Tesco’s (LSE: TSCO) new CEO Dave Lewis has a tough task ahead of him. That’s because the company has experienced a dismal few years that have seen its market share shrink, its profits fall and its share price decline from as much as 487p in 2007 to the current 228p. However, all is not lost at Tesco; it remains a company with considerable potential that could deliver a total return of 25%+ over the medium term. Here’s why.
Changing Tastes
The shops that feature on a typical UK high street today are a lot different from those that appeared before the credit crunch. For instance, today there is a plethora of charity shops, pound shops and other discount stores that have replaced a number of chains and independent stores that have ceased to trade. A key reason for this is a change in customer tastes, with people now far more focused on price than they have been for a considerable period of time.
Clearly, price is not the only consideration; quality and service remain important to many shoppers but, it seems, they have become a distant second and third. That’s because a combination of relatively high inflation in recent years and anaemic wage growth has left many people feeling the effects of a real terms decrease in disposable income. This has allowed the ‘no-frills’ discount supermarkets such as Aldi and Lidl to eat away at the market share of Tesco and hurt its bottom line.
More Change?
However, the tide could be turning. Just last week, Bank of England Governor Mark Carney said that he expects wages to begin rising in real terms as early as mid-2015. This means that, for the first time in a number of years, people may start to have more cash (in real terms) in their pockets and could begin to feel under less financial strain. In turn, this may have the effect of reducing their focus on price and cause them to again consider quality and service more important than they have done in recent years.
The Effect On Tesco
This would be great news for Tesco because its niche has been to offer decent quality and service at a competitive price. Clearly, Dave Lewis and his team must be ready to communicate this message but, if customer desires do begin to switch back to what they were before the financial crisis, the company could find itself swimming with the tide rather than against it. The impact on Tesco’s bottom line could be significant.
Looking Ahead
Although Tesco has cut its dividend, it still yields an impressive 3.5%. Furthermore, its current payout ratio appears to be extremely cautious at 36% and, although earnings are set to fall again next year by 9%, it could be argued that a higher payout ratio is still warranted. After, all Tesco remains a highly profitable business.
Were Tesco to pay out 45% of profit as a dividend (instead of the current 36%) and assuming shares in the company continue to trade on a yield of 3.5%, it would mean Tesco’s shares reaching a price of 285p. That’s 25% higher than the current share price and seems to be a realistic price target over the medium term, with shares last being at that level as recently as July 2014.
Certainly, more share price growth is very achievable over the medium to long term but, for now, a return of 25% seems realistic (and would be welcomed) by Tesco’s long-suffering shareholders.
