After a tumultuous couple of years, all eyes are finally back on Tesco (LSE: TSCO) for the right reasons as 2016 proved the first year since 2009 that the grocer posted positive like-for-like sales growth and adjusted operating margins crept up from 1.8% to 2.3%.
These results are certainly to be welcomed as CEO Dave Lewis has done well to right the ship internally and bring the company out from under the cloud the accounting scandal created. Unfortunately, while the business is in much better shape than it was two or three years ago, I see little reason to believe it can regain the dominance it once had in the UK grocery market.
This is important because, with its shares priced at a rich 18.6 times forward earnings, many investors seem optimistic that it can return to the halcyon days of dominant market share, operating margins that were regularly above 6%, and bumper dividend payouts.
The problem is that it has been left flat-footed by dramatic shifts in consumption patterns and the rise of discount retailers that have slashed footfall at big-box supermarkets and led to significantly lower profitability. The detrimental effects of these patterns are clear in Tesco’s market share, which has fallen from 30.7% in 2010 to 27.8% in the three months to May and continues to slip.
And while Tesco is doing well to finally post positive same-store sales growth, its target for operating margins hitting 3.5% to 4% by 2020 makes clear that management itself doesn’t anticipate a return to those once-stellar margins any time soon. With Aldi and Lidl continuing to increase their market share at a rapid clip and prices across the industry still subdued, there’s little hope of profitability returning to those halcyon days.
Of course, this still leaves Tesco a healthy, profitable business, but at its current valuation and with such limited scope for growth, I reckon investors are better off elsewhere if they’re looking for a turnaround.
A proven path to profits
A more interesting comeback story is one of Tesco’s suppliers, Mcbride (LSE: MCB), which produces own-label household cleaning and personal care products for retailers. The business ran into trouble a few years back as growth stagnated and profits dipped due to pricing pressure from customers and rising production costs. But it is once again on the right track.
The company’s management team has spent the past two years focusing on cutting operating costs and simplifying its production base to improve margins. This plan is already paying dividends as earnings have increased by double-digits in each of the past two years as it has brought adjusted operating margins up to 6.2% and won new contracts with fast growing discount retailers.
The renewed focus on profitability is clear in the company’s half-year results to January, which saw operating profits jump 30.1% y/y at actual exchange rates and a still great 9.6% in constant currency terms. And with further simplification to product development and manufacturing processes in progress, there’s considerable scope for even higher profitability.
With its shares priced at just 13.9 times forward earnings despite improving margins, cash flow and level of leverage I reckon McBride is a very attractively priced turnaround story.
