Tesco's UK Sales Continue to Slump

Full-year results show like-for-like sales continue to slump in the UK, although the trading margin is still clinging on above 5%

Ken Perkins 16 April, 2014 | 3:58PM
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Tesco (TSCO) reported full-year results Wednesday morning that were slightly below our expectations, as increased competition in the second half of the year weighed on sales growth and gross margin.

The UK grocery market is very competitive, as limited switching costs make it difficult for firms with competitive cost structures to garner a sustainable competitive advantage over one another. While we think Tesco's size allows the firm to operate very efficiently and may offer some marginal scale advantages, we do not see clear evidence that Tesco's advantages are large enough to offset challenging industry economics. We are maintaining our no-moat rating, which reflects our belief that Tesco does not boast a sustainable competitive advantage over peers. We intend to update our financial model to reflect recent results, but we do not expect a material change to our 380p-a-share fair value estimate.

Our 4-star rating indicates the shares remain undervalued relative to our fair value estimate, which assumes that Tesco can generate 3% annual sales growth and sustain a 5% trading margin over the next decade. From a margin perspective, today’s results support our view; group trading profit margin stood at nearly 5.2%, although this was down 30 basis points from 5.5% last year.

Not surprisingly, Tesco's UK trading margin contracted about 20 basis points to 5% in the face of heavy promotions. Many in the investment community have argued that the value proposition of many of Tesco’s products is not competitive with the discounters such as Aldi and Lidl, and that the company will need to lower prices and cut its UK margin. We've maintained that Tesco could lower the UK margin, but margin-eroding price investments would be less pronounced than in the past (when Tesco cut its margin target to 5% from 6%). However, if Tesco's UK like-for-like sales consistently decline (down 1.3% excluding fuel in today’s results) due to lower traffic or transactions (rather than due to price and product mix), the firm may need to invest even more in pricing, which could prolong what already looks to be another price war.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Tesco PLC259.86 GBX-0.17Rating

About Author

Ken Perkins  is a Morningstar equity analyst covering consumer packaged goods firms.