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Is It The End Of The Road For Tesco PLC?

Tesco (LSE: TSCO) has been stuck at around 220p a share since mid-January, and that doesn’t look right: have investors forgotten the true potential of the largest grocer in Britain? 

The Bulls: Yes, Of Course They Have!

The obvious take for those in the bull camp is that Tesco’s earnings have bottomed out, while its balance sheet has been cleaned up after £7bn of assets were written off last year.

Furthermore, as it shrinks, Tesco should become more profitable. 

After all, the bulls insist, if chief executive Dave Lewis puts in place the right strategy, Tesco could easily keep at bay smaller rivals such as Asda, Morrisons and Sainsbury’s, retaining a market share of between 27% and 29% in the UK market over the short term, while growing it over time. On the face of it, Tesco will continue to squeeze suppliers, who will end up being the obvious losers. 

Moreover, as it continues to look for buyers for its international assets, Tesco will likely fetch a decent valuation for its operations held abroad — rumours have suggested its Asian assets could be valued at stellar multiples.

In fiscal 2017 and 2018, Tesco should be able to generate net income of £900m and £1.3bn, which would actually signal the bottom for its earnings in fiscal 2015. Now its stock is valued at 18x forward earnings, but Tesco’s relative valuation could become significantly lower than that if it delivers a higher growth rate for profits on the back of a more efficient use of capital, the bulls conclude. 

My Take: There is merit in such a view, as Mr Lewis and his auditors have taken an aggressive stance on the value of Tesco’s assets base. The grocer’s debt profile is sound, so Tesco could certainly deserve attention from value investors, although much of its fortunes hinge on big investment in price cuts, which carries obvious risks with regard to core cash flow and margins. 

The Bears: Tesco Is Going To Plummet 

Tesco operates in a fiercely competitive food sector — which is in dire straits, as recent retail figures showed.

Tesco is squeezed between Waitrose, Marks & Spencer and no-frills supermarkets such as Aldi and Lidl, but the problem is much bigger than that at present. 

Consolidation aimed at exploiting cost and revenues synergies seems to be the inevitable way, the bears argue, but Tesco cannot afford to acquire assets simply because the value of its own assets and its own equity valuation may continue to fall. If the bears are right, Tesco will likely be the biggest loser in the sector. Then, additional, huge write-offs may ensue, impacting earnings and rendering the stock much more expensive than its forward valuation implies. 

Face it: the UK’s largest grocer isn’t exactly in a sweet spot, while its relationships with suppliers remain strained.

(Tesco is paying more attention to its customers, I’d argue following several trips to Tesco stores of any size — but that may not be enough, the bears insist.)

Sainsbury’s, Asda and a few others are using the same tools to compete, so persistent downwards pressure on prices will likely continue to dominate the headlines. If that’s the case, the bottom for Tesco’s earnings may be at least a couple of years away, and a price target of between 100p and 150p is conceivable. 

It’s also worth considering that total economic losses of £4.6bn have been registered between 2013 and 2015, while the combined net income for 2013 and 2014 stands at only about £1bn. Finally, its operations abroad may need investment if they are not sold, which means returns and margins will unlikely satisfy shareholders for a very long time. 

Instead of Tesco, I'd rather choose two high-growth stocks mentioned in this value report, to be honest. The first is an online retailer outside the food space: its shares are up 38% this year, and could easily double by the end of 2016, hitting their previous levels. The second value candidate included in our free report is a construction equipment business with operations in the UK and in the US: its core profitability is expected to hit record levels in 2017 and 2018, but its shares still trade at a 30% discount to fair value, its trading multiples suggest. To learn more about these two value investments, click here right away and get your FREE copy now!

Alessandro Pasetti 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.