Every little yelps

Tesco's short-term pain could yield long-term gain

It's tin hats time at Tesco. The UK's biggest retailer saw annual pre-tax profit for 2012-13 dip for the first time in 20 years, and shuttered its disastrous US foray, Fresh & Easy. But for investors, the long-term value from reinvigorating a behemoth with 29 per cent of the UK groceries market is worth the pain.

Shareholders should look past the main reason for the nasty-looking results. Tesco has written off capital invested in Fresh & Easy, but the operations still removed £1.2 billion from its bottom line. A further £1.4 billion of writedowns on Eastern European assets and UK land acquired in the boom are the main reasons why net profit fell 96 per cent. But these were all boils that needed lancing.

The real focus should be on Tesco's UK operations, which provide two-thirds of group revenue. Although the retailer had a decent Christmas period, like-for-like sales in the fourth quarter only increased by 0.5 per cent. In the 10 weeks to March 16, Sainsbury increased its own by over three per cent. Mis-steps such as finding equine DNA in some Tesco products didn't help.

Yet, Tesco has already diagnosed its problems. Last year it pledged 1 billion pounds to freshen up a quarter of its somewhat tired stores, and has appointed 8,000 new staff to improve customer service. This should help the top line. The decision to cut capital expenditure by 19 per cent and further embrace online retail instead of building more big stores should cut costs and help the bottom line.

If all goes well, Tesco could have earnings before interest, tax, depreciation and amortisation (Ebitda) of £5.7 billion by 2016, according to UBS. This could enable up to £7.4 billion of net debt without increasing its current leverage. Factoring in Tesco's likely actual net debt in 2016, that could mean £3 billion for debt buybacks or extra dividends.

Judging by the 3.4 per cent drop in Tesco shares on April 17, investors see this rosy picture as way off. If the UK economy stays depressed it may not materialise at all.

But Tesco has the right strategy. If it can execute it then 2012-13 will be seen as a recalibration rather than the start of a long decline.