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Why Now Could Be Timely To Ditch Shares In Tesco PLC

Will Tesco (LSE: TSCO) shares continue their slide from the 251p or so they reached last month, further down from today’s 220p? I think they should.

Out with the bad news — even the kitchen sink

We should have known that new chief executive Dave Lewis’s first set of full-year results would give the company and its investors a good old kitchen sinking.

The warning lights were glaring right from the start of the new boss’s tenure. From the moment he took control of the ailing supermarket giant back in September, he took a hatchet to costs, selling prices, poor supply-chain practices, and dodgy corporate governance. Heads rolled, things changed, and it has been obvious that his new broom, more akin to a wire brush, would scour its way through Tesco’s financial accounting.

Around £7 billion of mostly property-related non-cash write-downs plunged the firm into a ‘healthy’-looking and headline-grabbing statutory loss of £6.4 billion for the year — an excellent base line from which to build turnaround progress.

An excellent base line it might be for the business, but I think the shares have yet to find their base line. City analysts watching Tesco expect earnings to come in at around 10p for the year to February 2016 and about 13p for the year after that. Those predicted earnings figures throw up forward price-to-earnings ratios of 22 and 17 respectively at the current share price around 220p.

If P/E ratios were all there is to the game of valuation, I’d say those multiples price-in a lot of future recovery and, in any case, look high for a firm that has just demonstrated its capacity for business underperformance.

But look at the underlying figures!

Yet there’s more than the mere valuation issue to make us cautious on Tesco right now. This time Tesco’s problems relate to the entire structure of the supermarket sector in the UK, and that shows in the figures.

Those of us ‘believing’ in Tesco’s turnaround potential will point to the underlying numbers as justification to ‘hold’. Tesco’s preferred measure is what it call Trading Profit, which it defines as an adjusted measure of operating profit that aims to capture performance before profits or losses arising from property-related items; the impact on leases of annual uplifts in rent and rent-free periods; intangible asset amortisation charges; and costs arising from acquisitions, goodwill impairment, restructuring and other one-off items.

On that score trading profit declined 57.5% to £1,390 million — well down, but not out. At least it’s a profit we might argue, and not the massive loss the headline figures suggest. After all, underlying profits point to the firm’s recovery potential.

Breaking it down

It’s obvious from the segmental breakdown of Tesco’s Trading Profit that the firm suffered a major profit haemorrhage during the year in its largest market, the UK:

Area

Trading profit (£m)

12-month decline (at constant currency rates)

Profit margin

12-month decline (basis points)

UK

467

79%

1.07%

 394

Asia

565

15%

5.72%

 97

Europe

164

31%

1.93%

64

Tesco bank

194

Unchanged

18.95%

40

Total

1390

57.5%

2.21%

 292

That 79% fall in UK profits means that Tesco’s earnings from the UK dropped from around 67% of the total the year before to about 34% of the total now. On top of that, earnings in all regions are down.

Look at the margin Tesco earns in the UK. At 1.464% it was thin the year before these results. Now, at 1.07%, it’s tempting to ask whether it’s worth all the effort! Think of the millions of pounds’ worth of stock that’s procured, shifted and sold to produce such a tiny percentage of profit. The potential for a profit ‘miss’ is enormous.

Will Tesco restore its margins?

If we think Tesco likely to turn around as an investment, we need to believe the firm capable of rebuilding its profit margins in the UK. That’s a tall order in the new supermarket-sector zeitgeist.

The firm built previous profit levels in an environment where customers would accept ‘less’ for more money, I reckon. If those times are truly over, we should adjust our profit expectations downwards, which makes Tesco’s apparent over-valuation all the more onerous.

Perhaps now really could be timely to ditch shares in Tesco. Instead, look at these  businesses with strong trading franchises that do not face the same levels of structural challenges in their sectors. You can find out why we love these firms so much by clicking here.

Kevin Godbold 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.