What Goldman Got Wrong Upgrading Britain's Biggest Retailer

(Bloomberg Gadfly) -- It's been a long time since Tesco felt some stock market love.

But on Monday, analysts at Goldman Sachs Group Inc. issued a double upgrade of the shares to buy from sell, making them the biggest gainer in the FTSE-100 index on Tuesday.

They're right to be more positive on Tesco. The company's 3.9 billion-pound ($5.2 billion) takeover of Booker Group Plc was recently approved by competition authorities with no forced store sales -- a far better outcome than had been widely expected.

There are still shareholder votes to get through, but the signs here are promising. Once the deal is completed, Tesco can set about wringing cost savings. Forecast synergies of 200 million pounds are likely to prove conservative. 

The focus of the Goldman report, written by analysts led by Rob Joyce, is a view that the U.K. grocery market will improve a little. They're expecting the strain from faster input price inflation to ease, and for the threat from the discounters to recede. They may be right on the first, but they're probably wrong on the second. Neither of them are grounds for turning positive on Tesco. 

The industry is certainly past the point a year ago, when the pound's slump pushed up supermarkets' input costs. If the currency's volatility isn't repeated, grocers might avoid a second spike. Some relief is already in sight, as supermarkets are starting to see price pressures ease in some areas such as dairy and salmon.

But Goldman also says that while discounters are continuing to gain market share, they may be less potent in their main weapon: price. That is because they are passing higher costs on to customers more than they did when inflation soared in 2011.

True, there may be some areas where the differential between the big four supermarkets and the German discounters, Aldi and Lidl, narrows from time to time. Aldi also makes a specific point of not undercutting milk prices. But to see the upstarts as anything other than a dangerous threat is wishful thinking.

Discounting the discounters is

Wishful Thinking

The big supermarkets were tardy in appreciating their threat three years ago, when they were slow to cut prices aggressively in an effort to stem the growth of their no-frills rivals. The value supermarkets' sales growth did slow, but has since rebounded and is still running ahead of the big four. 

Aldi and Lidl's aggressive opening of new stores is fueling further sales expansion -- new space is the key determinant of the threat level to the U.K. incumbents. 

As with prices, there may be some slowing of space growth at the fringes, as new stores increasingly butt up against existing outlets. But the discounters still have huge opening programs, with the south-east of England particularly in their sights, and this should keep sales growth moving higher. Until there is more concrete evidence that the discounters are reining in space growth, the big four supermarkets will continue to face a serious danger.

The reason to be positive on Tesco is because of Booker. That gives it the best chance of coming close to the discounters' prices. And with Aldi and Lidl increasingly trying to attract more upmarket shoppers, there may even be an opportunity to use the combined group's scale to target those value shoppers who might feel disenfranchised. Add in the potential to put Booker's wholesale business into excess space in Tesco stores, and this deal has much going for it.

Shares in Tesco rose 4 percent on Tuesday. They trade on a forward price earnings ratio of 17 times, just ahead of Wm Morrison Supermarkets Plc (which Goldman also upgraded from sell to neutral) and above J Sainsbury Plc. The jump in the shares from the Monday upgrade is the right outcome...but for the wrong reason.

There are undoubtably grounds to be more positive on Tesco. Help from the broader market is not one of them.

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

Andrea Felsted is a Bloomberg Gadfly columnist covering the consumer and retail industries. She previously worked at the Financial Times.

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

To contact the editor responsible for this story: Jennifer Ryan at jryan13@bloomberg.net.

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