Tesco (LON:TSCO) shares are still smarting after severe punishment that followed its operating profit miss last week. The stock is down 9% since Monday 1st October. Heaviness suggests investor views are hardening on chances that Tesco can meet key goals set two years ago.
The group itself is certain it will generate £9bn in retail cash from operations and lift group operating margin to 3.5%-4% by 2019/20. Hitting the margin target in particular has come to be seen as a key test of CEO Dave Lewis's formula for sustainable growth and, ultimately, shareholder returns. Scepticism has been rising for some time. Including last week’s price thrashing, the loss since 10th August has been about 20%.
It is possible investors have rushed to overly harsh judgement. Britain’s biggest retailer generated a 24.4% underlying operating profit rise in H1 to £933m, lifting the operating margin 29 basis points (bp) to 2.94%. That was backed by a solid 2.5% like-for-like (LFL) sales advance in the UK & Republic of Ireland division (UK & ROI) during the second quarter (up from 2.1% in Q1) taking six-month growth to 2.3%.
True, the operating result was below consensus by as much as £67m, whilst headline operating profits fell 6.5% to £819m. That was largely due to hefty profit and LFL slides in Asia (-29.1% and -9% respectively) and a £32m loss in Poland. Still, the worst that can be said about UK & ROI, the region where the group generates c. 80% of revenues, is that the operating margin excluding Booker fell 4bp between the second half of 2017 and the first half of 2018. That begs the question of whether slashing over £2bn from Tesco’s market cap last week was an over-reaction. The fall easily assumes zero operating profits between now and 2019/20 financial year end.
More to the point, it’s now clear investors have become more hawkish about which end of Tesco’s margin target range it might hit by that date, rather than whether it will achieve the range at all.
Whenever risks looks weighted to the lower 3.5% end, the shares are likely face pressure. But if UK sales growth remains stable (though, probably a tad softer, without the World Cup boost) Tesco’s now cheaper rating could help the shares close the gap to UK rivals. The group trades at 15.87 times 2018 forecast earnings compared Morrison’s 19 times, according to Refinitiv data. Investors will have to wait till 11th January for a Christmas update, though Kantar Worldpanel’s monthly UK grocery market share data are due out next week.
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