Should you invest in Tesco?

Ed Bowsher asks if the appointment of Dave Lewis as its new CEO means you should go out and buy Tesco shares.

After years of poor performance, Tescos board decided to shake things up last weekend. The CEO got the chop and was replaced by a Unilever executive called Dave Lewis.Lewis has an excellent reputation so he may be able to turn Tesco around. So does that mean that now is good time to buy shares in the supermarket?

Transcript

Now, as you probably also know, Tesco share price has been performing pretty badly too. At the end of 2007, the share price was £4.77. Right now, this morning it's £2.75.

So with a new CEO coming in, and a low share price, you might think, this is the time to slip in quickly, do a bit of bargain hunting and buy some Tesco shares on the cheap. And there definitely are some good arguments for buying Tesco shares now.

For starters, in spite of all Tesco's problems it still has a big network of stores, and it has 28% market share in the grocery market. And if you look at some of the investment metrics, some of the ratios, it's on a price earnings ratioof 11, and it's on a dividend yieldof 5%. So that price earnings ratio, all other things being equal, 11 is low.

And what we're doing here is comparing the share price with profitability, and Tesco looks attractive on that basis. And the same goes with the dividend;you're getting a good return, if you invest at £2.75. And then the final buy-point for Tesco, is it's got a strong online retail business, which is growing pretty quickly.

And actually one of my colleagues, Bengt Saelensminde, thinks you should buy into Tesco now.And one of the reasons, is he thinks the online business has the potential to become the UK's Amazon, if you like.

Now as I said, they're all good arguments for buying Tesco shares, but personally I'm not going to invest, I think the sell arguments are even stronger. I think the really crucial point here is that Tesco made a big mistake in its strategy.

In the 1990s and early 2000s. It decided the future was big out-of-town hypermarkets. It built them all over the UK, we all know them, I'm sure you've been to at least one of these stores many times.

And 15 years ago the strategy did make sense. The idea was you drive every week, or couple of weeks, to one of these big Tesco stores, you'd stock up on all your food, and then every so often you'd buy some other stuff, whether that be clothes, fridges, TVs, DVD players, whatever. And that was a formula that did make Tesco money for at least a while, and it was a good case for believing it would carry on working.

But the problem is, we started buying a lot of those extra things, things like clothes and the kitchen appliances, we started buying those things online. And even with food, we're shifting more towards the convenience stores and the smaller shops that are nearer our homes. So that meant that these big out-of-town hypermarkets are becoming white elephants. They're not giving Tesco a good return on their investment. And you can measure this using a metric called return on capital employed.

Now, if you want to find out more about that ratio, I looked at it in more detail in a video called What is return on capital employed?Basically, it's a measure that looks at how much return a company gets on any investment it makes. And right now Tesco has a 9% return.

All other things being equal, that's too low. You'd expect supermarkets to have relatively low returns anyway, but 9% is just too low. And the fact is that even in the good times, Tesco's returns on capital were too low. People didn't really focus on that number, because what was happening was Tesco kept opening new stores, new stores, new stores, that meant revenue was growing, and profits were growing, and investors said, "Well, that looks great. I'm not bothered about the returns, let's just carry on buying more shares".

But now the growth has stopped, and we're now seeing all the problems coming through. And Tesco's hidden problems are hidden no more.

Another big issue for Tesco is the competition has got much stronger than 15 years ago. It seems it's got its act together, and we've also seen the rise at the bottom end of the hard discounters - people like Aldi and Lidl. And at the top end you've got people like Waitrose and Marks & Spencer, who have got stronger and hit some of Tesco's more luxury sales at the top.

Tesco is being squeezed from both ends of the market, and that's hurting it badly. And that's one of the reasons the market share has fallen from 31% to 28%.

So what can Tesco do?

Well one obvious thing to do is to cut its profit margin. One of Tesco's strengths is that it does have a high profit margin for a food retailer 6%. But with the competition coming from Aldi and Lidl, it can't sustain that kind of margin anymore, so its inevitably going to cut the margin, which will hopefully boost sales, but it probably won't boost sales enough to ensure that profits overall start rising. If you cut the margin, profits fall. OK, you get higher sales, but profits won't rise enough to offset the falling margin that you had to cut to fight off the falling discounters.

So as I said at the beginning, there are good arguments in favour of buying Tesco and against buying Tesco, but for me when you look at the whole picture, the case is clearly a no' for me.

I hope I've helped you make your own decision on this, and I hope whatever decision you make, it turns out right. I'll be back with another video soon, so until then, good luck with your investing.

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