Tesco to go
Invesco-Perpetual's Neil Woodford tends to get the big calls right. He stood aloof from the technology boom. He sold banks before the financial crisis. So when he sold his remaining 167 million shares shares in the UK's largest supermarket Tesco plc (LSE: TSCO) (NYSE: TSCDY.US) one year ago, markets took notice. With Tesco's full-year results showing a whopping 52% drop in statutory profit before tax to £1.96bn, Woodford looks like he may have got it right again. I beg to differ.
So why did Woodford lose faith in Tesco, which he has held for 20 years and made up 3.4% of his Income and High Income funds? Like many investors, he had been shaken by a poor Christmas 2011, which triggered its first profit warning in 20 years and a 16% drop in the share price. He had expected food retailers to withstand the recession better than most, but was worried by Tesco's drift into non-food items and its faltering overseas expansion. This was no longer the defensive stock he thought it was. His big worry was that he was selling at a distressed price of around £3.20, but he sold anyway.
A few months later, I bought Tesco at the same price, and I'm glad I did. It now sells for £3.72, even after a 3.3% drop in early trading on Wednesday, after its results were published. Investors had braced themselves for a 10% drop in profits, they got 14.5% a drop in profits before tax, at actual exchange rates. The other piece of news was less of a surprise. We all knew Tesco was dumping its rotten US venture, Fresh & Easy. That may count as good news, despite the £1.2bn write-down. Tesco's results treat the venture as "discontinued", otherwise its big profit drop would have been even more dramatic. There was another £804m of write-downs in the UK, for more than 100 sites Tesco bought at a higher point in the property cycle, but now has no plans to develop. Tesco is a growth monster no more.
Tesco is still up 15% since Woodford sold. And it yields 3.8%, above the FTSE 100 average of 3.2%. Trading at 10.7 times earnings, it looks, if anything, undervalued. Then again, its future is mixed. Earnings per share (EPS) growth is forecast to fall 8% in the 12 months to 28 February 2014, although it may rebound 8% in the following 12 months. Its customers are under pressure, as inflation continues to outstrip wages growth. Shoppers see Tesco as downmarket, and its staff as downtrodden (and surly as a result). They shop there because it's cheap, not because it's cheerful. But they still shop there.
3.5 billion reasons to buy
Tesco is also going through a major strategic shift, transforming itself into a "multichannel" retailer, while battling to maintain its market share against stiff competition and the interminable slump. It got the US completely wrong, which makes you worry about its strategy in Europe and Asia (there were further write-downs in the Czech Republic, Poland and Turkey). Tesco claims to be making "good progress in the UK", but still posted an 8.3% drop in UK profits to £2.3bn. Management held its final dividend at 10.3p, giving a full-year dividend of 14.76p. It is looking to grow this in line with underlying earnings, with a target 2% cover (it is currently covered 2.4 times).
Management is fighting back, revamping stores, hiring more staff and cranking up its online operation, where sales rose 13% to £3bn. It is targeting free cash flow, disciplined capital allocation, mid-single digit trading profit growth and a 12% to 15% return on capital employed (ROCE). Do I think Neil Woodford was right to sell? Clearly not, since I bought at the same price. These are tough times for Tesco, but then, these are tough times. With the US written off, at least Tesco can move on. The next set of results can't be as bad as this one. The glory growth days may be gone, but it looks a solid long-term hold to me.
A Foolish thought
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