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Is Tesco plc heading back to 300p?

Photo: C41n. Cropped. Licence: https://creativecommons.org/licenses/by-sa/3.0/

Shares of Tesco (LSE: TSCO) fell by 3.5% to 188p this morning, despite the UK’s largest supermarket reporting its first like-for-like annual sales growth for seven years.

Sales, excluding VAT and fuel, rose 4.3% to £49.9bn, while like-for-like sales were 0.9% higher. Tesco’s adjusted operating profit lifted 24.9% to £1,280m. Operating cash flow from the group’s retail business rose 9.1% to £2,279m, which helped fund a 27% reduction in net debt to £3.7bn.

A notable success was that Tesco’s underlying operating margin rose from 1.8% to 2.3%. This suggests to me that the group’s target of 3.5-4.0% by 2019/20 may be achievable.

Not all good news

Unfortunately there was a downside to these polished headline figures. The group’s reported pre-tax profit fell 39.1% to £145m, on the back of £235m payments made to the Serious Fraud Office and the Financial Conduct Authority.

Although the 2.3% improvement in Tesco’s operating margin is good news, is still lower than those of its smaller rivals Wm Morrison Supermarkets (2.9%) and J Sainsbury (3.1%).

There’s no dividend for last year, but as previously promised payments will be restarted during the current financial year. Tesco says it is targeting medium-term dividend cover of two times earnings per share. Analysts’ forecasts prior to today’s results suggested a payout of 3.26p per share for 2017/18. This would give a yield of 1.7% at the current share price of 188p.

Don’t underestimate this supertanker

Tesco is the supertanker of the UK supermarket sector. It’s by far the biggest and is likely to take longer to turnaround. But once moving in the right direction, I believe the group could gain surprising momentum.

Chief executive Dave Lewis is keen to remind shareholders that he’s planning for the long term, not just trying to apply quick fixes. An example of this is the money being spent on increasing the number of big stores that are owned freehold by Tesco, rather than leased.

The group increased its proportion of freehold stores from 50% to 57% last year. Over the last 13 months, Tesco has bought back 23 stores, reducing the firm’s annual rent bill by £36m.

A second example of long-term planning is Tesco’s proposed acquisition of food wholesaler Booker Group. This £3.7bn deal has met with opposition from some big investors, but I’m impressed by the long-term growth potential it seems to offer. Combining with Booker would see Tesco increase its share of the lucrative convenience store market and become a major wholesaler to the restaurant trade.

Will Tesco get back to 300p?

On a short-term view, Tesco stock looks fully priced to me. At 188p, it trades on a P/E of 19 times 2017/18 forecast earnings, with a prospective yield of just 1.7%.

But if the firm can hit its target of a 3.5-4.0% operating margin by 2019/20 and deliver modest sales growth, then I estimate that earnings of 16-20p per share might be possible. Together with an increased dividend payout, this would make a 300p share price seem quite reasonable.

In my view, Tesco looks an attractive long-term buy at current levels, but investors looking for short-term profits may want to shop elsewhere.

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Roland Head owns shares of Tesco and J Sainsbury. The Motley Fool UK has recommended Booker. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.