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Analyst advises Tesco to launch a price war to damage the competition

So, Tesco had a disappointing Christmas, its new chief executive is due to start in March - what should it do next? Launch a price war, according to analyst Dave McCarthy at Evolution Securities.

In a 34 page report dedicated to this proposal, McCarthy says Tesco has a history of altering prices when it changes management, and he believes now is the right time to do it again. In short, investing around 2% of its sales in promotions would hurt competitors more than Tesco, would hit their cashflow and would bring an end to overexpansion in the industry. McCarthy believes the supermarket's competitors would fear the move, which is all the more reason for Tesco to do it. He said:

This would be the biggest strategic move by Tesco in over 15 years and the decision should not be taken lightly, but we know that [incoming chief executive] Phil Clarke has the strength to do it. We see more reasons to do it than not to do it, and believe that Tesco would be a very clear winner.

After one "bad" year, Tesco would be rewarded with a re-rating to reflect its improved positioning and its improved cash flows, plus attention would truly focus on the quality of its international expansion. Tesco has strategic issues in the UK (e.g. weak relative sales performance, cannibalisation and strengthening competitors) and the longer it waits the more expensive and difficult these issues become to address. Tesco should act now.

Will Tesco do it? We are not changing forecasts, but we are highlighting the crash to industry profits if Tesco repositions. We are also saying that the prospect of Tesco doing this is rising as performance deteriorates. Sector share prices would get hit very hard, but Tesco would emerge as a clear winner and its shares would rerate after the market had digested the implications of such a bold move.

But as my colleague Nils Pratley has pointed out, there is no guarantee this would work:

In the old days, we might have expected the group to turn up the heat on its rivals on price. But Tesco did that a year ago when it doubled the reward points on its Clubcard loyalty scheme. The boost to sales seems to have been temporary because competitors are getting cuter – even Waitrose has a "match Tesco" promise on 1,000 branded lines.

Still, McCarthy runs through a detailed list of why he believes Tesco should act:

Underperformance: Tesco has underperformed the competition for some time. Management are loathe to admit it and have looked for external reasons for underperformance rather than identifying issues through introspection. This self denial has suited the competition more than it has suited Tesco, and when the competition are prospering under the Tesco strategy, there is something wrong.

Affordability - Tesco can afford a war more easily than the competition. We estimate a significant move would cost Tesco around 15% of group profits (before any sales gains) but would cost Sainsbury over 60% to match.

Ending the capital war - a price war will make many new stores unviable and will hurt competitor cash flows, thereby restricting the ability and desire of most retailers to open new stores. The industry would be forced to stop opening
stores by investors and owners, either directly or indirectly by share selling.

More expensive in the future - the longer Tesco leaves it, the stronger the competition become, the better they will be able to compete and the more expensive it will be for Tesco to get the desired impact.

First mover advantage - the first mover sets the battleground and the consumer sees that retailer as a leader, not a follower. There are also a myriad of practical reasons why it is best to move first, including securing supplies,
choosing the extent of the price cut and choosing which prices to cut.

The UK remains core - it is still the biggest part of Tesco and it is still the region where Tesco is spending most capex. Tesco needs to protect its UK position and the best way of doing this is to damage the competition and to
restrict their growth. Remember this is not an equal sum game. Tesco can use its skill and scale to hurt the competition much more than it costs Tesco.

Time to harvest - some believe that Tesco should use the UK as an out and out cash cow. But it cannot do this while the competition expand as Tesco would lose competitive position, putting future profits at risk. If Tesco can stop
competitor expansion, then it can cut back its own expansion and improve its post capex cash flow from the UK, without losing competitive position.

Supplier relationships - we suspect that suppliers are more prone to support recovering retailers because most suppliers make a higher marginal profit from extra sales at say Sainsbury, than at Tesco (i.e. Tesco buys better). If Tesco takes away competitors' growth, suppliers will have to look back to Tesco for growth as they did in the middle of the last decade, when Tesco like for likes were much higher.

It is in the interest of Tesco stakeholders - Some short term pain for long term gain is almost always worthwhile. Tesco re-exerting, improving its relative growth and giving customers a better offer will suit its employees, its customers and its suppliers. If Tesco serves the interests of these groups, shareholders interests will ultimately follow. Of course short term, Tesco shares would suffer, but we believe that their longer term value would be greater than today.

Competition does not expect it nor do they want it - they will get caught on the hop. Phil Clarke is an unknown to many competitors and they are probably unaware of his strength of character, resolve and drive. They will be
expecting more of the same and will not expect a seismic shift in strategy - nor do they want one. The competition are happier with life and industry dynamics than Tesco is. If Phil undertakes a major repositioning quickly it will take the competition quite some time to react and Tesco will gain a major advantage.

New store restrictions - sooner or later we are likely to see intervention that will restrict new openings. This is likely to be done on a local market share basis and such a measure would inhibit Tesco more than the competition. Therefore it is in Tesco's interests to stop industry expansion now, before government intervention has a disproportionate impact on Tesco.

An end to excessive promotions - Promotional activity is at an all time high (over 40%) and retailers and suppliers are saying this cannot continue, but no retailer can stop unilaterally. An aggressive repositioning means the emphasis shifts back to base pricing rather than excessive promotions such as buy one get two free (we are unconvinced on the effectiveness of such promotions).

Weakened proposition - as in the early 1990s, Tesco has seen its relative offer weaken through deteriorations in pricing, service and quality (although we doubt if the company would ever agree). This is not a deterioration in each category against each competitor, but in each category against at least one major competitor. Tesco has been fighting on every front, but is now facing concerted attacks on each front by focused competitors, with better management than they have had in a long time. To deal with this, Tesco needs a step change in its value offer and reducing prices is the quickest way to do this.

McCarthy said he was talking about a permanent price cut, not a short term promotion, which of course would be music to the ears of those worried about the rapid rise in inflation through fuel bills, food costs and of course, the latest rise in VAT.

It's an intriguing argument but would Tesco really launch a price war to damage the competition - it may be big enough to shake off the worst effects, but such a move would hit all the supermarkets, including Tesco itself, and investors may not wish to hang around to see the long term benefits of such a strategy.

As it happens Tesco's shares are down 1.2p at 407.8p at the moment, while Morrisons has fallen 4.2p to 266.8p following a move by Morgan Stanley to cut its rating from equalweight to underweight and its price target from 295p to 240p.

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