It’s been a good few years for shareholders in the UK’s largest supermarket. A steady recovery in profitability has seen the Tesco (LSE: TSCO) share price rise by 35% in five years. That’s more than three times the 11% gain delivered by the FTSE 100 index over the same period.
If you’d invested £1,000 in Tesco five years ago, your shares would be worth around £1,350 today. You’d also have received dividends totalling 12.6p per share, or about £70.
It’s not a bad result, in my view. But much of this turnaround has been credited to ‘Drastic’ Dave Lewis, who took over as chief executive in 2014. Drastic Dave resigned recently and will leave the business in summer 2020.
If you’re a shareholder, you may be wondering whether to follow Mr Lewis out or sit tight and hope for further gains. Here’s what I think.
Dark days
To understand the changes made by Mr Lewis, I think we need to understand the problems Tesco was facing five years ago.
Back in 2014, the firm was sick. The company was found to have overstated its profits by £263m. Sales were falling and profits margins were collapsing. Pre-tax profit fell by more than 50% in 2014/15.
The group’s net debt had risen to £7.5bn — a level some analysts thought would be unsustainable without a rescue fundraising.
Customers were leaving the UK’s largest supermarket and shopping at discounters Lidl and Aldi. In addition to this, Tesco had gained a reputation with its suppliers for aggressive negotiating and slow payment.
It wasn’t a good time.
A lasting improvement
Mr Lewis has managed to address all of these issues in five years. Customer satisfaction ratings have improved, sales have returned to growth and the retailer’s profit margins have been repaired. The latest half-year results show the group delivering an underlying operating margin of 4.4%, up from just 2.2% in 2014/15.
Although Mr Lewis was forced to suspend the dividend between 2015 and 2018, he’s been able to cut debt and restructure the business without needing to ask shareholders for cash. The sale of the group’s Korean business raised much-needed cash, while the acquisition of wholesaler Booker has provided a welcome injection of growth.
What’s next?
The question for shareholders is what comes next? Tesco shares now trade on nearly 15 times 2020 forecast earnings, with a dividend yield of 3.3%. I’d view this price as fair, but certainly not cheap.
I expect continued incremental growth in the UK, helped by the firm’s wholesale and banking divisions. However, a more dramatic change could be in the pipeline if the company decides to sell its Asian operations. A review of these businesses is currently under way, following “inbound interest” from potential buyers.
The Asian stores are by far the most profitable part of Tesco’s business and reported an operating margin of nearly 6% last year. On the other hand, sales and profits have been falling in Asia as the firm has struggled with changing market conditions. This could become an uncomfortable distraction for a UK-based firm.
On balance, I’d view the sale of Tesco’s Asian stores as a positive development, allowing the firm to remain tightly focused on its core UK operations.
For now, I continue to see Tesco as a long-term buy-and-hold stock. If I was a shareholder, I’d sit tight.
