Tesco's Recovery Risks Being Thwarted by Asda Price Threat

(Bloomberg) -- There's an unexpected item in Tesco's bagging area. Asda is preparing a price war.

That's the conclusion of Dave McCarthy, the veteran retail analyst at HSBC. The market has taken the possibility of a fresh price assault seriously: Tesco shares sank more than 8 percent on Wednesday, the biggest decline in the benchmark FTSE 100 Index. 

Investors are right to be worried. Sean Clarke takes over as CEO of Asda next week, and the message from parent Wal-Mart's top management is that Asda will shift its focus from protecting margins to seizing market share. One way or another, price cuts are coming.

That will be a setback for Tesco. Dave Lewis, named as CEO almost two years ago, has got sales moving in the right direction. Two weeks ago, Tesco posted its second consecutive quarterly increase in U.K. same-store sales, the first time that it had managed two straight periods of like-for-like sales growth in five years.

But, as Gadfly has noted, that progress only slowly feeding through to the bottom line. Analysts expect the supermarket's operating profit will be 1.2 billion pounds this fiscal year after Lewis warned in April the retailer would be unlikely to reach its previous forecast of 1.25 billion pounds. While that's still an increase on last year's figure of 944 million pounds, it's far below the peak of almost 4 billion pounds in 2012.

Operating margins are being squeezed, too. In the U.K., the measure stood at just 1.6 percent in the six months to February -- down from a peak of about 6 percent.

Lewis doesn't have much room for maneuver if Asda does start to slash prices.

Tesco also has a significant pensions deficit that will constrain it further. The pension shortfall stood at 2.6 billion pounds at the end of February -- equivalent to almost 20 percent of its market value.

That shortfall will have since grown. Falling yields on government bonds force actuaries to assign a higher present-day value on a company's future pension promises. Tesco has already agreed to inject a further 270 million pounds a year into its pension plan and is closing its defined benefit plan. If yields remain low for a prolonged period of time, further contributions can't be ruled out.

Tesco stock has fallen almost 18 percent since Lewis's warning in April. Even so, the shares trade on about 22 times estimated earnings, a hefty premium over rivals Morrison and Sainsbury.

If Asda does start to turn the screws on its rival, there will be more price adjustments at Tesco. They may not be limited to the supermarket aisles.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story: Andrea Felsted in London at afelsted@bloomberg.net.

To contact the editor responsible for this story: Edward Evans at eevans3@bloomberg.net.