What's the Next Step for Tesco?

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Everyone's always looking for the very best buying and selling opportunities in today's uncertain market, and here to help you analyze the long-term prospects of a multinational retailer is Zarr Pacificador, from The Motley Fool UK.

What are the long-term prospects for Tesco Plc (LSE:TSCO) (NQ:TESO)?

I'm always searching for shares that can help ordinary investors like you make money from the stock market.

Right now I am trawling through the FTSE 100 and giving my verdict on every member of the blue-chip index.

I hope to pinpoint the very best buying opportunities in today's uncertain market, as well as highlight those shares I feel you should hold...and those I feel you should sell!

I'm assessing every share on five different measures. Here's what I'm looking for in each company:

1. Financial strength: low levels of debt and other liabilities;

2. Profitability: consistent earnings and high profit margins;

3. Management: competent executives creating shareholder value;

4. Long-term prospects: a solid competitive position and respectable growth prospects, and;

5. Valuation: an underrated share price.

A look at Tesco

Today I'm evaluating Tesco, a British multinational retailer, which currently trades at 363p. Here are my thoughts:

1. Financial strength: Tesco is in solid financial position. Net debt/operating cash flow is less than 2 times; net gearing is 50%; interest cover is an adequate 7.5 times; and free cash flow has averaged nearly £2bn per year over the last 3 years.

2. Profitability: Tesco has delivered outstanding growth for nearly two decades. However, with the continuing weakness in Europe and facing stiff competition at home, the company has struggled of late. In the last fiscal year, underlying profit before tax declined by 15%, while underlying earnings per share fell by 14%. Forced to compete in price, the company's margins have contracted from to 3.4% from 5.6% the previous year. Also, international trading profit declined by 22%, due to the impact of regulatory changes in South Korea and impairment of businesses in Turkey, Poland, and the Czech Republic.

3. Management: I believe the company's new direction under Philip Clarke, which focuses on developing its multichannel footprint, strengthening its core UK business, and adopting a more prudent international growth strategy, places the company in a better position moving forward.

4. Long-term prospects: Tesco has fallen out of favor with investors recently after a rough 18 months, where it was rocked by the horsemeat scandal, several quarters of declining market share and like-for-like sales, and write-offs of its Fresh and Easy US business and several UK properties of more than £1bn and £804m, respectively. However, despite the grim outlook, I believe Tesco's competitive position remains solid. It is still the largest UK grocer with a market share of 30%—almost doubling that of its closest rival Wal-Mart's ASDA. It also owns the UK's widest store network, with around 3,000 stores and the world's largest and most profitable online supermarket, which reached a record-high revenue of over £3bn last year. In addition, it is the number one or two retailer for general merchandise in eight out of nine of its international markets. Furthermore, to adapt to the rapidly changing retail environment, the company has announced new strategic objectives which include: a shift from traditional large-store formats to building its multichannel retail capabilities, such as convenience and online retailing; focusing on its core UK operations to maintain its leading position—the company has invested around £1bn to overhaul its superstores; and adopting a more disciplined approach to international expansion, concentrating only on markets that could deliver strong investment returns.

5. Valuation: With a market cap of £30bn, Tesco trades at a forward price-to-earnings (P/E) ratio of 11—slightly below its 10-year median P/E of 13 and the industry average of 12—and a prospective dividend yield of 4%, twice covered.

My verdict on Tesco

Although recent results have been disappointing and with competition in the UK likely to remain competitive, I think the company still owns a distinct advantage with its scale and size. Also, its profitable international business—29% of the company's profits come from outside the UK—and established online presence could be a source of future growth opportunities.

Moreover, the company intends to tighten capital spending during the next few years—around 3.5% to 4% of revenue—which will add to its already strong cash flow. What's more, shares are trading at an undemanding P/E of 12, a discount compared to its peers Wal-Mart and Carreouflour. So overall, I believe Tesco at 363p looks like a buy.

Zarr does not own any share mentioned in this article. The Motley Fool owns shares in Tesco.

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