The Motley Fool

3 Reasons To Sell Tesco PLC But Buy British American Tobacco plc And Imperial Tobacco Group PLC

Embattled British supermarket Tesco (LSE: TSCO) has shown definite signs of improvement in recent times — although sales dipped 1.4% during March-May, this marked a strong uptick from the 4% drop punched at the same point in 2014.

However, the Cheshunt firm can thank the impact of heavy discounting for this performance, and still has a mountain to get revenues moving back in the right direction. With this in mind I am highlighting why cigarette plays British American Tobacco (LSE: BATS) and Imperial Tobacco (LSE: IMT) may be a better option for savvy investors.

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Poor brand power

Once upon a time Tesco was the place to go for grocery shoppers, whether it was for a bottle of milk or for the weekly shop. It was famously estimated that £1 out of every £4 spent by British consumers once went into the company’s tills.

Its Every Little Helps slogan became a mainstay of the nation’s lexicon; Tesco’s Value range was a trailblazer in attracting less-affluent customers; and its Clubcard loyalty scheme proved critical in creating a loyal customer base. But since then a series of scandals have soured the company’s name, from the infamous horsemeat scandal right through to investigations over supplier bullying. Accusations of overcharging shoppers and maintaining a fleet of dirty, dated stores have hardly done the company’s reputation any favours, either.

But while the quality of Tesco’s products has come under the microscope in recent times, the popularity of British American Tobacco and Imperial Tobacco’s key brands remain as popular as ever. Indeed, the formidable pricing power of labels like Kent, Lucky Strike and Davidoff has proved pivotal in driving revenues higher even in spite of lower volumes.

Terrible overseas territories

As well as persistent travails in the UK, Tesco has shown renewed impotence in transforming its performance in international markets. Like-for-like sales abroad slipped another 1% during the first quarter.

The business quite rightly identified Asia as a hot long-term growth market, but a heavy-handed and unfocussed approach has seen foreign customers give nothing more than a passing glance to the supermarket giant. Tesco has subsequently been forced to restructure its operations in India and China, including establishing partnerships with local operators, and has more recently put its South Korean operations on the chopping block.

Conversely, both British American Tobacco and Imperial Tobacco Group continue to reap the rewards of their sprawling operations in emerging regions. The image of smoking in these places does not receive the same level of scrutiny by the general public nor regulators as in the West, and with affluence levels in these markets moving steadily higher, I expect demand for both companies’ blue ribbon cartons to follow suit.

Deteriorating financial firepower

The impact of three consecutive annual earnings dips have smashed Tesco’s balance sheet in recent times. Net debt rose an astonishing £1.9bn in the year concluding February 2015 alone, to £8.5bn, and with Tesco widely anticipated to print a fourth bottom-line dip this year things are not expected to get better any time soon. Indeed, the scale of capex reductions and expectations of more divestments illustrate the scale of Tesco’s battered balance sheet.

British American Tobacco and Imperial Tobacco are not facing the same travails, however, their abundant cash reserves enabling them to carry on business as usual. Indeed, the former bought Central and Eastern Europe-focussed TDR for €550m last month, while its industry rival has hoovered up a number of US brands — including the blu e-cigarette brand — following the Reynolds Lorillard merger. This financial strength underpins the far superior growth potential of these companies over that of Tesco, in my opinion.

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Royston Wild owns shares of Imperial Tobacco Group. 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.