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Why Tesco PLC Isn’t A Recovery Play Yet

About a decade ago, Unilever (LSE: ULVR) was in the throes of upheaval. This consumer goods giant had expanded steadily, decade after decade, since the early years of the twentieth century. Its growth had coincided with the beginning of the consumer economy in the West, and its spread around the world. Companies like Unilever, Procter & Gamble and Coca-Cola were some of the strongest investments of the post-war period.

The supermarkets are under pressure

But as the century drew to a close, the growth of consumption in Western economies slowed, and the supermarkets increasingly had the upper hand in their dealings with the consumer goods companies. With reduced pricing power, the margins, profits and share prices of firms like Unilever were falling.

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The company responded by stopping its expansion, and by scaling back its business. It was a time of terrible pain, with thousands of jobs lost. But the manufacturing titan emerged the other side transformed.

Fast forward to today, and now it is the supermarkets that are under pressure. After so many years of growth, too many market entrants — with the rise of the discounters on the one side and premium retailers on the other — mean that the UK is oversupplied with shops at a time when shoppers are not spending any more money. It is now consumers who have the upper hand.

Of course, you can take a comparison too far, and I’m sure Tesco (LSE: TSCO) won’t experience anything like the job losses that the consumer goods companies experienced. But chief executive Dave Lewis, an alumnus of Unilever, can see clearly the difficulties Tesco has.

But Tesco is now facing reality

What has been impressive is that Tesco is now facing reality. It has stopped blindly expanding, oblivious to the state of the retail sector.  There will be no more ridiculously expensive corporate jets. It is ensuring corporate and financial integrity, by dealing with the recent accounting scandal. And it is focusing on improving retail, instead of being distracted by businesses like blinkbox.

These are very positive steps, and the gradual recovery in the share price shows that the market approves. But analyse the fundamentals of the company, and you will see how far Tesco has to go. At the current share price of 224.7p, consensus predicts a 2015 P/E ratio of 22.7, rising to 26.2, with a dividend yield of just 0.5%. Even with the share price having fallen so much, the company still looks expensive.

This gives you some idea of the challenge Tesco now faces. Profitability will gradually improve, but this will take several years. This firm will eventually be a recovery play, but the shares currently lack appeal and I still think it is too early to invest.

However, Tesco is now taking all the right steps to ensure that it will soon, like Unilever, be able to look to the future not with fear, but with hope.

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Prabhat Sakya has no position in any shares mentioned. The Motley Fool UK owns shares of Tesco and Unilever. 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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