How Much Lower Can Tesco PLC Go?

Shares in the UK’s largest retailer, Tesco (LSE: TSCO), have had a tough year. After exiting 2014 on a positive note, Tesco’s shares rallied to a high of 244p during April before the market began to doubt the company’s turnaround, and Tesco’s shares have been sliding lower ever since. Now, Tesco’s shares are more than 35% below their April high, and down 13% on the year. 

Tesco has been trying to convince the market that its turnaround really is starting to take shape throughout 2015, but there’s not much evidence to back up this claim, and it’s clear that the market isn’t buying management’s rhetoric. Unfortunately, this means that there’s a chance Tesco’s shares could fall further before finding support and management can produce concrete evidence that shows that Tesco’s recovery is starting to take off. However, looking at the figures, it seems as if it could take a while before management can produce the sort of evidence the market will require to change its opinion.

Indeed, wider industry trends such as food deflation and the rise of the discounters Lidl and Aldi, are just two of the many factors that will weigh on Tesco going forward. Tesco chief executive, Dave Lewis revealed last month that UK retailers are “running through an unprecedented period of food deflation,” which is making it tough for companies to generate the necessary funds to invest and restore profitability. According to Mr Lewis, UK food deflation is now around -2.4%, making it almost impossible for food retailers to grow sales. What’s more, costs are going up. Tesco’s business rate tax bill has increased by well over 35% in the last five years and next April the company will have to pay the new national living wage premium of £7.20 per hour for over-25s. 

Tesco is targeting £250m of cost savings per annum as part of its restructuring plan but with wages set to go up, and sales still falling, the company is facing an unprecedented number of margin pressures, which are unlikely to dissipate anytime soon. Only time will tell how long it will take Tesco to reorganise its operation to cope with higher costs and lower sale prices, but City analysts expect earnings per share to trough this year, reaching a low of 5.2p per share before rebounding by 77% to 9.2p during 2017. However, based on these figures, Tesco is trading at a forward P/E of 34.6, which doesn’t leave much room for error if the company encounters unforeseen headwinds. 

So, how much lower can Tesco go? The answer is much lower. It’s highly unlikely that the company will go out of business, but the group could be forced to shrink itself to adjust to the rapidly changing retail environment. Investors should brace for further turbulence ahead. 

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Rupert Hargreaves has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.