Tesco changes: what next for shareholders?

The supermarket giant has announced some major cost cutting as it looks to fight back, including scrapping this year's dividend.

In what may well be its most important announcement since the launch of Clubcard 20 years ago, Tesco today revealed a radical plan to revive its plunging profits and share price. But will it work?

Tesco's war on costs

In a trading statement released on Thursday morning, Tesco dropped an entirely predictable bomb on its shareholders. In order to “invest in a better offer for customers”, it scrapped its once-juicy dividend, worth 14.76p a year in its past three financial years.

Investors, relieved that Tesco did not announce a rights issue to strengthen its balance sheet, piled into the shares. As I write, Tesco's share price has leapt 25p to 207p, up around a seventh (14%).

However, new Chief Executive Dave Lewis also announced a whole raft of other deep cuts to strengthen the firm's balance sheet and cut costs by a quarter of a billion pounds a year. In what is known in the City as a 'kitchen sinking' of past problems, here's how Tesco's new broom aims to turn around his struggling supertanker.

Closing 43 unprofitable stores.
Shutting the huge head office in Cheshunt in Hertfordshire next year, to make Welwyn Garden City the UK and group centre.
'Significantly revising' the store-building programme across the UK by cancelling 49 new stores.
Reducing capital expenditure to just £1 billion in 2015/16.
Cutting jobs by simplifying store management.
Closing the group's guaranteed, final-salary pension scheme to all UK workers (following a staff consultation).
The sale of Tesco Broadband and film-streaming service Blinkbox to TalkTalk.

In addition, Tesco has appointed Matt Davies, former Chief Executive of Halfords, to run its core UK and Irish operations from 1st June. The grocer is also looking to release value from dunnhumby, which runs its Clubcard loyalty scheme, possibly through a £2 billion sale or stock market flotation.

Taken together, these steps amount to an effective rejection of Tesco's previous strategy of simply building 'big box' superstores and then waiting for customers to come running. In total, Dave Lewis wants to cut Tesco's UK overheads by about 30%, freeing up cash to fund yet another price war with rivals Asda, Sainsbury's, Morrisons, Aldi and Lidl.

Will this U-turn work?

Under retail guru and former boss Sir Terry Leahy, Tesco's massive success during the nineties and noughties came from organic growth in Britain. This was achieved largely by building superstores in every major population centre across the UK, supplemented by thousands of smaller stores, including Tesco Metro and Express convenience stores.

Although this grand plan aims to 'regain competitiveness in the core UK business', I'm far from sure that it will actually achieve this key goal. Frankly, shopping habits have changed in this post-crash economy and, sadly, Tesco is a retail dinosaur having its heels nipped by fast-growing mammals such as Aldi and Lidl.

According to Luke Johnson, serial entrepreneur and founder of Pizza Express, for any high street retailer to succeed, these three key performance indicators must be strong:

underlying sales growth;
gross margins;
free cash flow.

While Tesco's modified strategy may help slow the slide in sales, drastic price cuts will lead to lower gross margins, undermining the second of these three indicators. Buying growth though price cuts may work in the short term, but often leads to sharply reduced profits caused by intense market competition.

In short, when supermarkets start cutting each other's throats in a brutal price war, customers win, but their shareholders usually lose.

Right now, Tesco's numbers don't add up

Given that Tesco is in a state of transition at present, and after four profit warnings in six months, there is little point in crunching the usual numbers. Obviously, scrapping the dividend could mean Tesco has a 0% dividend yield for the next 12 to 24 months, making it a no-go share for income-seeking investors.

Likewise, on a forward price-earnings ratio above 17, Tesco shares are more expensive than the wider market at present. Similarly, growth in earnings per share is likely to be subdued for perhaps two years, so today's buyers are pinning their hopes on a sustained recovery before 2017.

Personally, I do not believe that Tesco can restore its sales and market share to peak levels, especially after Aldi recently announced plans to double its UK store estate. The retail behemoth is being squeezed at the top end by upmarket retailers Waitrose and Marks & Spencer, while its prices are easily undercut by the 'cheap and cheerful' deep discounters, which will soon include the newly relaunched Netto in partnership with Sainsbury's.

For me, Tesco has a long way to go

Furthermore, investment gurus such as multi-billionaire Warren Buffett argue that you should buy, and therefore own, the businesses you most admire. In other words, the firm with which you spend most of your hard-earned money can often be a good business to own. Here are two personal anecdotes that make me wary of piling into Tesco shares.

First, my wife's shopping habits have changed permanently in recent years. She has abandoned Sainsbury's and Tesco in favour of the convenience of shopping online with Ocado, topped up by regular visits to Waitrose (for quality) and Aldi (for low prices).

Second, in a visit last June to our local Tesco superstore in Hampshire, we found a confusing layout, poorly stacked shelves, long queues and too few staff. Indeed, we had to wait 10 minutes at the 'Click & Collect' point merely to pick up one online order (a mobile phone for our son's birthday). Seven months later, we haven't been back.

Will you be buying Tesco? Or are you staying away for good? Let us know in the Comments section below.

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