A To-Do List For Tesco PLC’s New Boss

The shares of Tesco PLC (LON:TSCO) could be about to bottom out, argues this Fool.

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

TescoSo, Philip Clarke is stepping down. That didn’t come unexpected, did it?

Dave Lewis, the new boss of Tesco (LSE: TSCO), doesn’t have much experience in the supermarket space, but if Mr Lewis gets his priorities right then the shares of the largest food retailer in Britain could be a bargain, particularly if weakness in their valuation persists. 

Analysts estimate that Tesco stock is worth between 230p and 360p. It currently trades at £275p. Its fair value is 233p, in my view.

1) Assets Base

Tesco must shrink to preserve its core operations in the UK. I voiced concern about its Japanese and US operations well before they were sold.

The retailer has recently received the green light from state authorities to combine its Chinese operations with those of state-run China Resources Enterprise, retaining a 20% stake in a joint venture with sales of £10bn. 

While the allure of growth has led many retailers to believe that Chinese expansion was worth heavy investment, for generalist retailers such as Tesco, China has not been the answer so far. The Chinese retail market is highly competitive, with the top 10 food retailers boasting tiny shares and very little pricing power. “Cannibalisation” is of paramount importance in Tesco’s strategy, but it has become a very expensive strategy in countries where operations are sub-scale. 

(Elsewhere, the food sector in China is under the spotlight today — and for all the wrong reasons.)

Tesco should consider partnerships in Europe, too, before a full exit occurrs there. As I recently argued, European operations should be fully divested even at a paper loss. Strategic partnerships are a valid alternative, yet full attention must be devoted to the UK market, where web presence, the format of shops, and loyalty programs pose problems. 

2) Return On Equity

Return on equity (ROE) is a key metric to gauge the performance of management. Tesco’s ROE before losses from discontinued operations stood at 12% in 2014. Tesco is struggling to grow its core business, so in order to boost its ROE, it can decide to cut costs — as it has done in recent quarters — or to raise more debt.

This is where things get complicated. High leverage for food retailers in the UK would be very risky, but Tesco’s payout ratio is under threat, while its net leverage is manageable. Raising cheap debt could be an opportunity.  

3) Capital Deployment

Management should state their intention to preserve the payout ratio. Debt financing could be used to support dividend payments, whose sustainability has been questioned in recent days. Banks won’t pull the plug on such a key client if business prospects deteriorate.  

Tesco may also state its intention to undertake shareholder-friendly activity. A £1bn debt-funded buyback would likely be accretive to earnings, and could be combined with targeted divestments. For instance, £1bn of proceeds from asset sales would help Tesco offset a rise in its net debt position, meaning net leverage would likely remain constant. This assumes a minimal loss of earnings from disposals. Such would be the case for ad-hoc divestments in Europe, which recorded a gross trading profit of just £238m in 2014.

The Press/Carrefour

“Tesco’s major strategic problem was no one was quite sure what it was for – it was marooned between the more upmarket offer of Sainsbury’s and Waitrose and the value offer of Aldi and Lidl,” the BBC reported in the wake of Mr Clake’s departure.

It’s not unusual to read such comments about Tesco these days. In truth, Tesco’s problems are much deeper and they started to show as soon as international expansion plans were implemented. The press has also drawn parallels with another troubled retailer, France’s Carrefour, since Mr Clarke resigned.

Carrefour, the third-largest food retailer in the world, has gone through several changes of leadership over the years. It had to shed assets, too. From a 10-year high of EUR57.4 in 2007, Carrefour shares plunged to a record low of EUR13.7 in 2012, but they have rallied to record a 100% performance since.

Tesco is a better business than Carrefour, so there’s no reason why its shares shouldn’t bounce back if the right strategy is executed. 

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Alessandro Pasetti has no position in any shares mentioned. The Motley Fool owns shares of Tesco.

More on Investing Articles

Investing Articles

Could the JD Sports Fashion share price double in the next five years?

The JD Sports Fashion share price has nearly halved in the past five years. Our writer thinks a proven business…

Read more »

Bus waiting in front of the London Stock Exchange on a sunny day.
Investing Articles

If interest rate cuts are coming, I think these UK growth stocks could soar!

Falling interest could be great news for UK growth stocks, especially those that have been under the cosh recently. Paul…

Read more »

Investing Articles

Are these the best stocks to buy on the FTSE right now?

With the UK stock market on the way to hitting new highs, this Fool is considering which are the best…

Read more »

Petrochemical engineer working at night with digital tablet inside oil and gas refinery plant
Investing Articles

Can the Centrica dividend keep on growing?

Christopher Ruane considers some positive factors that might see continued growth in the Centrica dividend -- as well as some…

Read more »

Smiling family of four enjoying breakfast at sunrise while camping
Investing Articles

How I’d turn my £12,000 of savings into passive income of £1,275 a month

This Fool is considering a strategy that he believes can help him achieve a stable passive income stream with a…

Read more »

Person holding magnifying glass over important document, reading the small print
Investing Articles

2 top FTSE 250 investment trusts trading at attractive discounts!

This pair of discounted FTSE 250 trusts appear to be on sale right now. Here's why I'd scoop up their…

Read more »

Smiling young man sitting in cafe and checking messages, with his laptop in front of him.
Investing Articles

3 things that could push the Lloyds share price to 60p and beyond

The Lloyds share price has broken through 50p. Next step 60p? And then what? Here are some thoughts on what…

Read more »

Young female business analyst looking at a graph chart while working from home
Investing Articles

£1,000 in Rolls-Royce shares a year ago would be worth this much now

Rolls-Royce shares have posted one of the best stock market gains of the past 12 months. But what might the…

Read more »