Interactive Brokers - Tesco's Earnings Spur Sour Sentiment As U.K. Retail Sector Braces For Brexit

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Includes: EWU, EWUS, JSAIY, JSNSF, KO, LDNXF, LNSTY, MAKSY, MRWSF, MRWSY, TSCDF, TSCDY, WTBCF, WTBCY, WTBDY
by: Interactive Brokers
Summary

British retailer Tesco’s stock tumbled Wednesday despite improvements in the UK market, while uncertainties over Brexit have recently spurred significant shifts in the sector.

Along with other UK food retailers, including Sainsbury's and Morrisons, Tesco has been battling against intensified domestic competition – notably from hard discounters such as Aldi and Lidl.

Meanwhile, some food retailers already seem to be preparing for downside Brexit scenarios.

British retailer Tesco’s (LSE:TSCO) stock tumbled Wednesday despite improvements in the UK market, while uncertainties over Brexit have recently spurred significant shifts in the sector.

Shares of Tesco plunged after the company revealed losses related to its Central European and Asian operations.

In the first half of 2018/19, the firm said like-for-like (LFL) sales in Central Europe fell 1.5%, driven by Sunday trading regulations, and in Asia, LFL sales dropped by 7%, due in large part to adverse impacts from brand repositioning and investment in Thailand.

Tesco said it expects the adverse impacts in Asia will continue in the second half, as it struggles to compete in the Thai market.

Following the news, the company’s stock plunged more than 8.5% intraday Wednesday to £215.10, with its American Depositary Receipts (ADRs, TSCDY) last quoted down around 8.45% to just south of US$8.34, according to the IBKR Trader Workstation.

The firm’s first-half financial performance fared better in its local markets, including a 3.8% rise in UK and Irish LFL sales, which stepped-up from 3.5% in Q1 to 4.2% in Q2.

While Tesco also paired down its debt obligations by more than 4% to roughly £3.13bn, the yield on its 6.15% notes due November 2037 shot up to a 52-week high of 5.795% -- a rise of a little more than 46bps since late January.

Shifting landscape

Along with other UK food retailers, including Sainsbury's (LSE:SBRY) and WM Morrison Supermarkets (LSE:MRW), Tesco has been battling against intensified domestic competition – notably from hard discounters such as Aldi and Lidl.

According to analysts at global advisory firm Deloitte, while consumer confidence in the UK has risen, growth in spending has slowed, and although inflation has fallen as expected, so has wage growth – “meaning that there has been no easing of pressure on consumers.”

However, a jump in online sales appears to have helped the sector, amid a rash of brick-and-mortar store closures, and overall retail activity has been generally stable – defying expectations for weather-inspired erosion.

Deloitte suggested the recent “robust” performance of sales, underpinned by the food and beverage industry, may be evidence of a broader structural shift in the sector. They added that years of “rising costs, technological disruption and changing consumer behavior has led to a tipping point that has forced the UK high street to undergo considerable structural change.”

Against this backdrop, Tesco has been busy shoring-up its domestic business.

The company completed its merger with wholesale food operator Booker in March, which is expected to fetch at least £60m this year in synergies, and are anticipated to grow to around £140m in 2019/20 and £200m by 2020/21.

Tesco also recently agreed to enter into a long-term strategic alliance with Carrefour, and launched its new Jack’s brand in mid-September.

Competing against itself

While Tesco has made strides to bolster its domestic offering, some analysts think its latest value-brand poses risks to its existing lines.

Analysts at Fitch Ratings, for example, recently noted that while Jack's could benefit from cross-selling
opportunities with Tesco's other lines, as well as products of recently acquired Booker, they think it could promote potential cannibalization with its existing brands.

Fitch said Tesco's 'value' proposition may be in “direct competition with the newly launched chain, especially for overlapping stores in a given catchment area. Hence, in our view, the Jack's concept will have to be significantly different from Tesco's existing offerings, which could be difficult to achieve in the current environment of intense competition and anaemic demand-growth prospects.”

Fitch recalled how Tesco “tried entering the discounter market in the mid-1980s with the Victor Value brand, while Sainsbury's did it more recently in 2014, when it launched a JV discounter with the Danish chain Netto. Both projects were abandoned after a few years.”

The road ahead is paved with Brexit

Meanwhile, Tesco CEO Dave Lewis confirmed his company continues to be “on track” to deliver its medium-term targets, including £1.5bn in cost reduction, £9bn of retail cash from operations, as well as operating group margins of between 3.5% and 4.0% by 2019/20.

Lewis added the company also continues to maintain a disciplined approach to capital, with spending for the year now expected to be no more than £1.2bn, and aims to keep it within a range of £1.1bn and £1.4bn going forward.

However, Tesco’s plan to contain its capital expenditure could be thwarted should the UK exit from the EU without a deal – or without amiable terms – on March 29, 2019.

British Retail Consortium chief executive Helen Dickinson recently stressed that securing a clearly defined deal with the EU is critical in providing certainty and protection to UK consumers. She warned that any delays caused by increased red tape will pose a serious impact on over one-third of UK food imports, pointing to the government's recent technical notices as evidence a No-Deal Brexit is likely to spur reduced availability and higher prices of food and medicine.

Indeed, EU Secretary of State Dominic Raab recently said that in the event of a ‘No-Deal’ exit, “practical measures” have been set out to mitigate any risks of supply disruption.

Some UK food retailers already seem to be preparing for downside scenarios.

Aldi, which touts itself as the UK’s lowest-priced supermarket, said it has been considering increasing its shipments of Britain-based products, amid the approaching Brexit date.

Aldi, which sources its meat, eggs, milk, butter and cream from British suppliers, said it had switched to 100% British on dozens of other grocery lines, including mushrooms, potatoes and seasonal spinach.

The company said it is “actively looking to source even more products from Britain by expanding its UK supply base. It currently spends over £100m each week with more than 1,000 British suppliers.”

In the meantime, investors in the UK retail space will be eyeing the release of KPMG’s and BRC’s updated report on UK retail sales on Monday, October 8, after a relatively weak reading for August.

Note: This material was originally published on IBKR Traders' Insight on October 3, 2018.

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