A few months ago, I've suggested that income investors should avoid the British retailer Tesco (OTCPK:TSCDY) despite its 4% yield, as its sustainability over the long term was not strong due to a weak operating environment, especially in the U.K. Moreover, even though Warren Buffett is one of Tesco's largest shareholders, investors who followed Buffett's investment could be disappointed. Since then, Tesco's shares have dropped by almost 30%, while during the same time the S&P 500 is up by 20% as shown in the next graph.
Tesco is one of the world's largest retailers, with more than 6,000 stores worldwide. The company is mainly present in Europe and Asia, but its largest market remains the U.K. Domestically, it is the market leader with a market share of about 28%. Even though its market share has been relatively stable over the past decade, it has consistently declined over the past few years due to fierce competition from discount retailers Aldi and Lidl. This performance has resulted in the appointment of new top management team at Tesco, that will start on September.
This challenging operating environment has led Tesco to report quite weak financial results over the past few years, despite huge investments on store refurbishments. Tesco has spent more than $1.6 billion to remake stores to lure back customers, but that has failed to stem the decline. Over the past 12 months, Tesco has reported its worst sales drop in more than two decades and continues to lose market share in the U.K., to about 28.8% currently from more than 30% a year earlier.
Tesco released today its trading update, releasing a profit warning leading to a downward revision of its financial goals.
The combination of challenging trading conditions and ongoing investment in our customer offer has continued to impact the expected financial performance of the Group.
The business continues to face a number of uncertainties, including market conditions and the pace at which benefits from the investments we are making flow through in the second half and consequently the Board has revised its outlook for the full year. We now expect trading profit for 2014/15 to be in the range of £2.4bn to £2.5bn. Trading profit for the six months ending 23 August 2014 is expected to be in the region of £1.1bn.
Tesco will promote its smaller stores to boost demand domestically, competing directly with German "hard discounters" Aldi and Lidl. The U.K. retail market is somewhat concentrated with the top four retailers dominating around 80% of the market. However, the polarization between discounters and premium formats is pressing negatively the performance of large retailers. Tesco's position will certainly lead for both top-line revenue and profits to remain under pressure, given the current competitive environment in the U.K. that shows no sign of slowing down.
Additionally, it unexpectedly slashed considerably its dividend and reduced investments, providing a weak outlook for its business.
The Board is focused on maintaining a strong financial position in order to maximise its business and strategic optionality. Reflecting this and our current expectations for future performance, the Board anticipates that it will set the interim dividend at 1.16p per share - a reduction of 75% from last year's interim dividend.
In addition, we are implementing further reductions in capital expenditure. For the current financial year capital expenditure will now be no more than £2.1bn, some £0.4bn less than originally planned and a reduction of £0.6bn from the previous financial year.
The dividend cut is a clear message that despite its past management commitment to a growing dividend, its short-term priority is to protect the balance sheet and improve fundamentals. This fiscal year (2014-15) appears to be a lost year, as former management has not taken the appropriate measures to address the company's fundamental woes. Turning the group around will certainly be tough for newly appointed management, and it may take some time.
Tesco's strategy over the past couple of years has been focused on differentiation, offering more quality than pushing higher volumes. This has failed and new management may be forced to cut prices even more to recover its market share. If Tesco has to enter a price war with smaller competitors, this will lead to lower profitability down the road, something that does not appear to be currently expected judging by consensus estimates that expect Tesco's EBIT margin to remain relatively stable over the next three years.
Tesco continues to suffer from fundamental issues and its outlook for the next few months is not good. Tesco's warning and tangible dividend cut highlights how tough the situation currently is, given that a strong shareholder remuneration was one of its main strategic goals. New strategic initiatives should not be presented until the end of the year, so visibility on Tesco's turnaround strategy is low and therefore its stock should be avoided for the time being.
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