Tesco's Shares Are Not a Buy for Me

LONDON -- Regular readers of The Motley Fool U.K. will have read quite a number of articles from my colleagues suggesting the fall in the share price of Tesco (OTC: TSCDY) (ISE: TSCO.L) since its profit warning in January represents a great buying opportunity.

This is a fabulous chance for contrarian investors; the fall is overdone; Mr. Market is offering you a bargain... or so the arguments go.

I disagree. And I'm going to tell you why.

Contrarian schmontrarian
First, there's the nice point -- as lawyers say -- of just how contrarian a bet Tesco can be when every share tipster under the sun is calling it a buy; when 96% of voters in a poll on our dedicated Tesco discussion board after the profit warning rated it a buy; and when the mood in TMF's recent live debate on the company's full-year results was overwhelmingly bullish -- with only 1% of voters in a poll during the debate plumping for the share price being meaningfully down in a year's time.

Even among the professional analysts we all love to hate, 10 out of 34 have the shares marked as a "strong buy," while the consensus is for a solid hold. For my money, as things stand, we aren't in a classic darkest-hour, blood-on-the-streets contrarian environment with Tesco.

Before the profit warning, Tesco's shares were at around 390 pence, putting it on a forward price-to-earnings ratio of 10.7. Today, with the share price at around 320 pence, and revised expectations, the forward P/E is 9.2.

If you want to see what a top-tier Footsie company that really is unloved looks like, check the P/E and analyst recommendations for big pharma group AstraZeneca (NYS: AZN) .

As far as Tesco is concerned, I believe that, despite the substantial share-price fall, paying 9.2 times earnings today is actually less of a bargain than the 10.7 times earnings investors were paying before the profit warning -- on the known information at the time.

The U.K. problem
Tesco's 2011-12 U.K. year-over-year sales were disappointing. Excluding gas and value added tax, YOY sales turned increasingly negative through the year culminating in a 1.6% decline in the fourth quarter. Tesco got its Christmas offer wrong in a big way, but the numbers reveal -- and the company admits -- that the U.K. performance in 2011-12 reflected deeper-rooted problems coming home to roost.

It's well-known that Tesco has been using its mature bricks-and-mortar U.K. operation as a cash cow to fund expansion in other areas, most notably international expansion. What is now apparent, though, is that the company has been taking too much out -- "running the stores too hot," as chief executive Philip Clarke puts it.

Tesco is hoping to arrest the decline in year-over-year sales by committing 1 billion pounds in 2012-13 to improve the shopping trip for customers, which will include 8,000 new staff in existing stores (part of a plan to create 20,000 net new jobs over two years) and a refit program for a quarter of the estate, with more refurbishment to follow in 2013-14.

Put another way, Tesco will be spending about half a year of group earnings just on trying to get the U.K. back to wherethe market thought it was before January's profit warning.

Furthermore, going forward, Tesco's average annual maintenance capital expenditure -- the amount it needs to invest just to stand still -- will have to be higher than the historical level that the market had previously believed could sustain the business.

It's now clear that with rival supermarkets having gotten their acts together after many years of offering fairly feeble competition, Tesco will have to spend more money, more frequently on refreshing and updating its stores than in the past.

Prior to the profit warning, it was widely assumed Tesco's sustainable level of group sales growth was in the 10%-11% area, based on a blend of lower growth in the U.K. and higher growth overseas.

Tesco CFO Laurie McIlwee has knocked that on the head, recently saying that the blended growth rate will be below those assumptions: "We see it at high single digit." In addition, the CFO tells us: "Our objective is to grow profits in line with sales."

Thus, before the profit warning, investors were paying 10.7 times earnings on the assumption of 10%-11% annual sales growth with profit growth maybe a little ahead of that if the company could edge margins higher. Today, investors are paying 9.2 times earnings for high single digit sales growth and profits growing in line with sales.

So, the way I see it, today's investors in Tesco know that half a year's earnings will be going to get the core U.K. business back on track. They can also assume, on a 10-year investment horizon, that rebased sales growth will produce earnings of around one full year less than on the assumptions of the pre-profit-warning investor. Hence, the current P/E of 9.2 no more than reflects the new reality of the one-off turnaround cost and Tesco's new growth guidance.

There seems to me to be no additional discount for risks that are now present but that weren't in the purview of the investor before the profit warning.

A big ask
Executing on the plans for the U.K. is, in the words of the chief exec, "a big ask." That implies there's a risk it may take more time and money -- perhaps quite a lot more time and money -- to turn U.K. year-over-year sales round. It's especially difficult for companies when they start to lose their customers' trust, and Tesco has problems in the all-important area of trust on pricing.

Tesco's abandonment of aggressive margin expansion, coupled with a new scaling back on the capital-intensive activity of racing for new store space, has implications for the group's previously established target for return on capital employed: 14.6% by 2014-15.

ROCE came in at 13.3% in 2011-12, but will fall back a bit in the coming year. The CFO acknowledges that there are fewer avenues now to get to the 14.6% target, "so it is more challenging, but we believe still doable."

Value range
Tesco has built up a lot of goodwill with investors over the years. If it wasn't for that, and the support of master investor Warren Buffett (and perhaps a small army of private investors who have simply followed Buffett's lead), I'm sure Tesco's share price would be lower today than it currently is.

As things stand, I think the situation is set up for Tesco to fall short in one way or another, somewhere along the line in the next year or two, and to disappoint a market that has put quite a lot of faith in the company not disappointing.

If I'm right, even a relatively minor upset -- and I haven't had space to mention all the problems facing Tesco and risks facing shareholders -- could send the company to a new value range, with the shares comfortably below 300 pence and the P/E below nine.

When my fellow financial scribes aren't universally tipping the company as a buy, when broker recommendations turn resolutely bearish, and when black clouds of depression reign and rain on private investor discussion boards... then I might start thinking of Tesco as a contrarian opportunity.

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At the time thisarticle was published G.A. Chester owns no shares of the companies mentioned. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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