Are Tesco shares now a bargain?

Across the UK, there is hardly a city, town or village that doesn't sport at least one Tesco outlet. Given Tesco's immense financial strength and market dominance, why on Earth are its shares hitting 10-year lows this week?

What has gone wrong at the high-street behemoth? And do its shares now represent a bargain for investors?

Five big problems for Tesco

The top brass are scarpering

The past 12 months have seen a mass exodus of top executives from Tesco. Shockingly, after the resignation of finance director Laurie McIlwee in early April, Tesco's main board had but a single executive director: chief executive Philip Clarke.

Clarke - a 40-year Tesco veteran who started off stacking shelves in 1974 before climbing to the very top - found himself under intense pressure from major shareholders after Tesco's strategy and share price shuddered. Last week Clarke fell on his sword, confirming he will leave in January.

UK market share is falling

In the 12 weeks to 22nd June 2014, Tesco held a commanding 28.9% share of the UK grocery market. But this percentage has actually been falling. For example, 12 months earlier, Tesco's market share was 30.3% in the 12 weeks ending 23rd June 2013.

What's more, when market share starts to decline, this trend tends to continue. 

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Tesco is besieged on both fronts

At the budget end of the grocery market, German discounters Aldi and Lidl are eating into Tesco's profits. At the premium end, John Lewis Partnership-owned Waitrose and online grocer Ocado have won over many middle-class customers.

Anecdotally, I've seen this happen at home. In the past, my wife would shop mostly at Sainsbury's and Tesco. These days, she does her weekly shop online with Ocado, with tops up at Waitrose and Aldi. In my town, these two stores are right next to each other - and you see the same shoppers in both, week after week.

Profits have plunged

In its latest financial year, Tesco's profit before tax (PBT) was nearly £2.6 billion. While most businesses would envy such a handsome figure, Tesco's profits have plummeted in recent years. Here's how this key measure has fallen since 2010:

As you can see, Tesco's PBT hit an all-time high of over £4 billion in 2012 and then almost halved in 2013. Although profits were up almost a tenth in 2014, this was not enough to save the chief executive.

Margins have slumped

In the retail world, the biggest and best players have three core strengths: rising sales, strong margins and solid free cash flow. Tesco's problem is that its margins have declined markedly of late, as this table shows:

As with profits, Tesco's margins peaked at 6.5% in 2012, before crashing to 3.7% in 2013. Like profits, they recovered slightly in 2014, perhaps indicating that the worst of Tesco's problems may be behind it.

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Are Tesco shares a bargain?

So far, all I've done is unveil bad news for Tesco, but there are some glimmers of light at the end of the tunnel, too. It has curbed loss-making ventures in the US and in China. What's more, in a radical departure for an old-school business, Tesco has appointed ex-Unilever star Dave Lewis to run its business, the first outsider in its 95-year history.

Of course, all this bad news may already be priced into Tesco shares. After all, Tesco shares are at their lowest level since September 2004, having fallen a quarter (25%) in the past 12 months and almost a third (31%) in three years.

In other words, if the price is right, Tesco shares could be a buy. Let's crunch the numbers to find out:

* At time of writing

Buy now, gain later?

Scanning these figures, one thing stands out. For income-seeking investors (those chasing chunky cash dividends), Tesco shares offer a mouth-watering dividend yield of almost 5.4%. Hardly any other blue-chip, FTSE 100 shares offer such a high dividend payout. On the other hand, Tesco's dividend is unchanged for three years, having been frozen since 2012. Also, it is covered only 1.6 times by earnings, which will be a little low for comfort for some.

On a price-earnings ratio below 12, Tesco's shares don't look overly expensive right now, yet offer a highly attractive cash payout in the form of twice-yearly dividends adding up to a yearly income nearing 5.4%. If - and that's a big if - Tesco stops stumbling and finds its feet again, then its shares are a snip at the current price. 

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