The Only Way Out For Tesco PLC

Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) shareholders are in pain, but their future could be bright if the food retailer takes decisive action on its asset base. In short, European operations should be fully divested, even at a paper loss. Only then, Tesco may be a bet worth considering. Today, its fair value is £2.33 a share.

First-Quarter Figures

Tesco reported first-quarter results on Wednesday, when it announced a 3.8% fall in like-for-like sales in the UK. Elsewhere, international sales “rose by 0.5% at constant exchange rates, with a significant currency impact resulting in a sales decline of (8.0)% at actual rates,” Tesco said. Its performance in Asia is not acceptable, either.

Things aren’t moving in the right direction and it doesn’t look like Tesco has bottomed out yet. In fact, quarterly declines in sales are accelerating and about one million customer visits per week are being lost on a like-for-like basis, according to certain estimates.

Tesco stock was up 0.92% at 8.31am, making an attempt to recoup some of the value it had lost in the days before first-quarter results were released. It was down almost 1.5% at 10.00am.

Mr Clarke

“Our accelerated plans are making a real difference for customers and we are more competitive than we have been for many years,” CEO Philip Clarke noted.

Under his reign, value destruction has been the name of the game. Trust has gone out of the window. Rather, Tesco should inform the investor community that its strategy is very simple: it’s going to shrink to get fitter. Tesco is intent on “building long-term customer loyalty,” but who is loyal these days?

Mr Clarke needs to be bold and announce a drastic turnaround plan that not only focuses on the size and format of Tesco’s shops but also focuses on the geographical reach of the “New Tesco”. Once that is done, Mr Clarke will have to re-visit the business model of Tesco in the UK, considering a more diverse and smart online platform. What to do with domestic hypermarkets and supermarkets that don’t make their cost base should also be high on the agenda.

Since the departure of Sir Terry Leahy, Tesco has struggled with the concept of “sustainable growth”. Its stock hit an all-time record of £4.91 in November 2007, but seven years ago its revenues were £20bn lower than today.

Tesco Without Europe

Tesco turns over £43bn from the UK, £10bn from Asia and £9bn from Europe. Its pre-tax operating profit is £2.1bn (4.9% margin) in the UK, £683m (6.8%) in Asia and £221m (2.4%) in Europe.

Not only is Europe a drag on profitability, and hasn’t grown for years, but Tesco is investing less there. Capital expenditure has dropped from £833m two years ago to £281m in the last fiscal year. A lack of competitiveness will result in further loss of market share.

A full exit from Europe — just like Tesco did in the US and Japan — would benefit Tesco’s profitability and would free up capital that may be re-invested in less capital-intensive operations and/or in shareholder-friendly activity.

“In Europe, like-for-like sales were positive in the Czech Republic, Hungary, Poland and Turkey,” Tesco said on Wednesday, but its European operations are at least problematic.

There are signs that Tesco is considering to shrink in certain countries. More drastic measures are needed, however, or a fall in its valuation will be inevitable. 

There’s little value in Tesco these days. Its stock is cheap, of course, but could get much cheaper. The company operates in a very competitive market and is struggling to grow cash flow. If you are still searching for value, however, we have identified a few stocks in our latest report that make for a better investment.

There are plenty of choices with regard to the sector and the risk profile of the investment you require. We have also looked at recent IPOs and how they have performed, including Royal Mail's. And we suggest alternative investments that could yield market-beating returns.

Finally, we answer a key question: where is the smart money heading next?

Alessandro doesn't own shares in any of the companies mentioned. The Motley Fool owns shares in Tesco.