Even though investor appetite for embattled grocery chain Tesco (LSE: TSCO) has become more tempered in recent weeks, I believe that the Cheshunt business remains chronically overvalued. The stock has still gained more than 20% since the turn of the year, propelled by optimism over chief executive Dave Lewis’ turnaround plan and improving checkout activity since late last year.
As a result, Tesco is currently changing hands on a P/E multiple of 23.1 times prospective earnings, based on City projections of a 5% bottom-line uptick for the year ending February 2016, to 9.85p per share. And this remains elevated at 18.3 times for fiscal 2017 as earnings are expected to surge by more than a quarter, to 12.39p.
But in my opinion Tesco’s current share price does not reflect the number of challenges it faces to return to earnings growth following three heavy annual declines. In fact, I believe that the supermarket should be trading on a P/E multiple closer to the benchmark of 10 times or below, territory usually occupied by companies with high risk profiles.
Consequently I believe that Tesco should be changing hands around 98.5p per share, a colossal 57% dip from current levels around 227p.
Tesco’s travails keep on stacking up
Critics of my position will point to Tesco’s improved steady sales uptick since last autumn, underpinned by waves and waves of discounting. But latest Kantar Worldpanel data indicated that these initiatives may be running out of steam, and the firm saw sales drop 1% in the 12 weeks to 26 April. And even though price deflation is taking a chunk out of the budget chains, Aldi and Lidl maintained the chokehold on Tesco by posting sales growth of 15.1% and 10.1% respectively.
And the discounters are determined to keep on beating Tesco et al on price — Matthew Barnes, head of Aldi’s UK and Ireland operations, recently told trade paper The Grocer that the firm intends to keep a 15% cushion between Aldi’s prices and those of Britain’s established chains. Of course the business of discounting is an ultra-expensive strategy, so just how far Tesco is prepared to go to keep chasing its new rivals should be cause for worry.
On top of this, Tesco is also facing intensifying pressure from premium outlets such as Waitrose, operators which — like their low-cost peers — are embarking on aggressive expansion plans to boost footfall. In addition, Tesco is also facing intensifying competition in the red-hot online supermarket category, while concerns have surfaced that the lucrative convenience store sub-sector is reaching saturation point.
Tesco also faces huge questions over how to turn around the fortunes of its flagging overseas operations. And closer to home the company still faces a Serious Fraud Office investigation over last year’s calamitous £263m profits overstatement, as well as a probe by the Groceries Code Adjudicator over the way it deals with its suppliers.
Given the sheer scale of these problems, I believe that Tesco is likely to experience intense scepticism over its earnings prospects in the coming months and years. Consequently, I am convinced that the business is in danger of another severe price correction.
