Why The Market Is Wrong To Bet Against Tesco PLC’s Boss

The shares of Tesco PLC (LON:TSCO) are not expensive at this price, argues Alessandro Pasetti.

| More on:

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

The bears are in town. Investors are betting on a decline in Tesco‘s (LSE: TSCO) stock price “as optimism around chief executive officer Dave Lewis’s revival plan has waned“, Bloomberg stated on Friday. 

Tesco short sellers are coming back in droves,” the news agency wrote, adding that “the number of bets taken out against the company’s share price has risen sevenfold since Tesco’s annual results in April.

In a short selling, investors borrow shares from a broker in order to sell them to someone else at the current price, betting that their value will fall fairly quickly. If that happens, they can buy the borrowed shares for lower than the price they sold them for, in order to fulfil the trade, thereby banking a profit.

Should you invest £1,000 in Tesco right now?

When investing expert Mark Rogers has a stock tip, it can pay to listen. After all, the flagship Motley Fool Share Advisor newsletter he has run for nearly a decade has provided thousands of paying members with top stock recommendations from the UK and US markets. And right now, Mark thinks there are 6 standout stocks that investors should consider buying. Want to see if Tesco made the list?

See the 6 stocks

This sort of trading carries big risks. If the price goes up you’ve got to buy the borrowed shares for more than you’ve been paid — and is likely to backfire with Tesco, in my view. 

Two Problems

The first problem is to determine whether the UK’s largest grocer will be able to hit a 2016 underlying trading profit higher than £1.3bn–£1.4bn, hoping that Tesco will meet estimates of £1.6bn and £1.8bn in 2017 and 2018, respectively.

Investors also have to make sure that based on the value of its assets Tesco is a reasonable value play. 

Trading Profit

Say that Tesco’s sales decline 2% to £61bn in the current year (fiscal 2016) — a drop in line with that of fiscal 2015. Both its quarterly performance — at constant rates, excluding fuel and VAT — and market share data suggest that such a performance is pretty likely. I’d not expect Tesco to surprise investors on this front. 

Its 2015 trading profit was down 58% to £1.39bn year-on-year, with the UK — the biggest revenue contributor at £43bn, excluding VAT — generating some £467m. Previously a cash cow, the UK operations have become a money pit. 

Its domestic trading margin came in at 1.07% in 2015, a reduction of almost four percentage points year-on-year: the impact of like-for-like sales decline was clearly felt, but the combination of “prior initiatives” and “net cost base inflation” had a bigger impact on Tesco’s poor performance, which read -79% over the previous year in terms of trading profit.

Prior initiatives, in particular, were a drag on performance, and a much bigger issue than much-publicised investment in lower retail prices. 

Quite simply, once “prior initiatives” in the UK are deducted — and there’s reason to believe they will go down over time — the “New Tesco” led by Mr Lewis may be able to record a trading profit margin of between 2.5% and 3%, yielding a trading profit of between £1.5bn and £1.8bn. There are risks associated with these estimates, but Tesco could indeed hit its medium-term goals sooner than expected. 

You should also consider that its Asian operations reported £9.8bn of sales and a trading profit of £565m (down 18%, trading margin at 5.7%), while Europe’s £8.5bn of revenues contributed £164m (down 31%, trading margin at 1.93%) to the group’s underlying trading performance.

Management is playing down expectations, of course, but a target of at least £1.5bn for a 2016 trading income is doable, I’d argue. 

Assets 

Some £5bn of undrawn credit lines cover for the majority of its net debt position, while the duration of its debt profile offers some reassurance, although net leverage is high. 

So, let’s move on to the value of its current and long-term assets. 

Taking into account the book value of:

  • inventories, £2.9bn (as at 28 February)
  • trade and receivables, £2.1bn
  • loans and advances to customers, £3.8bn
  • Cash and equivalents, £2.1bn
  • other current assets, £650m

you’d be buying Tesco’s equity at 213p a share against £11.5bn of cash-like items, whose value is 141p a share.

Yet there are still some £30bn of long-term assets that must be taken into account.

If we apply to these non-current assets a massive discount of about 80%, thus betting on huge write-downs over time, we’d still have to add £6bn (about 74p a share) to a valuation of 141p a share for Tesco’s current assets.

Then, Tesco’s equity would be valued at £17.5bn, which is bang in line with its current market cap, but does not include the difference between the book value of its total long-term assets and the aggregate value of net debt, discounted operating lease commitments and pension deficit. 

That’s about 37p a share, or £3bn in terms of additional market cap. 

Should you buy Tesco now?

Don’t make any big decisions yet.

Because Mark Rogers — The Motley Fool UK’s Director of Investing — has revealed 5 Shares for the Future of Energy.

And he believes they could bring spectacular returns over the next decade.

Since the war in Ukraine, nations everywhere are scrambling for energy independence, he says. Meanwhile, they’re hellbent on achieving net zero emissions. No guarantees, but history shows...

When such enormous changes hit a big industry, informed investors can potentially get rich.

So, with his new report, Mark’s aiming to put more investors in this enviable position.

Click the button below to find out how you can get your hands on the full report now, and as a thank you for your interest, we’ll send you one of the five picks — absolutely free!

Grab your FREE Energy recommendation now

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

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.

More on Investing Articles

Investing Articles

At a 52-week low but forecast to rise 73%! Is this growth share the FTSE’s top recovery play? 

This FTSE 100 growth share has taken an absolute beating over the past two years but Harvey Jones says the…

Read more »

Investing Articles

This FTSE 250 share offers a juicy 9.8% yield. Will it last?

This well-known FTSE 250 share has a percentage dividend yield approaching double digits. Should Christopher Ruane add the income share…

Read more »

Investing Articles

Is a £333,000 portfolio enough to retire and live off passive income?

A third of a million pounds can generate a serious amount of passive income, but relying on this sum alone…

Read more »

The flag of the United States of America flying in front of the Capitol building
Investing For Beginners

Why FTSE 100 investors should pay attention to ‘Liberation Day’

Jon Smith explains why the upcoming tariff announcement from across the pond could have an impact on the FTSE 100,…

Read more »

Concept of two young professional men looking at a screen in a technological data centre
Investing Articles

Here’s why Nvidia stock fell 13% in March

The Nvidia stock price rise was looking unstoppable. Should investors now be wondering if the same might be true of…

Read more »

US Stock

It’s ISA deadline week! Here’s my 3-step game plan

Jon Smith tries to calm the hype around the last minute ISA rush to buy stocks and explains why he's…

Read more »

Snowing on Jubilee Gardens in London at dusk
Investing Articles

£10,000 invested in BAE Systems shares at Christmas is now worth…

BAE Systems shares have been surging in the FTSE 100 in 2025, driven higher by the wavering US commitment to…

Read more »

Investing Articles

Up 19% in 2 weeks, can the Tesla share price rebound further?

Tesla's first-quarter delivery numbers came out today. Will they help persuade our writer to invest his money at the current…

Read more »