Tesco (LSE: TSCO) is in a sorry state these days.
The supermarket chain is currently trading on a price/earnings ratio of 11. That would have seemed like an absolute steal three years ago.
But that was before the company’s performance really started to go off the boil.
This week, we’ve had an update on trading from the supermarket giant. So is now the time to buy, or are there still-harder times to come?
Tesco wants to have its cake and eat it
When Tesco’s boss, Philip Clarke, spoke to the press this week, he made it clear that he wanted to maintain the company’s operating profit margin somewhere around its current level of 5.2%. He rejected any suggestion of cutting that margin to 3% and launching a price war.
But I don’t think that’s going to work. I can see why Clarke doesn’t want to cut margins. But if he doesn’t, it merely leaves Tesco increasingly vulnerable to competition from low-price rivals.
The latest market share figures from Kantar Worldpanel show that the leading discounters Aldi and Lidl are growing fast. Aldi’s market share has soared from 3% to 3.9%. Both chains are aggressively opening new stores.
Meanwhile, at the posh end of the market – which Tesco has no real foothold in – Waitrose continues to grow its market share.
The rise of the discounters is a huge problem for Tesco. I don’t believe that a store modernisation programme on its own is enough to deal with this challenge.
After all, Tesco launched its £1bn modernisation programme a year ago, yet it still reported a 1.5% fall in UK like-for-like sales this week. In other words, if you exclude recent store openings, UK sales are falling.
Tesco is doing some things right in the UK. It’s slowing down the rate at which it is opening new hypermarkets. Amid competition from the internet, it is also trying to give people other reasons to go to its existing hypermarkets, by offering nice restaurants, yoga classes and other attractions.
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The launch of Tesco’s iPad knock-off, the ‘Hudl’, has also been a big success, selling 300,000 units so far. And continuing to open more high-street ‘Express’ stores is another good move – like-for-like sales are rising in this part of the business.
But these positive moves aren’t enough. The essential problem is that Tesco believes it can maintain its current margins whilst growing sales at the same time. That’s not going to happen.
As JP Morgan Cazenove recently pointed out, UK supermarket margins are higher than in other Western European countries such as France and Spain. That can’t last – as Aldi and Lidl grow, Tesco will have to accept that the UK market has changed.
To maintain sales, margins will have to fall and that will hit profits. Permanently. And if profits aren’t going to rise for some time, then the current share price isn’t cheap, regardless of the seemingly low p/e.
Forget the overseas branches – Tesco’s story is all about the UK
Tesco backers might argue that Tesco’s overseas operations in Asia and Eastern Europe are a promising source of future growth. Indeed, these overseas businesses were a big part of the bull case for Tesco a few years ago.
Back then, bulls would point out that Tesco was generating huge amounts of cash in the UK and using some of that cash to invest in promising businesses abroad – especially in Asia and Eastern Europe.
It was a great idea in theory – I even agreed with it at the time – and it’s possible that some of these foreign businesses will come good in the end. But there’s no sign of that right now.
Like-for-like sales in Europe are down 4% this week. Asian like-for-likes are down 5%. Those are big falls, and I wonder if the management team has the ability to reverse these declines.
And even if Tesco does turn these overseas operations around, they still only account for around a third of Tesco sales right now. The UK still accounts for two thirds.
So in the end, it’s the UK that counts. And as far as I’m concerned, I’ve lost faith in the company’s ability to fight off competition from the likes of Lidl while still maintaining margins. The share price has fallen 17% over the last two years (particularly drastic given the backdrop of a rising market). But it still looks too pricey for me.
I do think it’s possible to make good money from a retail revival in the UK. As the government pulls the stops out to pump up the economy ahead of the election in 2015 – George Osborne will no doubt be warming up for that today in his autumn statement – consumer spending is likely to get a boost. But there are better ways to play that. I looked at a few of them in a Money Morning last month.
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