It’s well known that supermarket giant Tesco (LSE: TSCO) is in turnaround mode after retreating from its global growth ambitions and aiming all its hoses inwards to fight internal fires.
Plunging profits and share prices are good catalysts for focusing management minds, and it’s pleasing to see that earnings are building up again. The share price has climbed back a bit from its lows, and the dividend has been reinstated. But whether Tesco makes a decent investment now or not is a different question. I think the stock is risky.
A changing backdrop in the sector
The days of considering the London-listed supermarket chains as relatively safe, cash-generating, defensive businesses are long gone. They’ve been exposed for what they really are, which is low-margin, essentially undifferentiated commodity-style outfits operating in a fiercely competitive environment.
It only took a couple of upstart super-discounting German supermarket chains in Aldi and Lidl to poke into the market a bit and the whole sector seemed to collapse into a floundering heap, with Tesco flapping the hardest. There’s no doubt in my mind the market is saturated with competition in the UK, and fast-expanding players such as Aldi and Lidl are disrupting the old order of things.
Meanwhile, with Tesco’s share price close to 229p, the forward-looking price-to-earnings (P/E) ratio for the trading year to February 2020 sits close to 13.5 and the predicted dividend yield is just over 3%. I reckon that valuation suggests the market is pricing in continuing double-digit percentage advances in earnings in the years ahead.
But I worry that restructuring, and nipping and tucking the operations, can only go so far. At some point, the firm will need decent growth in revenue and solid gains in market share to keep earnings growing, which I believe will be hard to sustain in the sector in the years ahead.
A big yield and turnaround prospects
For me, the valuation is too high and assumes too much. I’d be more comfortable if Tesco had a single-digit P/E rating and a dividend yield around five or more. So, I’m forgetting the Tesco share price and would rather go for the 4%-plus yield on offer with PZ Cussons (LSE: PZC).
In fairness, the fast-moving consumer goods stalwart is looking for a turnaround in its African and Asian operations, particularly in Nigeria. The share price has been falling for some time because of difficult trading in the regions, but I think we are seeing some signs that the troubles could now be priced into the valuation.
In the recent half-year report, the firm posted falls in revenue and operating profits in Africa and Asia, which accounted for around 52% of total revenue in the period. So a big chunk of the firm’s operations are under pressure, but there were gains in Europe.
Chairwoman Caroline Silver said in the report the company is making decent progress in Europe and Asia developing new products. But macroeconomic conditions in Nigeria are “extremely challenging,” which is inflicting “significant negative impact” on overall results.
Nevertheless, City analysts following the firm predict decent single-digit earnings increases ahead. I’m tempted to buy some PZ Cussons shares to lock in the yield and wait for recovery.
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Kevin Godbold has no position in any share mentioned. The Motley Fool UK owns shares of PZ Cussons. The Motley Fool UK has recommended Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.