Just under eight years ago, Tesco’s (LSE: TSCO) share price came close to touching 500p. Since then the company has endured one of the most miserable periods in UK corporate history, with perhaps the banking sector and now the oil sector being the only places where it has been more difficult to do business than the supermarket sector in recent years.
As such, Tesco’s profitability has come under huge pressure, with it culminating in a pretax loss of £6.3bn last year. Clearly, that’s hugely disappointing – especially when just three years earlier it delivered a pretax profit of £4bn and seemed to be making a comeback of sorts.
Now, though, Tesco trades at under 200p per share, which is a fall of 60% from its all-time high. Many investors understandably believe that the company will never reach such heady heights again.
However, Tesco has the potential to do just that. For starters, it is set to become a very different business in the coming years, with it eschewing diversity and breadth of operations in favour of focusing its energy on being competitive at its core activity: a good value grocery retailer. As such, it is selling off a number of non-core assets, such as its film streaming service and Korean operations, while reinvesting heavily in store refurbishment and improved customer service. In other words, it is trying to add value to the shopping experience.
Tesco is also reducing the size and scale of its operations. For example, it is stocking a smaller range of products and, therefore, is likely to become more efficient as it turns over stock levels more frequently. Furthermore, it has shelved a number of new store openings; preferring to reinvest in maximising sales from its existing estate.
Certainly, Tesco’s turnaround plan will take time to come good. However, the new management team appears to be somewhat successful at managing the expectations of the market, since they have repeatedly stated that Tesco is in a challenging situation. However, with the UK economy continuing to improve, it could be argued that the company may enjoy a return of customers who have been shopping at no-frills operators such as Aldi and Lidl, since their disposable incomes continue to rise in real terms. As such, they may begin to favour the higher staff numbers, more presentable stores and larger range of goods (even under Tesco’s new strategy) which Tesco may argue are among its differentiators.
With Tesco forecast to increase its bottom line by 35% next year so as to post earnings per share of 10p, it would need to trade on a price to earnings (P/E) ratio of 50 to be priced at 500p. However, it currently has a P/E ratio of 20 so, assuming that its rating is maintained, the company would need to increase its earnings at an annualised rate of 20% in each of the next five years to trade at 500p and, in doing so, post a capital gain of 150%. Over ten years, the required earnings growth figure is 9.6%, which many investors may argue is very achievable.
Of course, 500p is a very long term target for Tesco and, in reality, the company’s shares may never reach that level again – especially since it is due to become a smaller entity. However, with a sound turnaround plan and an improving economic outlook, it still appears to be a worthwhile investment at the present time.
