LONDON — Tesco faces a crucial test this week when it delivers full-year result on Wednesday.
The supermarket chain’s planned merger with food wholesaler Booker is facing pressure from two key shareholders and Bernstein’s retail analyst Bruno Monteyne says “results need to impress to keep the deal on track.”
James Grzinic and Caroline Gulliver at Jefferies, likewise, see Wednesday’s 2016/17 results as an opportunity to “remain on the front foot on the Booker deal.” However, Grzinic and Gulliver add that they are “trying to keep an open mind on booker for now but ultimately our concerns around the 2017 industry challenges remain.”
If Tesco cannot impress investors with solid full-year numbers, then the £3.7 billion deal could be thrown into doubt.
The Tesco and Booker tie-up: key facts
Tesco announced in January plans to buy food wholesaler Booker in an ambitious deal that would take it into the “out of home” food market — people eating out at restaurants and at catered events. This market is growing faster than supermarket sales.
The deal is not straightforward. Booker supplies corner shops such as Budgens and Londis and the Competition and Markets Authority (CMA) has opened an investigation into the deal to decide if it gives Tesco too much control over the food market.
Schroders and Artisan Partners, who of Tesco’s biggest shareholders, have also come out against the deal. Schroders fund manager Nick Kirrage said in a letter that he believes Tesco is paying too high a price and the deal will destory value for investors. Hermes Fund Managers, an influential investment advisor, also criticised the deal.
A survey of investors by Bernstein’s Monteyne last week found an estimated 70% support the deal, suggesting it will be approved, but Monteyne warned that there is a margin for error in his work and scope for Schroders and Artisan to sway key shareholders.
Wednesday’s results: what to expect
This week’s full-year results look like a crucial test for Tesco. CEO Dave Lewis must show strong progress for the supermarket, signalling that it is in good enough health to take on the task of a complex merger outside of its core business are.
Tesco’s previously told the markets to expect full-year underlying earnings of £1.2 billion, but consensus has moved to around £1.25 billion after a solid update from the supermarket in January.
Grzinic and Gulliver say in a preview note last week:
“We assume H2 UK (including Republic of Ireland) margin largely unchanged vs H1, or +25bps year-on-year. Internationally we expect tougher trading conditions in Thailand to have led to a sharper margin fall in H2 (was -30bps ex-Turkey deconsolidation help in H1, Jefferies estimates closer to -60bps in H2). Closing net debt of c.£4bn for us and consensus would represent a year-on-year reduction of over £1bn. But at current levels of UK profitability (and given ongoing £270m p.a. pension cash top-up payments, which we expect to be reconfirmed with the upcoming triannual), the business requires working capital improvements and property proceeds in order to make appreciable progress on leverage.”
The analysts add that: “Ultimately it is improvement in Tesco’s UK relative sales momentum that is needed to defend a recovery multiple. Evidence on this front remains erratic.”
Lewis was bought in to rescue Tesco in 2014. At the time, the supermarket was reeling from a £300 million accounting scandal and facing intense competition in the UK from discounters Aldi and Lidl. Lewis has helped Tesco return to better shape in the UK but some investors feel he has moved too soon on M&A.
Bernstein’s Monteyne says: “There is a strong sense out there amongst investors that “Tesco’s recovery has stalled”.” However, he argues this is not true and expects “UK profits, cash generation and volume growth all set to surprise.” Monteyne forecasts a UK and Republic of Ireland operating profit of £430 million, 15% above consensus forecasts.
Monteyne also expects Lewis’ to unveil “Phase III” of his turnaround plan at Tesco. He writes:
“Dave Lewis announced phase II (rebuilding business) at the interims, putting closure to phase I (crisis-control). Dave is not a 2-phase CEO. Phase III will be about Innovation and Growth. Booker deal fits in perfectly with that. Shareholder vote is another 9 months off, so another set of UK results before then to assuage fears about the strength of the UK recovery.”
If he can pull it off, Phase III could be a triumph for Lewis. But if his gamble doesn’t pay off, then it could be a costly error for Tesco’s CEO. Wednesday could well prove to be the decider.
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