Tesco: how can it recover and should you invest?

The supermarket has had a rocky time over the last few years, but is Tesco still worth investing in?

There was a time when Tesco was a stock market darling. With a reputation for competitive pricing, it dominated the supermarket sector and came up with innovations such as the Clubcard customer loyalty scheme.

For a while its dominance went unchallenged and its growth was rapid. Customers loved the choice it offered and investors relished having their money in a company whose profits ran into billions of pounds.

But then it all went sour.

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How it went wrong for Tesco

The emergence of cut-price rivals, a string of profit warnings, an investigation into how the company overstated profits by £250 million and the subsequent suspension of some executives put the brakes on its march.

Its share price tells the story.

From a peak of 492p back in 2007 it had fallen more than 70% to 139.2p by early this year as investors took fright. Recently it’s been trading around the 160p mark – Brexit notwithstanding – as people remain understandably cagey about its future prospects.

Ferocious competition from rivals such as Aldi and Lidl has increased the pressure. Tesco’s last full year pre-tax profit figure was £162 million. When you consider it was making almost £4 billion a few years ago, its fall from grace is all too apparent.

According to Graham Spooner, investment research analyst at The Share Centre, the company had started to receive a negative press in the years before its real financial problems started to take hold.

“There was a little bit of ‘Manchester United syndrome’, in that it got a bit too big for its boots and people started to turn against it,” he said. “You heard stories from farmers and other providers that Tesco was a bit of a bully on the high street.”

Tesco: is it worth investing?

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Repairing the damage

However, a recent trading statement has given cause for optimism with chief executive Dave Lewis announcing a second quarter of positive like-for-like sales growth across the business. After years of gloom, such news is very welcome.

“We are encouraged by the progress we are making,” he said. “By growing volumes, transforming the way we work together with our suppliers, and further optimizing our store operating model we are rebuilding profitability in a sustainable way.”

Lewis said Tesco’s focus was on its core UK business. “We continue to reinforce our brand proposition by giving customers lower, more stable prices they can trust across their whole shopping basket,” he said.

He also emphasised that the company is working more closely with suppliers to “enhance the uniqueness” of its customer ranges, as well as reducing costs by “improving efficiency and leveraging our scale”.

Other developments include selling the Harris and Hoole coffee chain to Caffè Nero, just weeks after revealing it was offloading Dobbies Garden Centres, the Turkish Kipa stores and the Giraffe restaurant chain.

These moves come in the wake of its decision to reduce opening hours at many stores across the country, a decision it claims was made in response to the way customers want to shop and to make more efficient use of company resources.

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Should you invest in Tesco?

Richard Hunter, head of research at Wilson King Investment Management, describes Tesco as a work in progress. “It is looking to get back to its core UK business and has posted two quarters of sales growth – the first time it’s done that in five years,” he said.

However, there are issues. “In a virtually nil interest rate environment, one of the things investors are looking for is income,” he added. “Tesco is not paying a dividend and it doesn’t seem to even be on the horizon. That’s a big distraction for the stock.”

While he applauds the moves made so far, he wants to see more detailed information from Tesco’s management. “We’d like to see more concrete statements about its strategy,” he said. “What it’s doing seems to be working but doesn’t give much indication of what it has planned for the next year or two.”

However, while Tesco has suffered, it still boasts a very dominant position among UK supermarkets. “It’s still the market leader by far,” said Hunter. “Management took its eye off the ball in terms of the core UK market but is trying to get that back.”

This is illustrated by grocery share figures from Kantar Worldpanel for the 12 weeks ending May 22^nd, 2016, which put Tesco’s share at 28.3% - comfortably ahead of the 16.2% claimed by Sainsbury’s and Asda’s 15.8% slice of the pie.

Adrian Lowcock, head of investing at AXA Wealth, is cautiously optimistic. “The results point to a company which has got things back under control,” he said. “However, there is little good news in the sector as the price war continues to rage on.”

The cost of a food shop in Tesco is already 6% lower than it was in September 2014, he points out, adding that the message from executives is that they’re battening down the hatches and concentrating on lower prices and better customer service.

“The company is doing the right thing but the entrance of Lidl and Aldi has changed the landscape and as Tesco reinvests it profits back into the business investors are not going to see much in terms of profitability,” he added. “The company is still in recovery mode and therefore that in itself has its risks.”

Crawford Spence, a professor of accounting at Warwick Business School, believes Lewis has played a canny game since he’s been in charge, pointing out that its return to profit vindicates his own personal strategy of positioning himself as a turnaround CEO.

“On taking up the job in 2014, he immediately brought as many skeletons out of the closet as possible: profit overstatements, bullying of suppliers and identification of loss-making parts of the business,” he said.

It has worked well. “This had the dual effect of creating a sentiment of gloom around Tesco’s long term prospects on the one hand, and legitimately blaming this perceived malaise on his predecessor on the other,” he added.

Looking ahead, Graham Spooner believes Tesco’s long-suffering investors need patience while suggesting anyone determined to buy exposure to supermarkets should consider Sainsbury’s due to its stronger balance sheet.

“Fierce price competition and promotions are likely to remain a squeeze on margins for some time and the revised strategy is going to take time to implement,” he said. “We subsequently recommend Tesco as a ‘hold’ for medium risk investors seeking growth.”

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