Investors may have been surprised by the news CEO Dave Lewis had purchased (8 Oct) £200,900 worth of stock in supermarket Tesco (TSCO). Having flagged a self-imposed boardroom ban on buying shares on the grounds they were privy to sensitive information, it then emerged Lewis and fellow directors including numbers man Alan Stewart and chairman John Allan had bought stock the day after interim results (7 Oct).

Director buying sends a highly reassuring signal that the turnaround at Britain’s leading grocer by market share is gaining traction, albeit at a grinding pace. Tesco still has much to do to regain the confidence of investors following a string of profit warnings, a £263 million profit overstatement of commercial income, not to mention a criminal investigation by the Serious Fraud Office (SFO) into alleged accounting irregularities. Prospective investors in the supermarkets sector, where fierce price competition and promotions continue to squeeze already razor-thin margins, are taking a leap of faith.

A year into his tenure, Lewis has lived up to his ‘Drastic Dave’ nickname, slashing thousands of head office jobs, selling off assets, closing loss-making stores and shelving new store development projects. In the core UK business, Lewis has been investing in staffing and price cutting, in raising Tesco’s product innovation game as well as in simplifying ranges. Last week’s interims underscored the scale of the turnaround required at the tainted retail titan.

First the bad news. Operating profit before exceptional items halved from £779 million to £354 million in the six months to 29 August, well south of the £400 million consensus estimate, while profit before tax slumped 75% to £158 million (before exceptionals and pension financing costs), as the £16.64 billion cap and other ‘Big Four’ rivals continued to duke it out on price with German discounters Aldi and Lidl. In line with Lewis’ stated prioritisation of cash flow and repairing the balance sheet there is no dividend.

Green shoots

Yet the statement had some bright spots. Yes, like-for-like sales in the UK and Republic of Ireland declined by 1.3%, but there was an improving trajectory in performance. A 2% same-store fall in the previous year’s fourth quarter moderated to a 1.5% fall in the first quarter, then a 1% decline in Q2.

And a sole focus on like-for-like sales during this period of unprecedented price reductions across the industry and general food price deflation in the market doesn’t do Lewis’ efforts justice. Grounds for encouragement were found in the volume of goods sold, up 1.4%, as well as 1.5% growth in the number of transactions in store, showing Tesco is finally winning back customers on home turf.

‘We have delivered an unprecedented level of change in our business over the last twelve months and it is working,’ commented Lewis, adding ‘the first half results show sustained improvement across a broad range of key indicators. In the UK, we continue to improve all aspects of our offer for customers, resulting in volume growth which is allowing us to create a virtuous circle of investment.’

Tesco says it remains on track to deliver £400 million of annual cost savings and is rebuilding relationships with suppliers, the latter a key part of expanding its compressed margins. Encouragingly, a total of 53 unprofitable stores have been shuttered since the start of the year and new store openings dramatically stripped back, reducing the first half capital expenditure bill by 61% to £400 million.

Lewis also announced that total international like-for-like sales had increased in the half for the first time in almost three years; same-store revenues were in growth mode in all European markets and positive second quarter like-for-like sales growth was generated in Thailand too.

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BIG PLAYER

Tesco’s size and ability to lead on price is one of the key reasons why Shares is sticking with a positive view on the stock and a more cautious stance on smaller rival Sainsbury’s (SBRY) (see Shares, Talking Point, 8 Oct).

As John Ibbotson, director of retail consultancy Retail Vision explains, Tesco’s size remains its trump card. ‘At nearly twice the size of its nearest rival, and with the highest margins of any of the big four, it can use its scale to hold down prices longer than anyone else.’

On results day, Lewis called an end to asset disposals, saying ‘we have concluded our portfolio review with the sale of Homeplus, our business in Korea, enabling us to take a significant step forward on our priority of strengthening the balance sheet. Further progress will be driven by continuing to increase the level of cash generated from our retained assets.’

Tesco successfully sold off its South Korean business, something of a jewel in the portfolio, to Asia-focused buyout firm MBK Partners for £4.2 billion last month (7 Sep). Following a review, Tesco will not be selling off Dunnhumby, the data analysis business that runs the Clubcard loyalty scheme. This had been valued at as much as £2 billion, yet with the auction failing to drum up sufficient interest at an acceptable price, Tesco will now keep the unit in-house.

The Dunnhumby sale debacle means investors do still need to fret over the balance sheet. Even after the sale of Homeplus, Tesco’s total indebtedness stands at nearly £17.7 billion including a £4.2 billion pension deficit. This is less than ideal given the continuing need to compete on price. Furthermore, Lewis says Tesco should ‘never say never’ when an analyst raised the real possibility of resorting to a rights issue that would help strengthen the stretched balance sheet.

Analysts’ view

City analysts appear cautious towards the stock to say the least, highlighting risk factors in the form of future market share erosion, dilution from a rights issue or unexpected demands on cash flow.

Mike Dennis at Cantor Fitzgerald Europe regards the numbers as ‘disappointing on many levels: across the regions, profit and loss and balance sheet.’ The Cantor number cruncher says: ‘The risk now is that Tesco’s recovery needs more time, requires more restructuring and asset sales and, with less cash flow, could require a rights issue to lower the indebtedness.’

Jefferies has a ‘hold’ rating and 185p price target, forecasting modest improvement in underlying pre-tax profit from £501 million to £510 million for the year to February 2016 for earnings of 4.72p (2015: 4.7p), ahead of £1 billion of pre-tax profit for earnings of 9.42p by February 2017. In a note entitled ‘Detox Continues’, Jefferies writes: ‘Tesco’s interims confirmed a UK recovery slightly ahead of our estimates. We appreciate the extent of positive changes at the group but believe the stock already prices in a sensible UK margin recovery (of >2%), especially given that multiples remain highly leveraged.’

Shore Capital will shortly unveil finessed financial estimates following a sit-down with management and reiterates its hold rating, writing: ‘We continue to sit on the fence on the recommendation front, which given the ebb and flow of the stock and the sector, has not been the wrong place to be to our minds over the last year.’

We’re staying positive on the stock in the belief a rebound to 203.25p could mark the start of an uptrend. Tesco’s stock does look expensive on a punchy recovery multiple and we concede patience is required before Tesco returns to meaningful sales and earnings recovery and recommences paying a sustainable dividend.