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Tesco PLC Shares May Only Be Worth 200p

tesco2Stock market forecasts tend to assume that the future will look like the recent past. Unfortunately, this approach doesn’t always work.

In my opinion, Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) could be a case in point: I think there’s a real possibility Tesco’s share price might fall as low as 200p, as I’ll explain.

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A fresh look

To come up with my own view on Tesco’s future earnings, I’ve started with last year’s sales figures, and applied some fresh assumptions about profitability, divestments and dividends:

Tesco Value
2013/14 sales £70,894m
10% for further declines & selected disposals of overseas businesses -£7,089m
New sales total £63,805m

My somewhat arbitrary 10% cut in sales is based on two assumptions: firstly, that Tesco’s UK sales will fall again this year, and secondly, that the firm may scale back operations in selected overseas markets.

Falling margins

It’s clear that Tesco’s prices will have to fall to lure customers back from Aldi and Lidl, but we don’t know how far Tesco’s profit margins will fall.

However, France’s largest supermarket, Carrefour, has seen its margins fall from more than 6% to less than 3% during its turnaround, while J Sainsbury also has an operating margin of less than 4%.

To calculate my estimate of Tesco’s earnings, I’ve assumed that the firm’s operating margin will fall to 3.5%:

Tesco Value
New operating margin 3.5%
New operating profit £2,233m
Net interest costs -£315m
Tax (c. 20%) -£384m
New post-tax profit £1,534m
New earnings per share from continuing operations 18.9p

Tesco reported earnings from continuing operations of 23.8p per share in 2013/14, so my figures represent another 20% fall, which is drastic, but certainly not terminal.

What about the dividend?

In my new scenario, Tesco’s existing 14.75p dividend is only covered 1.3 times by earnings, which looks too tight to me. I’d expect the payout to be cut to give a cover level of around 2, as has been the case historically.

This would mean a dividend of around 10p per share, equating to a 4% yield at today’s share price, or a 5% yield at a share price of 200p.

Another coincidence

It’s also interesting to note that currently, both Wm. Morrison Supermarkets and Sainsbury trade at close to their book value, whereas Tesco trades at 1.4 times book value.

A share price of 200p would value Tesco’s shares at 1.1 times book value — a more modest valuation that would still value the firm ahead of its peers.

Is Tesco still a buy?

Tesco’s shares might fall to 200p — and they might not. Trying to time the bottom is always risky, and I believe Tesco shares are already cheap enough to rate as a buy, ahead of the firm’s half-year results in October.

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According to one leading industry firm, the 5G boom could create a global industry worth US $12.3 TRILLION out of thin air…

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Roland Head owns shares in Tesco and Wm. Morrison Supermarkets. The Motley Fool UK owns shares of Tesco. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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