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Why Is Tesco plc So Cheap?

TescoI’ve been taking a gander at the FTSE 100, and the valuations of its top companies.

And with recession behind us and strengthening economic growth on the horizon, I really can’t work out why so many are on such low P/E valuations.

Take Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) for example, on a forward P/E of only 11… well, I do understand why that one is so cheap. But that doesn’t mean I agree.

Falling sales

Ever since that dreadful Christmas period a few years ago, Tesco has been struggling to show why it deserves to be by far the UK’s biggest seller of groceries. And despite news of stores being refurbished and coffee shops being bought out, sales continue to slide.

For the first quarter of this year, Tesco reported a 3.7% fall in like-for-like sales (excluding fuel).

So, yes, I really can see why Tesco is so cheap.

But it shouldn’t be.

We knew it was coming

The thing is, that recent fall in sales really was predictable. The company told us it implemented “Significant price cuts on the lines that matter most” during the quarter, and you know what that does? It lowers the cash taken at the tills for the same volume of food.

If you cut prices, there will inevitably be a deflationary effect on revenue, and it can take a few quarters for that to shake out.

In fact, chief executive Philip Clarke made that very point, saying that “As expected, the acceleration of our plans is impacting our near-term sales performance“.

And so we may well see a further like-for-like fall over the next quarter too — but what’s a few quarters when we’re just starting to come out of that recession and we really should be looking forward to the next 10 or 20 years?

While Tesco’s international operations haven’t exactly been taking the world by storm of late, progress is still being made as the company has now “completed the formation of our partnerships with CRE in China and Tata in India“. It’s a tough time in Asia too, so again we shouldn’t let the short term dictate what we do for the long term.

Refreshing

During the quarter, Tesco also “refreshed” over 100 more stores, and the refresh programme is “on track to bring a new face of Tesco to 650 neighbourhoods this year“. My nearest Tesco still looks the same — but it is always packed with shoppers!

It’s taken time, admittedly longer than some of us thought. And it will take longer still.

But with the shares down 13% over the past 12 months to 292p, on that low P/E, and still paying well-covered dividend yields approaching 5% — well, that’s cheap in my book.

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