Tesco sales improving, but investment case remains clouded

Tesco is set to report another quarter of improving underlying sales, but its investment case remains dogged by the continuing fallout from its accounting scandal and concerns over a ballooning pension deficit.

Dave Lewis, chief executive of the UK’s largest supermarket group, has spent the past two years turning the company around. He has simplified the business by selling off units abroad and those deemed non-core in the UK. He has simplified the complicated supplier deals that were a major cause of the company’s £326 million profit overstatement, cut costs, and he’s been decisive in fighting back against the German discount retailers who quickly built market share in the UK at the expense of Tesco and its British peers.

In a further sign of that fightback, analysts are expecting Tesco to report a 1% increase in sales from stores open for more than a year during the 13 weeks to August 27. That would be up from 0.6% for the second quarter a year earlier, and an increase on the 0.3% growth the company reported for the first quarter of the current year. It would also mark a third consecutive quarter of like-for-like sales growth.

While sales appear to be back on a growth trajectory, profit margins are volatile. The whole UK grocery sector remains embroiled in a margin-sapping price war, and Tesco’s investments in price have already taken their toll. Now, its investments in new ranges of ‘Farm Brands’ fresh produce, another of its initiatives to compete with Aldi and Lidl, are set to weigh on second-quarter margins.

Analysts expect Tesco to report a rise in operating margins compared with the 0.8% reported in the first-half of its last financial year, but a slight drop from the 1.6% achieved in the second-half of that year. Investors may forgive the profit margin volatility for a time if Mr Lewis’ investments continue to keep sales on a growth trajectory.

Tesco’s shares are up 23% so far in 2016, although they are off the peak of 201 pence hit in March. That’s good news for Mr Lewis, after four consecutive years of declining stock price. The question now is whether the gains can be sustained?

A new problem for Tesco is the UK’s decision to leave the EU has put pressure on bond yields, and that is causing company pension deficits to balloon. In Tesco’s case, the deficit is expected to rise by about £2 billion to over £5 billion. There are plenty who think short-term fluctuations in pension deficits due to market movements can be ignored, but for investors the steep rise in the deficit could delay the resumption of a dividend.

On top of that, some 60 large investors that claim to have lost £150 million because of Tesco’s 2014 overstatement of profits are reported to be about to launch a UK lawsuit against the company. That’s about ten times the $12 million that Tesco paid in the US to settle a class action with holders of its American Depositary Receipts. It didn’t admit any liability in the US settlement.

While Tesco continues to suffer from the repercussions of Brexit and its accounting scandal, upside for the shares may be limited.

Indeed, the analyst community remains mixed on the stock. Seven have it at buy, six at hold and nine at sell, according to data compiled by Bloomberg. It’s also worth noting Tesco is trading at multiples much larger than those of rival J Sainsbury, whose shares have shown little reaction so far to its acquisition of general merchandise retailer Argos.  

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