I’ve been fairly positive about the long-term investment potential at Tesco (LSE: TSCO), but the firm’s shares have fallen by 12% since its results were published on 13 April.
Over the last month, consensus forecasts for Tesco’s 2016/17 earnings per share have fallen by 20%, from 8.71p to 6.96p. And there’s no sign of any end to the supermarket price war, which could keep a lid on profit growth.
Tesco shares currently trade on a 2016/17 forecast P/E of 25 and a 2017/18 forecast P/E of 17. These valuations don’t seem to leave much room for disappointment, in my view.
It’s not all bad
Despite this downbeat view, I thought that Tesco’s recent results were pretty good, considering the position the group was in one year ago.
Net debt fell from £8.5bn to £5.1bn, and the group’s operating margin rose slightly, from 1.64% to 1.73%. Perhaps more importantly, cash flow improved significantly. Free cash flow from Tesco’s retail operating activities rose from minus £1,340m in 2014/15 to plus £1,280m last year. That’s an impressive achievement, if it’s sustainable.
My only concern with this figure is that it includes sales from Tesco’s discontinued Korean business, plus a number of changes to supplier payment procedures. I’m not sure whether this strong performance is repeatable. It may take another year to get a more realistic idea of the firm’s sustainable free cash flow.
Profit margins could rise
Tesco boss Dave Lewis plans to continue to focus on selling unwanted businesses and maintaining low prices this year. Doing this means that delivering rising earnings will depend on increasing the firm’s profit margins.
Last year’s overall operating margin of 1.7% was flattered by Tesco Bank (17%) and Tesco’s more profitable overseas operations (2.7%). Tesco’s UK retail business generated an operating margin of just 1.2%. Improving this margin is essential if shareholders are to enjoy rising earnings and a return to dividend payouts.
This could be a slow process. In its recent results, Tesco said that improvements in profitability could slow this year as the group continues to focus on price cutting to win back customers.
I think this is the right approach, but it’s likely to be a bitter pill for shareholders to swallow, as it could reduce the firm’s ability to deliver rising earnings and restart dividend payments.
What about dividends?
Until 2014, Tesco was one of the most popular dividend stocks among UK investors. That reputation has now been lost, as Tesco hasn’t paid a meaningful dividend for two years.
Payouts should resume this year, but at a much lower rate than in the past. Current forecast suggest a payout of 1.74p per share is possible for 2016/17, giving a forecast yield of 1%.
Buy or sell?
In my opinion, Tesco’s recovery is going well and could well succeed. But it’s going to be a long haul. Investors holding on now should probably plan to tuck the shares away for at least another two or three years for any chance of a decent return, in my view.
