Picture: BLOOMBERG/SIMON DAWSON
Picture: BLOOMBERG/SIMON DAWSON

For the best part of a decade good news from Tesco (once a firm favourite of many SA fund managers) has been in short supply.

Now things could be changing for the better for the £54bn annual sales UK food retail giant.

Tesco has been battered by falling market share, plunging margins and an accounting scandal. But it is again attracting the attention of some astute SA fund managers and analysts in their personal capacities.

Among them is Neville Chester of Coronation. “Tesco is way too cheap. It is a classic turnaround situation,” says Chester.

Says independent retail analyst Syd Vianello: “It is the reason I bought a few Tescos.”

Tesco is starting to live up to their expectations. It dropped a good-news bombshell on an unsuspecting market in late January, when it announced it had made a £3.9bn bid for Booker Group, the UK’s largest food wholesaler.

Marking Tesco’s first move into wholesaling, the proposed deal has the full backing of Booker’s board. The deal, masterminded by Tesco CEO Dave Lewis, has also received a thumbs-up from the market and Tesco’s share price was up almost 12% on the day it was announced.

Booker will bring with it annual sales of £5bn and a distribution network serving 503,000 customers — including independent convenience stores, grocers, leisure outlets, pubs and restaurants.

Booker reported a £155m operating profit in its year to March 2016.

“It makes sense for Tesco to be consolidating its market position in its own backyard,” says Chris Gilmour of Barclays Wealth & Investment Management. He is alluding to Tesco’s disastrous foreign forays, particularly into the US and China. Tesco exited the US in 2013, taking a £1.2bn asset write-down in the process. China was effectively exited the same year when Tesco exchanged its Chinese operation (plus £558m) for a 20% stake in China Resources’ food retail business.

The Booker deal is not without the risks one associates with a move into a new sector, says UK stockbroker Hargreaves Lansdown. But there are also some easy wins, with synergies in distribution and corporate costs, it adds.

Tesco has put some initial figures on the easy wins. They include annual pretax synergies of at least £200m within three years of the deal’s completion.

Financing of the deal, primarily through the issue of new Tesco ordinary shares, has also gone down well with the market, notes Hargreaves Lansdown. Only £770m is to be funded in cash to acquire Booker, which will bring with it £100m cash on its balance sheet and robust free cash flow (net operating cash flow less capex) of £150m/year.

With Booker, Tesco is signalling to the market its determination to move forward after a turbulent period during which pretax profit plunged from £2.8bn in its year to February 2012 to a £5.8bn loss three years later. It was also a period during which Tesco was rocked by a £263m accounting scandal which has led to three former senior executives being indicted on fraud charges.

Booker brings exposure to the fastest-growing segment of the UK food market and should provide Tesco with a useful growth kicker. In a market in which food prices have fallen by about 7% since September 2014, Booker bucked the trend, lifting sales 8.7% in the 24 months to September 2016. Operating profit lifted 19.5% over the period.

By contrast, Tesco has been going backwards for many years. In part it was a victim of its own success, its market share soaring to a dominant 32% a decade ago.

“Tesco reached a point where it could not gain more market share,” says Gilmour.

Tesco is an interesting offshore play which can be bought through an SA stockbroker using one’s offshore investment allowance

Tesco’s market share and those of other big-name UK food retailers fell victim to aggressive pricing by German discounters Aldi and Lidl, which have used tough economic times to attract customers in their millions. Aldi’s market share now stands at 6% and Lidl’s at 4.4%.

Tesco seems to have stopped the rot, with research firm Kantar Worldpanel reporting that in the third quarter of 2016 it gained market share for the first time in five years.

This took Tesco’s share to 28.2%.

In its battle with Aldi and Lidl, Tesco has fared remarkably well, says Gilmour. But it has come at a big cost to its operating margin, which stood at only 1.7% in its past two financial years. Restoring margin is a key focus of Lewis’s recovery strategy for Tesco.

His target is an operating margin of 3.5%-4% by 2020. In this respect, Tesco has much in common with a recovering Pick n Pay, where lifting operating margin is a key focus of its CEO, former Tesco UK CEO Richard Brasher.

Results of Lewis’s strategy are already showing, with broker consensus forecasts indicating that Tesco’s EPS in the year to February will more than double and will rise by about a third in the following year.

For SA investors looking to back Lewis, Tesco is an interesting offshore play which can be bought through an SA stockbroker using one’s offshore investment allowance.

However, Tesco’s share price is already discounting a big recovery, with even a doubling of EPS leaving it on a high 27 p:e.

Some SA managers who once held Tesco are cautious. For Ricco Friedrich of Denker Capital it is a case of once bitten, twice shy.

“The risk/reward trade-off does not make sense,” says Friedrich.

Evan Walker of 36One Asset Management is not as dogmatic. “I would not rule out buying Tesco again but would first need to examine it very closely,” he says.

For investors prepared to accept the risks that come with a turnaround play, Tesco is a share to be accumulated on price weakness. Weakness may come when Tesco faces competition authorities on the Booker deal in a process expected to stretch until late this year and even into 2018.

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