Tesco continues to look attractive

Apr 16 2008 by Peter McCusker, The Journal

THE Bank of England eased interest rates last week by 0.25%, as many analysts had expected. The Bank’s reluctance to cut rates more aggressively stems from concerns about inflation and the fact that, outside the housing market, there has not yet been a pronounced deceleration in demand in the UK.

That said, the traditional British ‘high street’ is not in great shape. Many high street firms have had a tough start to the year, with leading retailers reporting falls in consumer spending. On the back of this, the price of many retail shares has fallen and valuations for some might look cheap.

But we would argue that one should still approach the UK retail sector with caution as there are still considerable risks to earnings.

Economic slowdown is not the only problem faced by the sector, with broader structural changes possibly more damaging. Internet retailers and the big supermarkets are gaining market share, meaning that the traditional retailers face the twin problems of excess capacity and declining margins. If, as seems likely, difficulties with the housing market and credit availability depress consumer confidence further in coming months, then the sector’s woes can only intensify.

Even if the UK housing market doesn’t follow the pattern of that in the US, where many regions show double-digit year-on-year price falls, UK consumers’ disposable income is being eroded at a rapid rate: the price of some meat and dairy products is up over 60% over the past year and the United Nations has already warned that basic food costs could continue to rise to 2010. This is bad news for UK consumers, of course, but even worse news for consumers in poorer countries who are unable to withstand such rapid increases.

For investors who want some exposure to food retailers within their portfolio, Tesco continues to look attractive.

Although primarily a food retailer, Tesco’s significant expansion into non-food items means that it is no longer quite as defensive as it used to be. That said, the shares have underperformed since we downgraded them in November, and they are currently trading at a discount to their historic average price-to-earnings multiple relative to the FTSE All-Share index.

Although we have trimmed our fair value to 465p to reflect higher debt costs (as well as the cautious UK outlook), Tesco remains a powerful retail player on an undemanding rating.

Andrew Miller is regional office head Barclays Wealth