Tescos (LSE: TSCO) share price may still be worth less than half its pre-recession high of 488p, but that does not necessarily mean its shares are cheap. The supermarket is the second worst performer in the FTSE 100 index, as its shares have fallen 29% in the past 52 weeks. Shares that have underperformed the stock market index in the past 52 weeks typically also underperform the index in the following months. This phenomenon, which has been observed for more than a century, is known as the momentum effect.
Fundamentals are not looking any better, either, with Tescos problems being largely structural. A high-cost structure, competition from discounters and the changing shopping habits of its customers are the main causes behind the decline in the firms profitability. In its effort to restore profitability, the company faces many execution risks.
Shrinking sales everywhere
The UK grocery market appears to have changed the market for good. Tescos gross margins of more than 5% appears to be a thing of the past. In hindsight, more intense competition should not have been unexpected. Profit margins in the UK grocery market have been almost twice as high as in Europe, and discounters have already succeeded in side-lining retailers with larger stores in France and Poland.
To add insult to injury, its international business is hardly faring much better. Tescos sales are falling in almost every country. In Europe, competition from discount retailers have intensified; and in South Korea, big retailers face stricter regulations on opening times. Add in a downgrading of Tescos debt to junk status and a higher pension deficit, Tesco is gradually losing the financial flexibility it needs to turnaround its business.
Forward P/E of 23.3
Value, like beauty, is in the eye of the beholder. Whether Tescos shares offer value depends on how quickly you believe the business can recover its profitability (if ever). Tesco currently trades a forward P/E of 23.3, with the recent collapse in its profit margins. At this valuation, there is little room for any more disappointments.
There is a lot of optimism surrounding the companys new CEO, Dave Lewis. But, how much can he really change the way Tesco is run? Remember the ubiquitous phrase: the greater the expectation, the deeper the disappointment.
High cost structure
Cost cutting and closing underperforming stores can only go so far. Discounters, including Aldi and Lidl, stock only around 2,000 products, compared to Tescos 40,000 products. Tesco can cut a few thousand product lines, but that just wont be enough.
The supermarket also seems to be less competitive in the UK online grocery market, with its delivery costs estimated to be significantly higher than Ocado, an online-only supermarket.
Tescos business model simply has an innate high cost structure. As the German retailers grow their number of stores, they also reap the cost benefits of scale, allowing them to strengthen their lead on prices. But, even if Tesco manages to defend its market share, it would only be consigning itself to become a low margin business. Where is the value of a low margin business in a slow growth market?
Worst to come?
Tesco cannot win the battle by competing on prices alone. It needs to improve customer satisfaction, expand its range of services and increase customer loyalty. This is where the discounters cannot compete on. Tesco needs a re-invented business model for todays market environment, let alone tomorrows world. So far, we are seeing very little evidence of this. The worst may be yet to come.
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Jack Tang 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.
