Tesco Loses Magic Profit Touch as Its ‘Big Price Drop’ Flops

Tesco Plc (TSCO) investors are questioning whether the U.K.’s largest retailer has lost its magic touch.

After generating operating profit growth of at least 5 percent in every year bar one since 1994, Tesco yesterday canceled estimates for 10 percent earnings growth in the 2013 financial year after Christmas sales missed analyst estimates and its “Big Price Drop” campaign failed to deliver.

The announcement, which slashed the retailer’s market value by 4.9 billion pounds ($7.5 billion), comes 10 months after Chief Executive Officer Philip Clarke took over from Terry Leahy, raising concern that Tesco has reached its peak and competitors will continue to eat into its 30 percent market share with promotions and fresh food offers.

“Tesco had got too clever,” said Tim Green, who helps manage more than 24 billion pounds at Brewin Dolphin Holdings Plc in London, including 0.8 percent of Tesco’s stock. “It was paring costs to the bone, it was spending too little on staff and training, service and quality and that doesn’t work when the rest of the market is moving to upgrade the fresh food offer.”

The company took its eye off the ball in the U.K., according to analysts at Shore Capital, allowing rivals such as J Sainsbury Plc (SBRY) and Wal-Mart Stores Inc.’s Asda to win shoppers with coupons and promotions.

Buffett Stake

Tesco shares plunged 16 percent yesterday, the steepest decline since at least 1988, as analysts such as Jeremy Carter at Fitch Ratings said the retailer’s dominant position in the U.K. is likely to slip further in the next two years. Warren Buffett’s Berkshire Hathaway Inc. owns 3.64 percent of the stock after raising its stake in September and the investor told CNBC in November he’d buy more shares if the price declined.

Brokerages including Shore Capital, Charles Stanley, Oriel Securities and Standard & Poor’s Equity Research cut their recommendations on Tesco after yesterday’s announcement.

“The surprise was the guidance for next year and the implications in terms of what that means for margin investment in the U.K. business, which is a structural shift in the U.K. retail food industry,” Shore Capital analyst Darren Shirley said. He cut his recommendation to “hold” from “buy.”

“The U.K. was overlooked at the expense of funding some of the international expansion,” Shirley said.

Tesco, based in Cheshunt, England, gets more than a third of sales from outside the U.K., with operations in Asia, eastern Europe and the unprofitable Fresh & Easy chain in the U.S.

Improving Competition

A difficult U.K. economy and improving competition mean low prices must remain “a central plank” of Tesco’s strategy, reducing its ability to boost margins, Fitch’s Carter said.

The retailer announced its Big Price Drop on 1,000 everyday items in September and extended the campaign before Christmas. Double points on its Clubcard loyalty program were dumped in favor of a reduction in price on milk, bread and detergents.

“In a very noisy promotional market with heavy couponing, our very strong pricing position didn’t cut through as much as we’d expected,” Clarke told journalists on a call yesterday. Tesco will make “faster, more comprehensive investment in the U.K. business,” which will be to address “long-standing issues” such as product quality, range and service, he said.

Tesco’s U.K. same-store sales declined 2.3 percent, excluding fuel and value-added tax, in the six-week Christmas period, trailing growth of 1.2 percent at Sainsbury and 0.7 percent at William Morrison Supermarkets Plc (MRW) on that basis. Sainsbury began its Brand Match price-comparison program in October and held promotions on fuel and toys to win shoppers.

Market Share

“After several years of investment, Tesco’s main competitors have significantly improved,” Fitch’s Carter said. “Tesco’s plans to improve the quality, range and service in its U.K. supermarkets will not halt the rise of its competitors.”

The retailer’s market share slipped to 0.4 percentage point to 28.9 percent in the 12 weeks to Dec. 24, according to Nielsen. It fell to 30.1 percent from 30.5 percent, according to Kantar Worldpanel.

Product availability, ambience, checkout times and customer service are areas where the retailer must improve, Shirley said.

“It’s going to be a number of quarters before in-store initiatives start to gain traction and impact like-for-like sales as well,” the analyst said.

Analysts such as Deutsche Bank AG’s James Collins say Tesco will stop short of starting a “price war” with competitors.

“It will continue to invest in Big Price Drop and will rebalance the promotional mix, but much of the incremental investment will be in operating costs such as in-store labor, which have become too pressured in efforts to improve productivity and which have damaged the customer shopping experience in areas such as fresh produce in particular.”

To contact the reporter on this story: Sarah Shannon in London at sshannon4@bloomberg.net.

To contact the editor responsible for this story: Sara Marley at smarley1@bloomberg.net

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