Nick Bubb’s verdict: Tesco - no easy solution

The stockmarket had been softened up for bad news on Q3 sales, so, with no profit warning today, Tesco’s shares have rallied.

Once new CEO’s are in place for more than 2 years or so, it becomes difficult to keep blaming their predecessors for their wretched inheritance, so Phil Clarke is entering a dangerous phase at Tesco. Having lost most of his eyebrows through fighting so many fires around the Tesco global empire, metaphorically speaking, he must now be tearing his hair out in frustration at the failure of LFL sales to respond to all the work that has been done on reinvesting in the UK business.

But there was no profit warning from Tesco today with the gloomy Q3 sales update and, interestingly, Phil Clarke made a point of noting that “despite the challenging conditions in many of our markets, we are performing in line with market expectations for the full year” and based that on the consensus estimates published on the Tesco website on 8 November, ie well before the recent profit downgrades by many analysts.

With sales in every single region down LFL in Q3 (the group was 2.5% down LFL overall, with Ireland down as much as 8.1% and Thailand down 6.9%), it is not immediately apparent how Tesco have limited the bottom-line damage to profits, notwithstanding the improved performance in Poland and Turkey.

In terms of the UK performance, Clarke made clear on the conference call with analysts this morning that although the -1.5% LFL sales outcome was disappointing, there were mitigating factors on profits. The heavily loss-making Non-Food online business is being rapidly turned around, with Tesco no longer selling unprofitable Electrical lines and Clothing performing very well, whilst the high-margin Convenience Store operation (Tesco Express and One Stop) is outperforming and range relaunches like “Finest” have been good for gross margin. So, various mix changes have helped the achieved gross margin in the UK, whilst productivity improvements have also helped the operating margin (Clarke pointed to the benefit of self-service checkouts) and rent increases have been less of a burden.

And, needless to say, Clarke does not meekly agree with the recent view that it should demolish its 5.2% UK operating margin target and launch a price war and states that “We are confident that our strategic priorities - strengthening the UK business, establishing multichannel leadership and ensuring capital discipline - are the right ones and that they will drive long-term value and returns”.

However, the challenge from Aldi and Lidl is a strong one and the whole industry is having a tough time in the UK, with austerity measures still biting into the incomes of those working in the public sector. By implication, Waitrose is not affected by these macro-economic pressures. In time, Clarke hopes that the moves to make Tesco more distinctive in the UK will be translated into better LFL sales next year, but he will be finding life uncomfortable if this time next year he is still saying the same thing.

Although all the recent focus has been on the struggles of Tesco in the UK, the painful truth is that all around the world Tesco’s big hypermarkets are under attack from discounters, convenience stores and online grocers and there are no easy solutions to the problem. The share price rally today will get Tesco some better headlines tomorrow, but meeting the modest City expectations on group profits this year is one thing and meeting expectations next year is quite another. Investors would probably be wise to accept that turning around this super-tanker will take longer than they might think.