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Was I dead wrong about Tesco plc?

Photo: C41n. Cropped. Licence: https://creativecommons.org/licenses/by-sa/3.0/

The recent Marmitegate spat with Unilever may have garnered more headlines, but shares of Tesco (LSE: TSCO) have quietly been enjoying a bumper 2016 and are up 42% year-to-date. For those of us who were bearish on Tesco this offers a great opportunity to reassess our position and determine whether the grocer has dealt with the many problems it’s facing. 

The accounting scandal

Dave Lewis’s nasty surprise on taking the reins at Tesco put a cloud over the grocer that has yet to lift. The Serious Fraud Office recently charged three former managers in relation to profit inflation and could yet end up levying a fine against Tesco. While it has cooperated with the investigation it’s far too early to say that the company has put the scandal behind it, especially when fines could potentially stretch up to 400% of the perceived gain from any wrongdoing.

Falling market share

There was good news on this front as Kantar Worldpanel data for the three months through early October recorded a 1.3% increase in sales, the first positive movement in 18 months. However, it’s too early to celebrate yet as Tesco’s market share is still significantly lower than it was even a few years ago and budget chains continue to grow by leaps and bounds.

Price wars crimping profits

The big four traditional grocers appear to have learned their lesson and have recently refrained from the worst of margin-destroying discounting they engaged in over recent years. That said, the potential is still there for price competition to once again cause problems if, for example, Asda made a concerted push to claw back market share. Recent data on the subject has been positive for Tesco but investors shouldn’t completely rule out another scramble for volume over pricing by any of the major players.

Shrinking margins

Unsurprisingly, the confluence of above problems led to operating margins collapsing from the 5%-6% range in the late 2000s to the 0%-1% range in the past few reporting periods. Interim results for the six months through the end of August contained great news on this front, though. UK operating margins leapt from 0.8% to 1.8% year-on-year and group margins were a solid 2.2%. This gain marked significant forward progress towards achieving the stated goal of 3.5%-4% operating margins by 2019/20. Achieving this target range will still leave margins much lower than they were less than a decade ago, but any improvement should still be cheered.

Falling dividends

Dave Lewis reiterated in his latest conference call that it’s too early to think about dividends making a reappearance. But, net debt did fall to £4.4bn in August, cash flow from operations is picking up significantly and with earnings finally gaining positive momentum analysts are expecting a return to dividends within the next two years.

With the shares up over 40% in the past 10 months I was obviously wrong about Tesco in the short term. However, competition from discounters is only increasing and with little prospect for top line growth Tesco still isn’t a share I want to hold for the long term.

Luckily, there are still major blue chips out there that offer the diversification, global reach, reliable profits and steady dividends that Tesco once did. In fact, the Motley Fool's analysts have collected their favourites for their latest report, Five Shares To Retire On

Wide moats to entry for competitors, selling daily necessities people always buy and significant pricing power from beloved name brands have made these five investor darlings for decades. 

To read your free, no obligation copy of the report, simply follow this link

Ian Pierce has no position in any shares mentioned. The Motley Fool UK owns shares of and has recommended Unilever. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.