for the sector. The advance of the discounters Aldi and Lidl has been extremely significant and it could be argued that they have fundamentally changed the market place. The threat of further competition from online players, such as Amazon, is also on the horizon. In food retail market, market share is gained when operational performance of one of the big 4 (Tesco, Asda, Sainsburys, Morrison) is weak. With all big 4 retailers and the discounters currently doing well operationally, outperformance by any key player will be hard to maintain. In short, Tesco’s recent results are probably about as good as it gets operationally.

H1 sales figures 

Another reason for the adverse market reaction to Tesco’s results are its H1 sales figures.On the face of it 2.2% like for like (L4L) sales growth looks good. However, in the past year this measure has been flattered by nearly 3% inflation. Given current inflation rates, a 2.2% L4L growth rate could mean that sales volume comparatives are actually negative. If you dig deeper into Tesco’s H1 L4L sales growth, it declined by 10 basis points to 2.1% in Q2, which analysts cite as concerning.

Brexit and the living wage

In addition to intense competition and slowing revenue growth, food retailers have had to deal with higher import costs arising from a weak sterling post the Brexit referendum. There is also the living wage increase to absorb. To counteract these cost increases, expenditure has been cut in other areas, with Tescos for example having recently completed a brutal head office and call centre restructuring programme.

The balance sheet

The final area of concern is the balance sheet.You could argue that Dave Lewis has chosen to promote operational performance over balance sheet management. In February 2017 Tesco had a pension fund deficit of £5.5bn, which was approximately a third of their market capitalisation. The deficit has since decreased to £2.4bn, due to some changes in measurement assumptions, but this is a real issue that needs to be addressed.

Future performance

All of the above help to explain the market’s adverse reaction to Tesco’s results but let’s not forget there are some upsides. Tesco’s deal with Booker, which is awaiting final regulatory approval, was inspired and will give more operational momentum. Sainsbury’s acquisition of Argos has been successful and has delivered synergies beyond expectations. If as argued above enhanced operational performance will be hard to achieve going forward, value creation may come from other areas, especially mergers and acquisitions activity. The discounters may be viewed as disruptors in the market but they have enabled a change in landscape which means that deals previously off the table for the big 4 are now possible.