Tesco reported fourth-quarter results that were below our expectations, as pressures in Europe, regulatory changes regarding store operating hours in Korea, and several write-downs had a greater impact on profitability than we anticipated. For the full year, like-for-like sales declined in the U.K. (down 0.5%, excluding VAT and petrol), Europe (down 2.3%), and Asia (down 1.7%), although the sequential improvement in the U.K. between the third (down 0.6%) and fourth quarter (up 0.5%) may again suggest that Tesco’s price investments are yielding results.
These investments have come at an expense, though, as fiscal 2012 U.K. trading margin declined to 5.2% (from 5.8% a year ago). The company expects trading margins of around 5% in the U.K. to be sustainable going forward, but this level is below our previous forecast. We’ve long cautioned that operating conditions in Europe would not improve overnight, but we believe the operating margin guidance should be achievable. Overall, we believe Tesco should be able to navigate the difficult operating environment better than other European-based retailers because of its narrow economic moat, which stems from economies of scale and attractive properties.
Our long-term view remains unchanged, but we may revise our fair value estimate as we incorporate the firm’s recent results and guidance into our forecast. However, Tesco is attempting to significantly alter its long-term strategy, and given the execution risk inherent to such a strategic shift, we’d suggest investors purchase Tesco shares at a greater margin of safety. Tesco incurred a noncash charge (around GBP 1 billion) related to the sale of its unsuccessful Fresh & Easy concept rollout in the U.S., and we believe the firm’s struggles in the region support our view that the highly competitive dynamics in the U.S. market make it very difficult for to new entrants to profitably gain share.
In addition, Tesco also incurred an unexpected GBP 800 million charge, primarily from writing down around 100 U.K. properties. Many of these properties were bought in the last five to 10 years (at higher valuations), and Tesco has decided to forgo developing these locations and allocate capital elsewhere. More specifically, the company intends to build out a multichannel platform and smaller format stores, a move that we believe is appropriate given that the U.K., most of Europe, and the U.S. are already overstored
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