A year ago, with the shares at 210p, I was bearish on Tesco (LSE: TSCO). Today, with the shares down to 147p, I remain bearish on the supermarket giant and see potential for the shares to fall by half from here to around 70p.
This is why
Tesco seems unlikely ever to return to former glories. The supermarket chain was built and became dominant in an era when the food retailing landscape was different. Back then, the firm’s business model worked.
Now, the ferocious attack from upstart low-cost rivals such as Aldi and Lidl has forced giants like Tesco into retreat. Tesco has halted its expansion programme in the UK, is selling off assets as fast as it dares to, and has engaged the lower-cost chains head-on in a price battle. That’s a poor set of circumstances, which makes it even harder than it was before for Tesco to thrive. And that’s really saying something, because the supermarket business has always been very competitive.
We gained a strong flavour of the depth and breadth of the daunting challenges facing Tesco when the firm released its interim report back in October. The company set out its three key priorities:
- To regain competitiveness in its core UK business.
- To protect and strengthen its balance sheet.
- To rebuild trust and transparency.
These are big issues. A firm doesn’t have much going for it when it has lost its competitive advantage, has a weak and threatened balance sheet, and when its customers, investors and partners no longer trust it.
There’s no magic ‘fix’ for this. Tesco needs to be rebuilt from the ground up. The firm’s very culture needs to change, but I fear that it’s already too late and we may be seeing the start of managed decline for this once-mighty Goliath.
A pricey valuation
Of course, Tesco is trying to turn itself around. A series of cost-cutting measures and changes in operational practice will have some effect in the short term. Indeed, City analysts following the firm expect earnings to rebound by as much as 78% for the year to February 2017. However, such growth in earnings seems likely to be transitory. For the long haul, I’d wager that Tesco is likely to struggle to grow its earnings.
Despite the firm’s problems, investors keep the shares on a forward price-to-earnings rating of about 16. That’s a severe case of counting chickens before they’ve hatched. Why give a firm the benefit of the doubt when it has just proved its ability to underperform? Turnaround hopes seem misplaced here, and in any case I’d set the firm’s rating at about eight – half what it is now – and allow for upside surprises rather than downside shocks. That’s why I think Tesco is only worth about 70p per share today.
