Tesco’s share price has increased by around 40% from its low point in December last year. The renewed optimism reflects investors’ favourable response to the new chief executive, Dave Lewis and a growing belief that the UK business has reached a turning point. The current share price is discounting a rapid return to “normal”, as the company reasserts its still dominant market position. The implicit assumption is that a resumption of growth in the UK business will automatically lead to a strong recovery in profits, even if margins do not return to prior levels.
However, this ignores the underlying structural issues facing the UK business. Sales productivity, measured in sales per square foot, has consistently fallen since 2007. At the same time, Tesco is saddled with high legacy costs that will be difficult to reduce: rental payments have ballooned following a decade of sale and leasebacks. It risks losing out to more nimble competitors. The level of future profitability is unclear, but will inevitably be much lower than it has been historically. Given the deep-rooted problems and considerable uncertainties, the shares are expensive. I am short Tesco.