Ocado frenzy overshadows under-valued Tesco

Much has been made of the Ocado valuation in recent weeks but in stark contrast little has been made of the valuation of the sector’s 60lb gorilla that could no doubt squash Ocado if it liked. Actually, Waitrose could probably squash Ocado if it liked.

Outlandish Ocado valuation has not helped Tesco yet.

What’s happened to Tesco is that it now sits on a PE (price/earnings) of a mere 11x, which puts it in-line with the rest of the sector. The problem with this is that it is so unlike the rest of the sector. Almost as unlike the rest of the sector as Ocado – at least that’s what the online grocer’s management told us, but the investment community didn’t buy it.

Tesco is different in that it is highly likely to deliver on its key potential areas of growth. And compared with the other major UK supermakets it has a lot more levers for growth to pull on. These include international, retailing services, a growing direct business, and a more advanced non-food operation.

However, the City has been cautious on its prospects in each of these key areas for a variety of rational reasons. The sort of rational objectivity that failed the numerous bankers advising on the Ocado IPO.

The research boffins at broker Bernstein Research have done plenty of legwork to answer the doubts about Tesco’s growth opportunities:

Beware: City retail analyst at work

1.For the question of whether the slowdown in the UK food industry’s growth will put ressure on Tesco’s margins? There is an argument that Tesco’s relative performance now places it among the rest of the grocery pack and that growth will accelerate in H2.

2. As to whether there is pressure on space growth? Tesco will grow square footage by 7.3% in the UK, compared with 5.5% in 2009. And a chunk of market share will continue to be gained from smaller players, especially in non-food, where almost 50% of Tesco’s space is being added in what remains a very fragmented market.

3. On the issue of whether Tesco’s internationmal returns will improve? There is the argument that those markets now giving low returns will be the big growth generators in the future. Tesco recently disclosed that returns were 30% higher than the international average in markets where it is the number one or two operator. And an additional 40% higher returns are gained when these store mature beyond four years old.

4. As to the concern about the viability of the US Fresh & Easy Business? Acknowledging that growth is 25% slower than intended, this should however accerate as the concept is unique and valid in the US market.

5. Concerns over the succession plans for Sir Terry Leahy’s departure are regarded as overblown and the new management structure is well suited to a business increasingly leveraging its global scale.

6. With regards the question of how much can be gained from Tesco’s services division (Dunnhumby, Tesco.com, Banking and Telecoms)? Yes, there are operational risks, but the opportunity to build on its existing customer relationships is massive.    

Bernstein reckons these arguments should justify a higher multiple for Tesco than the measly 11x it currently sits on. And with the Ocado frenzy out of the way and reality returning to valuations we may now see this being addressed by the market.

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