At 214p, the Tesco (LSE: TSCO) share price is back down near its spring, coronavirus-crash low. Meanwhile, City analysts have pencilled in a robust double-digit percentage rebound in earnings for the trading year to February 2022.
If this happens, earnings will then be within a whisker of what the company achieved in the year to February 2020. And that was before Covid-19 hit the economy.
Does the Tesco share price undervalue the company?
In an update near the end of June, chief executive Dave Lewis explained the costs of adapting the business for Covid-19 “have been significant.” Meanwhile, business rates relief and increased sales volumes only partially offset those costs. Nevertheless, he expects operating profit for the retail operation to come in around flat this year compared to last year.
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However, Tesco will likely report a loss for its bank of between £175m and £200m in the current trading year. The directors think a surge in bad debts is coming because of fallen GDP and rising levels of unemployment. Overall profitability is “impacted in the short term,” the directors reckon. And the working assumption City analysts have is for a decline in overall earnings near 20% for the current trading year.
Between the mid-March low and mid-May, the share price rebounded by around 20%. But now it’s dropped back again. Does that combination of circumstances make the stock attractive now? Not to me. I’ve been arguing for a while the business looks over-valued.
In an article in April, for example, I said Tesco is “a low-margin, high-volume business operating in a cutthroat sector with disruptive competition nipping at its heels.” Indeed, the rise of agile competition from Aldi, Lidl and others appeared to blindside the entire established supermarket sector a few years ago. Tesco saw the collapse of its fragile profits and reducing turnover — factors that pulled the rug from under the share price.
A challenging sector
Lewis executed a masterful turnaround. And, for a while, we saw double-digit increases in annual earnings. But I reckon the stock market became too excited about those figures, and the valuation overshot to the upside. However, stripping out costs and improving efficiency can only go so far. And those tasty earnings rises were never going to continue.
I reckon we’re now seeing the gradual unwinding of the over-valuation. To me, that’s one reason the shares are weak. And there isn’t much prospect of steady growth on the horizon. Instead, Tesco seems to be retreating from its global ambitions and aiming to build its defences against the onslaught from domestic competition.
Meanwhile, the forward-looking dividend yield is just above 4% for next year. That’s insufficient compensation for the risks I’d be taking with an investment in Tesco. I’d want a yield above 5% at least.
After all, the operating margin is running below 4%, which means the firm has little ammunition to fight back. I see the most likely outcome for Tesco’s business as a managed decline in the coming years, so I’m avoiding the shares.
