It may sound unlikely, but Tesco (LSE: TSCO) is currently one of the top risers in the FTSE 100.
Shares of the UK’s largest supermarket have risen by 16% over the last month and by 37% over the last year. In contrast, the big-cap index has managed a gain of just 3% since April 2017.
Tesco’s share price has now risen by 45% from its 52-week low of 165p. But as I’ll explain, I think there’s good reason to expect further gains over the next couple of years.
Why should the shares rise?
My Foolish colleague Kevin Godbold said recently that Tesco’s recovery was “an efficiency-driven rebound from a catastrophic earnings collapse and not a sustainable growth story”. In other words, the company isn’t growing, it’s just fixing problems that were crushing its profits.
You can make a good case for this. Underlying operating profit rose by 28.4% to £1,644m last year. But the group’s sales only rose by 2.3% to £51bn. So the extra profit was driven by cost savings and the absence of costly problems seen in previous years.
I’m happy to admit that Tesco is unlikely to become the kind of dynamic growth business which can be found at the small-cap end of the market. But that doesn’t mean growth is unlikely.
Fix first, then grow
Chief executive Dave Lewis knew that fixing the business was essential before it could return to growth. I think last year’s strong results suggest this turnaround process is now nearly complete.
I believe we’re now going to start seeing more growth, led by the integration of the Booker wholesale business into Tesco’s operations.
This deal means that the supermarket will now sell food to thousands of restaurants and supply an extra 3,000 convenience stores. Acquiring Booker also allowed Tesco to recruit the smaller firm’s highly-rated chief executive, Charles Wilson.
Mr Wilson is now running Tesco’s UK business, but he’s widely seen as the eventual successor to Mr Lewis. As the Booker sale left him with a Tesco shareholding that’s said to be worth more than £200m, Mr Wilson’s interests should be well aligned with those of shareholders.
What comes next?
I think the Booker merger will be a cost-effective route to sales and profit growth for Tesco. Analysts expect the combined group’s adjusted earnings to rise by 15% to 13.7p per share this year. A further increase of 22% is expected in 2019/20.
These projections put the stock on a forecast P/E of 17 for the current year, falling to a figure of 14 for 2019/20. Alongside this the forecast dividend yield rises to 2.1% this year, and to 3% next year.
I’d buy this dividend
Of course, earnings aren’t likely to continue growing at this rate indefinitely. Once the integration of Booker is complete, I expect more gradual growth.
However, Tesco’s current strong momentum could mean that earnings rise more quickly than expected. Broker profit forecasts for 2018/19 have risen by 13.5% over the last three months. Forecast for 2019/20 have climbed 10%.
At current prices, I expect the shares to yield 4% within three to five years. In my view, now could be a good time to buy this stock for a long-term dividend growth portfolio.
