Are Tesco shares now a bargain?

By David Bell - February 1, 2012 | Tickers: COST, DG, TGT, TSCO, WMT | 0 Comments

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Tesco (LSE: TSCO) is currently trading at its lowest share price for years. Excluding the darkest hours of the last recession, you have to go back to 2006 for a lower price. In a recent article, I covered the reasons why Tesco's Christmas trading statement caused their share price to drop 20%. Once you understand why shareholders were so concerned by the contents of that short statement, the important question is whether Tesco shares are now a good investment at this lower price.

At the current share price of around £3.23, the P/E for Tesco for the last full year (2010/2011) is under 9. The P/E for the trailing four reported quarters is around 8.5. Let's compare that with their rivals, firstly in the UK. Sainsburys have a P/E quoted at over 13, while Morrisons is over 11. In the US, Tesco's current P/E also seems cheap. Wal-mart (NYSE: WMT) has a P/E of 13. However, the PEG of 1.1 does suggest it has some growth to help justify the price. Wal-mart have been growing EPS and dividends for years, including throughout the last recession. It looks like a share worthy of more investigation itself, all be it on a higher P/E than Tesco. Target (NYSE: TGT) has a P/E of 12, and like Wal-mart has a PEG of 1.1 helping to justify its price. However, Target did drop earnings in 2009 during the recession, suggesting it isn't quite as solid in the harder times. Dividends did continue to grow through 2009, but only just. The yield is currently a little over 2%. By comparison the Dollar General (NYSE: DG) P/E of 21 looks very high. A quick look at the figures does reveal a PEG of 0.8, showing real growth in EPS. However, total revenue grew by a little over 10% in 2011, so its not clear how long the growth can continue for. Dollar General also has no dividend at all. Costco (NASDAQ: COST) has an even loftier P/E, at 25. The PEG of 1.4 doesn't do much to help justify the price either. The dividend continued to grow even through the last recession, but at just over 1%, investors are not going to get rich from that alone. This leaves Costco investors relying on EPS growth, yet EPS don't look that solid. EPS suffering a fairly major haircut in 2009, losing around 15%. All of this raises the question of whether Tesco can expect a reasonable level of growth in the coming years. After all, cheap or not, if there is little earnings growth, there will likely be little share price growth. If the growth dries up completely then I doubt investors would continue to pay a P/E of 8.5. We should probably expect a further share price drop if that happens. 

Tesco's revenue has been up every year in recent times, though the rate of growth has slowed. It was around 8% for the 2010/11 financial year, which ended in February 2011. Mid-year revenue for 2011/12, reported in October 2011, still showed around 8% revenue growth. However, by the third quarter, the revenue growth was down to a little over 5%. The worst was still to come though, in the form of Tesco's Christmas trading statement, as I wrote about recently.

Looking more deeply into the numbers, we see that the all-important UK like-for-like revenue growth is now negative. While the second and third quarter figures were basically flat at close to 0% growth, the Christmas figure was down 1.3%. It remains to be seen whether Christmas was the low point, or just the latest point on a declining line. Despite this negative like-for-like revenue growth in the UK, total UK revenue actually continued to grow. This was thanks to 3% growth from new stores and new floor space. However, as already discussed, Tesco's plan to reduce UK capital expenditure will likely reduce this new space growth, potentially leaving total UK sales flat over 2012/13.

With the UK struggling, can international growth drive Tesco forward? The Asia figures during the Christmas period showed growth of around 7%. This could have been higher, but for continuing issues in Thailand owing to the floods there. Asia currently makes up around 1/6th of Tesco's income. To put this into some context, we can use the rule of 72 to estimate that at this rate of growth, Tesco could double its Asian revenue in around 10 years. This would bring it up to around half as much as the current UK revenue. Europe is growing rather more slowly, at around 2%. The rule of 72 tells us that this will take around 36 years to double. Europe is also around 1/6th of Tesco revenue currently. At the current rate, Europe is not exactly going to drive Tesco forward quickly.  The US operation is continuing to lose money at the moment, but revenue grew by 40%, with like-for-like growth at an equally impressive 20%. There is therefore reason to believe Tesco's claim that they could start making a profit in the US by the end of this financial year. However, revenue numbers from the US currently make up only 1% of Tesco's total revenue. Once again, to gain more understanding of what the US could mean to Tesco in the future, the rule of 72 lets us estimate that US revenue could double every 2 years. In 10 years Tesco's US operation would contribute an amount equal to 1/3rd of the Tesco's current total revenue, assuming of course that it continues at the current growth rate. Pulling all these figures together, even if Tesco's UK revenue remains flat, in 10 years time it is not impossible that Tesco's total revenue could have increased by 50%. This would actually be an average growth rate of around 4% a year, though the US maths is extremely ambitious.

One of the primary reasons to hold Tesco shares has been for the dividends. The current yield, following the share price drop, is around 4.5%. Tesco has increased its dividend in each of the last 27 years. Its policy has been to increase the dividend in line with earnings growth. Sure enough, in the interim results it raised the dividend by 5.9%, in line with the EPS growth. Let's look at a realistic worst case, where Tesco's growth continues to drop. We could take the Christmas figures as representing the average of the reasonable third quarter and a much worse fourth quarter. From this we can estimate 3% total growth in the second half of the financial year. Some very rough maths suggests this would lead to 2% EPS growth, and so a 2% dividend increase. That would be a worryingly low increase. For a share with such a trusted dividend history, if it were to break that 27 year dividend run at some point, we could see another large share price drop. Thanks to Tesco's sensible dividend policy over the years, the dividend is covered around 2.5 times by earnings. However, I expect the dividend growth to continue to follow the EPS growth, and so I don't expect Tesco to eat into this cover to increase the dividend, should EPS growth flatline or go negative.

With all this in mind, if you were to buy shares in Tesco today, where could you expect to make your money? In the short term, it certainly looks as though revenue and EPS growth are going to be low. If you assume that it will remain flat and you buy just for the current dividend yield, the rule of 72 estimates that a one-off lump sum invested in Tesco would double your money in 16 years. The rule of 125 estimates that regular investments in Tesco would take 28 years to double. I find that using these rules helps to provide a better understanding of the real benefit of a particular rate of return. 

Away from the dividend, near zero growth in the UK could leave Tesco with an overall growth rate of just 1 or 2%. However, if you believe the international growth can continue for at least 10 years at the current rates, then you could be looking at a growing growth rate averaging 4% by 2022. Ultimately then, shareholders can expect the international growth to protect them from the UK issues in the short term, and can collect a good dividend whilst waiting for better growth in the long term.

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