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How Will Tesco PLC Fare In 2014?

For most shares in the FTSE 100, 2013 has been a good year and investors havelikely enjoyed capital gains and rising dividend income.

That makes me nervous about investing for 2014 and beyond, and I’m going to work hard to adhere to the first tenet of money management: preserve capital.

To help me avoid losses whilst pursuing gains, I’m examining companies from three important angles:

  • Prospects;
  • Risks;
  • Valuation.

Today, I’m looking at international supermarket chain Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US).

 

Track record

With the shares at 355p, Tesco’s market cap. is £28,673 million.

This table summarises the firm’s recent financial record:

Year to February 2009 2010 2011 2012 2013
Revenue (£m) 53,898 56,910 60,455 63,916 64,826
Net cash from operations (£m) 3,960 4,745 4,239 4,408 2,837
Adjusted earnings per share 29.06p 31.8p 36.45p 40.31p 35.97p
Dividend per share 11.96p 13.05p 14.46p 14.76p 14.76p

1) Prospects

Tesco investors are no doubt looking for success on two fronts: a turnaround and return to form in the UK, and profitable expansion abroad.

Looking at the recent interim results, it’s clear the firm has much to do; underlying earnings declined by 7.92% in the first half compared to the year-ago figure. That comes on top of last year’s full-time 14.5% reduction in underlying profits so, with my glass-half-full hat on, there’s evidence that the rate of decline in earnings is slowing, and the potential for a successful UK turnaround and return to earnings growth remains.

Last year, the UK delivered around 65% of underlying trading profit, so the home market is important. A catch-up investment programme aims to refresh the tired-looking UK store estate in an effort to win back the firm’s leaky customer base. 

Meanwhile, in Asia, which delivered 19% of the firm’s profits last year, a new partnership with China’s leading food retailer should provide a stable growth platform in the world’s most populated country.

2) Risks

In the UK, Tesco seems to be in every community, on every street and in every out-of-town shopping location. In 2011 Tesco’s sales were around three times its nearest supermarket rival, Asda.

With size, and market saturation, there is risk. We’ve seen what can happen when a winning team takes its eye off the ball in Tesco’s profit results. By its own admission, Tesco was running its UK store estate “too hot.” In other words, reinvestment was insufficient to maintain Tesco’s edge in the UK market and now the company finds itself engaged in a frantic catch-up investment programme to reverse the decline. Meanwhile, eager upstart competitors like Sainsbury’s, Morrisons, Asda, Aldi and Lidl continue to snap at Tesco’s heels, grabbing market share as the top dog slumbers.

It’s not easy abroad, either. Tesco started trading in Hungary in 1995; Poland, Slovakia and the Czech Republic in 1996; Thailand in 1998; South Korea in 1999; Malaysia in 2002; Turkey in 2003; China in 2004; and the USA and Ireland in 2007. Last year, around 35% of on-going underlying profit came from abroad, so earnings growth overseas has a long lead time, assuming it materialises at all. Indeed, Tesco recently pulled out of Japan and the US after finding those markets too tough to crack.

3) Valuation

Success abroad might feel like something of a slow burn, but the potential still exists for earnings growth if Tesco can succeed in large markets like China. If the firm can pull off the double whammy of foreign expansion and lifting its home game back to previous form, investors might see a good result on total returns over a period of a few years.

At the current 355p share price, there’s a forward dividend yield of around 4.4%, which City analysts expect forward earnings to cover around twice in 2015. The forward P/E rating of about 11 prices in expected earnings growth of 4%.

Conclusion

Tesco shares are not screamingly expensive but, if earnings stagnation persists, it is conceivable that the P/E rating could contract from here. On the other hand, the prospect of foreign expansion continues to attract.

Using dividend yield as a guide, I'm torn between Tesco's 2014 prospects and those of a company identified by the Motley Fool's top value investor who has discovered one of the most alluring income-generating plays on the London market.

It's an investment proposition that is already strong and not dependant on management turning the business around or succeeding in new markets, which should help me keep hold of my invested capital.

He sets out his three-point investing thesis in a report called "The Motley Fool's Top Income Share", which I recommend to you for your own research and due diligence. The report, setting out the attractions of this dividend-generating star, is available now by clicking here.

> Kevin does not own shares in Tesco. The Motley Fool owns shares in Tesco and has recommended Morrisons.