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Supermarket wars heat up as Tesco takes on the discounters

A woman shops at a Tesco supermarket in Sunbury, west of London.
Adrian Dennis | AFP | Getty Images

Shares in U.K. supermarket Tesco finished up just shy of 10 percent in European trade on Wednesday, following forecast-beating first-half earnings and a confident outlook as far ahead as 2020.

The buoyant results were widely interpreted as evidence of the success of Tesco's turnaround plan, kick-started with the arrival of CEO Dave Lewis two years ago at a crisis point for the U.K.'s largest supermarket.

Tesco's bounce also pulled shares in its "Big Four" U.K. supermarket peers higher on hopes the results signal an inflection point in their hitherto losing battle against discounting rivals – primarily Aldi and Lidl -- in the brutally competitive domestic grocery arena.

Supermarket wars

Customers are going back to Tesco: Analyst

But analysts are split over how much of a long-term battle the traditional supermarkets can put up against the low-cost segment.

Sounding a more bullish note, Bruno Monteyne, European food retail analyst at Bernstein, described a trend of customers once lost to Aldi and Lidl heading back to Tesco.

"That's a major dynamic we haven't seen for years," he said.

"It shows the supermarkets have improved their offer, not just price but service and different ranges. It won't replace Aldi and Lidl but it's a valid alternative if you want broader ranges."

However, Philip Benton, senior research analyst at Euromonitor International, warned that the U.K.'s impending exit from the EU could disproportionally benefit the likes of Aldi and Lidl in the aggressive price wars.

"Brexit will be better for the discounters because of their lean supply chain," Benton said.

Tesco's prices have fallen 6 percent in the past two years and CEO David Lewis told reporters on Wednesday that he sees no let up in food price deflation, particularly in the short-term. In such an environment, the ability to manage supply costs becomes an even more critical lever with which to preserve margins.

"There will be tougher battles ahead with the discounters," Euromonitor International's Benton cautioned Tesco and its ilk.

While acknowledging this, Himanshu Pal, vice president at Kantar Retail, said that with both a defensive and offensive strategy, Tesco can put up a decent fight.

"Tesco will need to keep reinventing its price and quality value proposition," he said, stressing that discounters carry far fewer individual products than Tesco. As such, Tesco can "afford to price defend (match) without burning a massive hole in its pocket."

Furthermore, Tesco has other tricks up its sleeve, according to Pal.

"Shopper experience, digital immersion and analytics are some of the areas where discounters have traditionally struggled. This is where a multi-channel retailer such as Tesco can truly innovate and drive differentiation versus the discounters," he said.

Pension headaches

Brexit will be better for supermarket discounters: Analyst

Beyond the challenges posed by fierce competition, also generating headlines on Wednesday was the monumental spike in the group's pension deficit. The company was hit with a jump in liabilities hurt by the ongoing suppression of interest rates by central banks and the further slide in bond yields witnessed since the Brexit vote.

Tesco's pension deficit has swelled from the £2.61 billion ($3.3 billion) figure recorded in February to £5.85 billion pounds this quarter. Although this is a paper problem rather than a cash problem for now, the more-than doubling of the obligation took some shine of the brighter outlook.

Given the mix of news in today's report, analysts were divided whether Tesco's interim results were enough to justify such heady enthusiasm from investors, which by afternoon trade saw the stock up over 13 percent.

Bernstein's Benton signified the stock was worth at least evaluating, saying: "It's a good stock to be looking at, but in terms of long term investment it's something you need to be looking at very carefully."

Striking a more positive tone, however, Monteyne suggested that Wednesday's rush of investors who hit the buy trigger could be picking up a bargain.

"For retailers in tough times, the only measure that's a little bit reliable is free cash flow… On these current numbers, Tesco is said to have double digit, 10, 11, 12 percent free cash flow yields. That is damn cheap for a boring, steady retailer," he said.

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