Tesco shares fall as Credit Suisse reiterates 'underperform' rating

Tesco’s shares fell on Friday as Credit Suisse reiterated an ‘underperform’ rating and target price of 130p, citing “structural problems”.

Credit Suisse said while Tesco reported a 34.4% increase in operating profit to £515m in the first half, it was “not from better trading”.

Tesco posted a return to sales growth in the first six months of the year, up 0.6% in the UK. However, pre-tax profit dropped 28.3% to £71m as the supermarket invested in efforts to regain market share amid fierce competition in the sector.

“On October 5, Tesco reported strong UK operating profit, bolstering its claim that the core business is back on track – we are not yet of that view,” said Credit Suisse analyst Stewart McGuire.

“More than 100% of operating profit was generated via cost savings and we estimate that like-for-like sales at its largest stores (which constitute almost 50% of space) remain materially negative once online sales are excluded.”

Credit Suisse said Tesco’s results showed weak free cash flow and a deteriorating balance sheet. Retail free cash flow fell from £281m in the first half of fiscal year 2016 to £203m in the first half of 2017. Total debt rose by nearly £2.5bn to £18bn, even after including one-time disposals of subsidiaries and properties as well as working capital inflows, the analyst noted.

Tesco also revealed a three-year, £1.5bn cost savings programme, which would represent a 2.7% increase in group margin at current trading levels.

“The company has scheduled a capital markets day on 16 November; until then, we remain sceptical of reaching such lofty targets,” McGuire said.

“We incorporate £100m and £300m of net cost savings for fiscal years 2018 and 2019, respectively, but keep our below consensus estimates unchanged.”

Credit Suisse, however, raised its full year 2017 forecast on UK and return on investment earnings before interest and tax by 16%, driven by the cost savings programme. The 2018 and 2019 estimates were also lifted by 17% and 49%, respectively.

The bank increased its UK terminal margin from 2.2% to 2.5% after Tesco restated is like-for-like numbers.

“However, any benefits from these changes are substantially offset by the £3.2bn increase in debt due to pension liabilities,” McGuire said.

“Our discounted cash flow-based price target does not change, and on a multiple basis, shares still appear expensive versus the sector.”

Shares fell 1.14% to 211.81p at 0932 BST.