Tesco spells out revival plan

Finally, the cycle of bad news has been broken. Of course, the challenges facing Tesco are by no means over, but it's a relief to hear some good news at last from the struggling supermarket and to see the smoke around its revival plans begin to disappear. Blighted by an accounting scandal and profit warnings in the first two months of his employment, chief executive Dave Lewis will be pleased to see the share price heading north again.

Christmas hardly dazzled, but at least UK like-for-like sales fell just 0.3% over the six weeks, much better than the -3.5% expected in the City. UK sales for the entire third quarter also improved on the previous period at -4.2%. That took sales for the 19 weeks to 3 January to -2.9% and group like-for-like sales down 2.7%. The international performance was mixed.

Tesco still expects to generate the already lowered profit guidance of £1.4 billion, and, as expected, it has confirmed there will not be a final dividend this year.

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Lewis took the opportunity to outline some of his plans to turn the ailing supermarket around, which include the appointment of Halford's CEO Matt Davies as head of Tesco's UK and Ireland business. Davies, who has overseen the recovery in the bicycle and car parts retailer's share price by 127%, will join the company in June.

In a £250 million cost-cutting drive, Lewis will also shut 43 unprofitable stores, consolidate its head office in Welwyn Garden City and see significant changes to its store building programme as it slashes its capex budget. It will also try to offload Tesco Broadband and BlinkBox to TalkTalk and is exploring the options for its dunnhumby business.

Changes will be made to employees earnings and benefits, with a pay freeze and closure of the company defined benefit pension scheme to all staff. A new flexible benefits package and turnaround bonus will be introduced.

Lewis has admitted there is much more to do and although there are plans in the pipeline he has kept his cards close to his chest. Fears of a rights issue were not dismissed, just not mentioned, but Bernstein analyst Bruno Monteyne thinks it's unlikely.

"Tesco for too long failed to adapt to the changes in the UK competitive landscape (more local competition and better execution by discounters). It made matters worse by losing its value credentials and now charging 6% more than Asda. After several profit warnings, a new CEO and an accounting scandal, Tesco's troubles are now well known. Things now seem so bad that consensus implies a rights issue is around the corner ...[but] we think a rights issue is rather unlikely."

Although the £250 million cost cutting benefits will be reinvested, Barclays sees stronger sales and improving margins having an impact on profits, giving a boost to guidance. It has upgraded forecasts slightly and now reckons the supermarket will make a trading profit of £1.48 billion in the year to February 2016, rising to £1.73 billion the year after.

They key message to take from the update is simplification, says Monteyne, believing there will be less of the "smoke and mirrors of the past". A rerating of the stock looks pinned on improving sales.

"In terms of likelihood of any form of turnaround, it isn't rocket science: cut prices to close to Asda and fund it all and more by radical cost cutting. Tesco used to be great at this and even if it only succeeds at half the things it tries, it will do better than the current consensus doomsday scenario. We rate Tesco 'outperform' with a target price of £2.35."

After losing over half of its value over the last year, Tesco's share price rose by nearly 10% to just under 200p on Thursday. The shares now trade on an eye-watering 22 times earnings forecasts for 2016, a premium to all European peers except online operator Ocado. The valuation for the year after is only slightly more palatable. UK sales will have to grow to justify anything like this rating. That, however, will take time.

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