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Tesco plc’s 2 Greatest Weaknesses

Tesco

When I think of supermarket-chain Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US), two factors jump out at me as the firm’s greatest weaknesses and top the list of what makes the company less attractive as an investment proposition.

1) Low margins

Selling food has great repeat-purchase attractions but dealing with such an undifferentiated commodity inevitably leads to low profit margins. For example, last year Tesco’s post-tax trading profit of £1,386m came in at just over 2% of its £64,826 million turnover. Now, that is admittedly a lot of profit, but it’s a mind-numbingly large amount of turnover when counted in, say, packets of butter.

Think of the vast operational effort required to manoeuvre that packet of butter, our metaphor for all Tesco’s goods, from the butter maker to our shopping bags. Think of the human effort represented by all Tesco’s staff, the cost of providing and maintaining the buildings the product is sold in, the systems for management and tracking of goods and monies, transportation and the myriad other things required that are part of the service Tesco provides with its business. When you add it all up, there’s huge potential for something to go wrong enough to wipe out what small profit the firm is making on each item it handles. In other words, there’s a lot of risk, and that is why investors watch sales figures so keenly: one little slip in the big sales number, or in the big number labelled costs, can lead to a stomach-churning movement in the ‘small’ figure representing end profit.

2) Market saturation

Investors are often attracted to Tesco for its overseas growth prospects. But, if you switch that onto its head, we could argue that Tesco ‘has’ to expand abroad because there’s nowhere else to go in Britain. The firm has done a good job of engraining itself into the hearts and minds of British consumers; there’s a Tesco supermarket near just about every town and on nearly every metaphorical street corner.

Tesco has done well in the UK and has played at the top of its game. Therein is the risk. When you reach such a standard, it’s hard to keep it up, and we recently saw a glimpse of what can happen when things slip: Tesco allowed its UK store estate to get tatty, service-levels slipped, and customers voted with their feet. Tesco ended up scoring lower on its British sales figures and pitched into a frantic catch-up investment programme to restore standards and re-attract its previously loyal customers.

Meanwhile, what of efforts to expand overseas? It’s not easy, and during the same period, the firm pulled out of the US, chalking the market up as one it couldn’t crack.

Tesco is attractive for its steady cash flow, which offers the potential of a reliable dividend payment. Growth, on the other hand, is a harder nut when you get to be the company’s size.

That's why I'm thinking big while investing small and hunting for bargain opportunities under the city's radar.

There's no doubt that, potentially, better returns from stock market investing can be generated by searching for smaller companies with more room to grow. To me that means looking at firms too small to qualify for a FTSE 100 listing.

If you feel the same, you'll be interested in reading a Motley Fool report called Ten Steps to Making a Million in the Market. To get your copy, click here.

> Kevin does not own any Tesco shares. The Motley Fool owns shares in Tesco.