Why I Took A 40% Loss And Sold Tesco PLC

Up until the beginning of December last year, I was extremely bullish about the outlook for Tesco (LSE: TSCO). The company’s recovery seemed to be gaining traction, the group’s international sales had returned to growth, and it was clear that Tesco’s size was giving it an edge over smaller peers in the battle for the consumer. 

However, during December, it started to become increasingly apparent to me that Tesco was facing enormous structural issues outside of the company’s control that would only get worse going forward. These issues threaten to unwind all of Tesco’s efforts to cut costs and return to growth here in the UK, its biggest market. 

A taxing issue 

Tesco’s battle for sales against low-price rivals Aldi and Lidl has been well documented. But it’s not this fight that will upend Tesco’s recovery, it’s UK government policy. 

For example, the national living wage in 2016 is a good thing for employees all over the country, but it will have a disproportionately large effect on big companies, which generally have a larger cost base built around lower wage assumptions. At the end of 2015, Lidl’s UK arm had 17,000 staff, compared to Tesco’s 310,000. 

Of course, higher wages aren’t the end of the world for Tesco and the company has dealt with similar changes in the past. In the short term, profit margins will come under pressure but over the long term, the company’s cost base should rebalance. 

Still, higher wages aren’t Tesco’s only problem. Business rates are also crippling the retailer. 

For every £1 of tax paid on profits, Tesco pays £2.31 in business rates, which was fine 10 years ago when retailers actually needed bricks and mortar stores to shift products. However, today large stores are no longer required, giving online retailers such as Ocado and Amazon a huge tax advantage over traditional retailers like Tesco, Sainsbury’s and Morrisons. Also, online retailers will soon (Amazon already is) be able to replace warehouse workers with robots, further lowering the wage and tax burden.

A higher tax and wage burden means that Tesco just can’t compete on price with its smaller, more nimble peers on price so lower profits are here to stay. City analysts are forecasting a pre-tax profit for the retailer of £610m for the year ending 29 February 2016, rising to £960m for the year after. Based on these forecasts Tesco’s shares are trading at a forward P/E of 34.4, which looks extremely expensive for a company that’s facing so many structural issues. What’s more, it’s not yet known how much of an effect the increase in the minimum wage will have on Tesco’s finances. 

The bottom line 

Overall, many structural headwinds are facing Tesco right now, and it’s almost impossible to tell what the next 12 to 24 months holds for the company. With such an uncertain outlook Tesco’s shares look overvalued right now, and I believe that there are better opportunities out there. 

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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.