Do Tesco – and Sainsbury’s – need to raise cash to fight the price war? Even six months ago it seemed unlikely that the duo would have to go cap in hand to their shareholders to ask for cash via rights issues. Now how they will raise fresh finance is the main debate among City analysts.
The problem for both companies is simple: when sales and profits start to slide, financial ratios can go haywire. Tesco had net debt of £6.6bn in February, the end of its last financial year. In the old days that would have been seen as a light burden for a company of its size and profitability. Pre-tax profits were still £3bn last year and the sum of cash generated by the stores was £3.5bn.
But look at the claims on that cash. Almost £500m was paid in interest to lenders; the tax bill was £347m; the dividend to shareholders cost £1.1bn; and capital expenditure across the group was £2.7bn. If new Tesco chief executive Dave Lewis decides to cut prices – and profit margins – he has to be able to fund the fightback without simply piling on more debt.
Lewis can sell assets – such as Dunnhumby or its Asian business – but disposals won’t provide immediate cash and nobody wants to be seen as a forced seller. It could also make savings: the group has already said it will chop its dividend by 75%, a big saving. Lewis can also stop opening more hypermarkets – Margate is the latest to be axed.
But some costs can’t be avoided. Rent still has to be paid on the stores Tesco leases. Cutting staff, and thus the level of customer service, would probably be a false economy. Then there’s the deficit in the pension fund, which is now looming large. The gap widened from £1.8bn to £2.6bn last year.
“Such are the concerns around the balance sheet at current levels of profitability that we expect a rights issue would be positively received by the market,” thinks HSBC’s analyst David McCarthy. He thinks Tesco needs £3bn – minimum – to make a difference.
Sainsbury’s is a simpler business – it doesn’t operate overseas – but a full strategic review is under way and chief executive Mike Coupe has said it will include the dividend policy and funding strategy. It is easy to see why the dividend is in peril: last year’s payment was worth 17.3p a share, but the City thinks earnings will be only 28.4p this year. Maintaining the dividend would breach the rule of thumb that dividends should be covered at least twice by earnings.
Opinion is divided about the need for a rights issue, but the company’s refusal to disclose details of its banking covenants on the grounds of commercial confidentiality has heightened suspicions. And, if the market leader is rearming for a price war, shouldn’t Sainsbury’s?
“We think it is unrealistic to believe that its [Sainsbury’s] quality positioning will make it immune to Tesco’s inevitable price positioning,” says Jamie Vazquz of JP Morgan Cazenove. “We remain of the view that the negative top line trends will lead to a major cut in the dividend and a potential rights issue.”
