Under chief executive Dave Lewis, the firm has been turning itself around for a few years, but the job is essentially done. The big increases in earnings are behind us, I reckon, and in July I said, “a firm can only go so far when it comes to squeezing efficiencies and profits out of an enterprise.”
Indeed, rather than the robust double-digit percentage advances in earnings that we’ve seen over the past four years, the forward predictions are for modest single-digit increases. Instead of looking for turnaround gains ahead, I think Tesco will be relying on ordinary business growth in the years to come.
But business growth is hard to achieve in the sector because of increased competition from discounting competition such as Aldi, Lidl, and others. Meanwhile, with Tesco’s share price near 237p today, the forward-looking earnings multiple for the trading year to February 2021 is at about 13, and the anticipated dividend yield is just below 3.8%.
That might sound fair, but I consider Tesco’s business to be in long-term decline and fighting against powerful headwinds. Just this month Aldi announced plans to open more than 100 new stores across the UK in the next two years, which represents a big investment in growth and a further grab for market share.
Based on past performance, I have every faith that Aldi will succeed in its expansion and that the market share it gains will be lost by the likes of Tesco, Morrisons, and Sainsbury’s.
Meanwhile, I think Tesco’s valuation hasn’t yet adjusted to the reality that the company’s turnaround has been completed. Considering the firm’s lacklustre forward growth prospects, I’d want the compensation of a dividend yield above 5%.
Potential for a valuation down-rating
On top of that, I reckon the earnings multiple should reflect that Tesco operates a high-volume, low-margin, undifferentiated, commodity-style business. Indeed, the business is nothing special or unique, and is highly vulnerable to competitive forces in the sector. To me, the price-to-earnings multiple should be no higher than about 10 and probably lower than that.
So, I see huge potential for a downward re-rating of the shares, which could drag on investor returns from current levels. And in the long term, my guess is that the enterprise will decline over time rather than grow – which strikes me as the wrong trend for supporting any investment.
That’s why I’d avoid Tesco shares right now and probably forever. I can’t see how Tesco will be capable of outperforming its index, so I’d rather invest in the index itself. In this case, an FTSE 100 index tracker would have a similar dividend yield and all the benefits of diversification across many underlying shares.
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Kevin Godbold has no position in any share mentioned. 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.