Advertisement

Shares in focus: The Tesco turnaround

Supermarket giant Tesco is restructuring and its shares are on the up. Should you buy in, asks Phil Oakley.

The retailer is restructuring and its shares are on the up. Should you buy in? asks Phil Oakley.

Tesco's bucket-load of problems was plastered all over the financial press for much of 2014. The supermarket giant will be hoping that 2015 is a better year, and that it can start the process of rebuilding its profits and restoring its reputation with investors.

Advertisement - Article continues below

Last week, Dave Lewis, the company's new chief executive, announced a strategy to put Tesco back on track. After he discussed his plans, the share price jumped by 15% although it's by no means certain whether this was because investors liked what they heard, or were just mightily relieved that things hadn't got any worse.

So here's the question for anyone eyeing up the shares: is Tesco really ready to take on its competitors again, or will last week's exuberance prove to be short lived?

The outlook

For much of the past 20 years, Tesco has been lauded as a retail champion and seen as a great success story. Throughout the 1990s and the early 2000s, this reputation was probably justified.

Advertisement
Advertisement - Article continues below

But for much of the last decade, Tesco has not been a good business from an investor's standpoint. Yet its share price and legion of fans kept on growing.

Why do I say this? Ultimately, companies grow and make profits by using the funds raised from their lenders and shareholders to make good investments. Companies that achieve this have lots of desirable characteristics.

Advertisement - Article continues below

Speaking from a financial perspective, I'd single out three specific ones. Profits should be growing. There should be a high return on capital employed (ROCE). And the company should be turning those profits into cash.

Tesco had the first one of these, but it fell down badly on the other two. So when its profits stopped growing, it shouldn't have come as a great surprise that its share price tanked.

So will Lewis's strategy make Tesco great again? It would be a great achievement if it could. But I don't think that it can. Here's why.

A lot of what Lewis is trying to do looks sensible. Closing loss-making stores and stopping the opening of big superstores is a good decision. So is the selling of peripheral businesses, such as the Blinkbox internet television service, and the possible sale of others.

The goal here is for Tesco to save £250m and use that money to cut prices so that it can be more competitive.

Advertisement - Article continues below

However, I can't help thinking that some of its proposed cost-cutting could backfire. For a start, shutting the final-salary pension scheme to all employees is unlikely to have a good effect on staff morale.

Advertisement
Advertisement - Article continues below

Meanwhile, cutting investment is something that Tesco should have done years ago. Over the last decade it has ploughed nearly £35bn into the business (excluding acquisitions) and doesn't really have that much to show for it.

But it can cut too far. The proposed capital expenditure of £1bn next year is below the £1.3bn annual depreciation charge (this is an estimate of the amount of money needed to maintain a company's asset base). That could mean that Tesco's supermarkets start to look more scruffy than some already are. This won't help maintain customer loyalty, or win new customers.

That's a potential problem. Cost cuts can only take the company so far. Tesco needs meaningful sales growth if its profits are to start expanding again. It looks as though the company did a decent job over Christmas, as sales only fell slightly.

Advertisement - Article continues below

But I think that Tesco and Sainsbury's, Asda and Morrisons, for that matter will all find it really hard to grow their sales. Tesco looks well placed in areas such as online and convenience stores. But I think it will struggle to get more money through the tills of its supermarkets.

That's because the UK's grocery market is barely growing. Instead, it is fragmenting into different segments. The rapid growth of discount retailers, such as Aldi and Lidl, is hurting the big four supermarkets, while Waitrose is growing successfully at the top end.

Tesco looks like it's starting a price war by cutting the prices of 380 branded items by an average of 25%. This might put pressure on Aldi and Lidl, whose low prices tend to come from unbranded goods. But Tesco's bigger rivals, such as Sainsbury's and Asda, will match these cuts and might be in a stronger financial position than Tesco to weather the storm.

Advertisement - Article continues below
Advertisement
Advertisement - Article continues below

In a sector that is already seeing falling prices, this move by Tesco will just squeeze prices even harder. To grow sales when prices are falling, you have to believe that Tesco will win back a lot of customers and that those who have stayed loyal will put more goods in their trolleys. This looks like a major gamble.

Although falling petrol prices have given household finances a bit of a boost recently, they are hardly healthy after years of stagnant wages and high levels of debt. I just can't see households spending more money on their weekly groceries. And if they don't, then profits at Tesco are unlikely to grow and could even fall further.

Last, but not least, there's the important issue of the valuation of Tesco's shares. Tesco as a business has been in some distress but its share price of 204p suggests that its valuation is not. At 15 times expected February 2016 earnings per share (EPS), they just don't look that cheap. The earnings yield of just 5.8% (EBIT/EV), based on February 2015 trading profits of £1.4bn, is similarly unattractive.

Tesco might prove me wrong and deliver a fantastic turnaround in its fortunes. However, it looks as if a decent chunk of improvement is already priced into its shares.

I'd be interested in buying at around a pound lower than the current price, but the rewards on offer from here compared to what are still very high risks mean I'd stay well clear of the shares.

Verdict: avoid

Tesco (LSE: TSCO)

725-Tesco

What the analysts say

Advertisement
Advertisement

Recommended

Visit/investments/stocks-and-shares/share-tips/600641/share-tips-of-the-week
Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
17 Jan 2020
Visit/519913/share-tips-8-stocks-for-robust-returns
Share tips

Share tips: eight stocks that should deliver robust returns

Ryan Ermey of US publication Kiplinger’s Personal Finance chooses his favourite stocks for the next decade, which should be able to grow for years.
28 Dec 2019
Visit/519724/share-tips-of-the-week-166
Share tips

Share tips of the week

MoneyWeek’s comprehensive guide to the best of this week’s share tips from the rest of the UK's financial pages.
20 Dec 2019
Visit/519447/tesco-should-keep-its-asian-assets
Stockmarkets

Tesco should keep its Asian assets

The £7bn that Tesco could get for its Tesco Lotus business in Asia looks enticing. But holding on to it would be smarter, says Matthew Lynn.
15 Dec 2019

Most Popular

Visit/investments/property/601606/house-prices-crash-uk-property-prices-falling-where-next
Property

House price crash: UK property prices are falling – so where next?

With UK property prices falling for the first time in eight years, are we about to see a house price crash? John Stepek looks at what’s behind the sli…
2 Jul 2020
Visit/economy/inflation/601584/the-end-of-the-bond-bull-market-and-the-return-of-inflation
Inflation

The end of the bond bull market and the return of inflation

Central bank stimulus, surging post-lockdown demand and the end of the 40-year bond bull market. It all points to inflation, says John Stepek. Here’s …
30 Jun 2020
Visit/investments/stockmarkets/601611/nasdaq-all-time-high-markets-and-the-real-economy
Stockmarkets

How can markets hit new record highs when the economy is in such a mess?

Despite the world being in the midst of a global pandemic, America's Nasdaq stock index just hit an all-time high. And it's not the only index on a bu…
3 Jul 2020