How far below its current level can go the valuation of the food retail sector in the UK?
This is a key question for investors eager to bet on a bounce for some of the major players such as Tesco (LSE: TSCO), Sainsburys(LSE: SBRY) and Morrisons (LSE: MRW). Unfortunately, the worst-case scenario is scary.
Tesco Slumps
Tesco stock was down by about 10% on Monday in early trade as the largest food retailer in the UK informed investors that it had overstated its first-half profits by a quarter of a billion pounds. Thats terrible news for Tesco and its new CEO, but it doesnt change my long-term view on the company. Tesco must shrink its asset base to preserve value. Moreover, its attractive right now for opportunistic traders.
Elsewhere, the shares of Morrisons were down 2% in early trade, while Sainsburys stock lost more than 1% of value. Its hard to say whether the food sector trades at a bargain or is expensive because its impossible to determine how the competitive landscape is going to change over the next few years.
Still, there are signs that these three food retailers are doomed, unless decisive action is taken.
Relative Valuation
Tesco stock trades at about 6x forward earnings before interest, taxes, depreciation and amortisation (EBITDA), which is slightly above the forward trading multiple for Sainsburys. The valuation of Morrisons is a bit higher, but it is in line with those of the other two.
Forecasts are for flat earnings at Tesco over the next three years. So, assuming Tescos trading multiple remains constant, the stock will not offer any value for a long time. Since Tesco is not expected to deliver growth, and doesnt offer an appealing yield, its trading multiples should continue to drop as investors will be less willing to pay up for the same amount of earnings in future. The same applies to Sainsburys and Morrisons.
But will the shares of Tesco and those of its rivals trade in distress territory in the next 12 months? If recent trends are anything to go by, they may well hit 3x EBITDA, the bears argue.
That depends on how much time no-frills supermarkets will need in order to steal market share from the top four. These figures should be very closely monitored in the next few quarters. If Tesco, Sainsburys and Morrisons prove they can weather the storm by losing only a few basis points of market share, they will likely continue to trade between 5x and 7x EBITDA, in my view. But if the likes of Lidl and Aldi speed up their expansion plans and continue to invest in lower prices, then the top four will soon be in serious trouble. Tesco is losing market share at the fastest pace in 20 years
No Solution?
Its hard to find a solution for these food retailers, but the good news is that shareholders may be rewarded if: a) these three companies find a way to shrink their asset base before it is too late (Tesco has plenty of options on this front); b) Tesco, Sainsburys and Morrisons find a way to diversify away from their core business once they have identified what is truly core and what is not; c) these three retailers receive takeover offers, which may become an increasingly likely option if their valuations plunge further.
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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK owns shares of Tesco. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
