One thing you need to know before you buy Tesco plc

It seems like people have been calling the bottom for Tesco (LSE: TSCO) for a couple of years now, declaring that the worst is over and that things are on the up again. There was a bit of a surge at the start of 2015, after a Christmas trading update seemed better than expected, but that soon tailed off and Tesco shares lost ground that year.

Something similar happened at the start of this year. But after full-year results were released in April, the share price turned south again — to 156p. Tesco shares are still up 12% since the start of 2016, but it’s looking like it could be 2015 all over again.

Looking back at the past year, forecasts for Tesco have been steadily scaled back too, as time after time the signs that it’s returning to its old winning ways keep fading away. The latest disappointment has come from JPMorgan Cazenove, which has warned that a number of one-offs are flattering Tesco’s financial appearance, and in the past week we’ve seen earnings forecasts scaled back again.

Price wars

That leads me to the one thing that you really need to know before you consider buying Tesco — it hasn’t beaten the low-price competition threat from Lidl and Aldi, not by a long way. No amount of store revamps and “customer experience” improvement is going to change that.

Tesco should see costs rising this year, after a year of unsustainably low capital expenditure and with a return to a more normal tax regime due. And to add to those woes, the latest Kantar Worldpanel report revealed a sales fall of 1.3% in the three months to 24 April 24, while Aldi and Lidl continue with their relentless growth.

After several years of rapidly declining earnings per share, analysts are forecasting a rise of around 150% by the time the current year ends in February 2017. But to put that into context, EPS would still be less than a fifth of the levels it stood at in 2012. And even at such modest earnings, Tesco shares would still be on a forward P/E of over 23, which seems way too high to me, especially with its current uncertainty and risk.

The harsh reality is that we’re going to continue to see further price deflation, after Kantar also told us that groceries prices have now fallen every month since September 2014 — and all indications suggest even the big four are ready for further price wars, with Asda set to try to regain its lost volume via aggressive price-slashing. That strongly suggests we’ll be seeing further forecast downgrades for Tesco over the course of the next 12 months too, and I place little confidence in current predictions.

No going back

Many observers seem to have seen Tesco as just having had a rough patch, like almost all companies at some time in their lives, and have assumed it will put things right and recover to its good old ways.

The problem is that thinking can miss the fact that there’s been a permanent change. It needed an assault from Lidl and Aldi to break the complacency of our big four, and we won’t be going back to the high-margin retailing that Tesco used to enjoy.

Tesco will surely get back to earnings growth, but I can see it as being at a significantly lower level than before — and at a significantly lower share price too.

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Alan Oscroft 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.