Tesco plc’s 3 Big Weaknesses

Despite Tesco’s (LSE: TSCO) recent return to profit, I’m avoiding the firm’s shares and focusing on three factors I think likely to undermine a long-term investment in the firm.

Low margins

Although selling groceries has repeat-purchase appeal, dealing with undifferentiated commodities means that low profit margins are normal for a firm like Tesco. For the year to 27 February 2016, the firm’s post-tax trading profit of £216m came in at just under 0.4% of the company’s £54,433m turnover. That small profit is better than the previous year’s gargantuan loss of almost £5.7bn, but supermarket firms like Tesco must turn over a mind-bogglingly large amount of goods to achieve any profit at all.

When I think of all the operational effort required earning such a meagre crust it seems clear that there’s huge potential for something to go sufficiently wrong to wipe out what small profit the firm is making on each item it handles. That, of course, is what we’ve seen recently with annual profits swinging from almost £4bn to a loss of almost £6bn and now some way back towards the middle of those extremes.

Low margins add a lot of risk to businesses such as Tesco’s. One small slip in the big numbers such as sales or costs can lead to a large movement in the small figure representing end profit.

Market saturation

Tesco grew so big in Britain that it ‘had’ to try to expand abroad to register decent growth figures, I’d argue. With a Tesco site in Britain just about everywhere, the firm did a good job of ingraining itself into the national psyche. Tesco did well in the UK and played at the top of its game. Meanwhile, expansion abroad proved problematic.

When any company reaches such a pinnacle of achievement, as Tesco did in the UK, the downside risk increases. It’s hard to keep up standards and recent events demonstrate what can happen when things slip. Tesco failed to keep up investment in its UK store estate, service-levels slipped, and customers voted with their feet. Sales figures declined as customers deserted the chain, and Tesco plunged into a frantic catch-up investment programme to restore standards and re-attract its previously loyal customers.

From Tesco’s lofty position, there will always be a giddying view down, which means the firm needs to maintain a tight and expensive grip to prevent itself falling.

Disruptive competition

On top of such fundamental operating disadvantages, Tesco faces a real and growing threat from a new breed of lower-price competition bent on disrupting the supermarket industry. Aldi and Lidl lead the attack commanding a combined 10.4% of Britain’s grocery spend, which is rising fast.

Aldi and Lidl are forcing Tesco and its big supermarket peers to do things differently, such as bearing down on costs, changing selling and operating practices, and providing better value and quality to customers. Such radical change moves Tesco so far from its traditional operating methods that future profitability seems more unpredictable than ever.

Tesco seems fraught with risk to me, even though it has returned to profit. The firm certainly doesn't make the cut as one of the quality, growing firms featured in this special Motley Fool investment paper.

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Kevin Godbold 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.