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Why You Should — And Shouldn’t — Invest In Tesco PLC

Today I am highlighting the pros and cons of investing in grocery giant Tesco (LSE: TSCO).

Sales turning the tide?

New chief executive Dave Lewis came under fresh fire last month over a lack of detail on how he plans to transform Tesco’s poor sales performance. Although it is true that the new man used the announcement to unveil yet more heavy cost-cutting across the store, but for the time being this strategy appears to be dragging customers back through the door.

Indeed, latest Kantar Worldpanel data released earlier this month showed Tesco’s sales rise 0.3% in the 12 weeks to February 1, the first increase for more than a year.

This improvement is not a fluke, either, with Tesco’s sales stepping steadily higher since the autumn. This month’s release was an improvement on January’s 1.2% dip, which itself was better than December’s 2.7% decline and November’s 3.7% fall.

Market share continues to dive

Still, Kantar’s release underlined how Tesco continues to be battered by the budget chains, with sales at Aldi and Lidl rising 21.2% and 14.2% respectively during the period. This breakneck performance pushed Tesco’s total market share lower again, to 29% from 29.2% last year.

Tesco’s recent resurgence coincides with cooling sales growth amongst the discounters — indeed, Aldi’s latest performance illustrated a notable slowdown from the record 36% advance punched last April.

Of course, Tesco would move heaven and earth to get anywhere close to the growth rates posted by Britain’s new supermarket entrants. And with the new kids on the block rolling out aggressive expansion schemes stretching into the next decade, Tesco’s recent bump may prove nothing but a temporary hiatus, particularly as the business of margin-crushing discounting cannot continue indefinitely.

Costs coming down

In fairness, since January’s update Lewis has since revealed plans to slash thousands of products from its shelves to improve cost visibility for customers, a critical move in taking on the discounters.

The move is also likely to take a chunk out of Tesco’s cost base as reduced shelving space requires less staff to fill. Indeed, the grocer has taken a tough line in reducing costs over the past month, including the closure of its Cheshunt HQ as well as 43 underperforming stores up and down the country.

Since then news has emerged that Tesco plans to cut an entire management layer at its superstores, taking the total number of staff reductions to 9,000 and reducing the cost base by around £250m. Such drastic moves are essential given that industry conditions continue to worsen.

Has investor enthusiasm overshot the mark?

But although Tesco has undoubtedly been making all the right noises in recent weeks, it could be argued that recent share price strength does not reflect the number of difficulties the firm still has to overcome.

The supermarket’s stock has gained more than 25% since the turn of the year, leaving it changing hands on P/E ratings of 21.9 times predicted earnings for the year concluding February 2016.

Not only is this figure far beyond corresponding readings of 12.2 times for Sainsbury’s and 13.9 times for Morrisons, but well above the benchmark of 15 times which represents attractive value for money. Should Tesco’s mild recovery run out of steam, a very real possibility as the competition continues to intensify, I believe that share prices could be set for a sharp correction.

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Royston Wild has no position in any shares mentioned. 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.