Shares of no-moat Tesco (TSCO) dropped by more than 7% after the company announced that group trading profit would not exceed £1.4 billion in fiscal 2014/15 yesterday, a level that is in line with Morningstar’s conservative forecast but well below consensus estimates. We may lower our near-term forecasts slightly and our £2.70 fair value estimate modestly, as we don’t see enough evidence to believe that sales growth will accelerate enough for Tesco to leverage expenses and drive trading margin back to a 4% level over the near to medium term.
This compares to 5% in fiscal 2014 and our expectation for a roughly 2% margin this year. However, given that our base-case assumptions remain relatively conservative – 2% annual revenue growth and 3.5% average trading margins over the next decade, we still believe that shares are undervalued.
We think that Tesco shareholders could realise upside once industry trends normalise, but enduring dismal business and investment performance, before market conditions stabilise, may be necessary over the near to medium term. Tesco is trying to reinvent itself amid difficult industry conditions and fierce competition, but Tesco’s size limits its near-term options.
The firm has more exposure to large hypermarket formats, and consumers are shifting away from these formats. This leaves Tesco in a difficult spot, as marginally less-productive hypermarket space can result in material operating deleverage.
Overall, we are maintaining a high uncertainty rating for Tesco, as it is very difficult to predict normal hypermarket traffic levels, which drive like-for-like sales, which is a key driver of format operating profit. That said, we continue to think that Tesco will remain a viable competitor in the U.K. market. The company has a well-established omnichannel business and a robust customer loyalty program, which help it to drive enough volume through its system to generate healthy long-term cash flows.
