Since the beginning of this year, Tesco’s (LSE: TSCO) shares have mounted an impressive recovery.
Year to date, the company’s shares have gained just under 16%, beating the wider FTSE 100 by 15% excluding dividends.
However, Tesco’s underlying trading does not reflect this buoyant performance. The group’s sales are still falling, and the discounters continue to steal market share.
That being said, Tesco’s relatively new CEO Dave Lewis has wasted no time in streamlining the group’s operations. Unnecessary costs have been slashed, and the group’s aggressive expansion plan has been curtailed.
But there’s plenty to be done before Tesco can claim to be on the road to recovery.
High expectations
The majority of Tesco’s gains over the past six months have been driven by optimism — the market is already pricing in a strong recovery.
Much of the company’s recovery, in the near-term at least, will be driven by cost cuts.
Tesco is planning to cut costs by £250m per year, which is a sizable figure. City analysts only expect the company to report a pre-tax profit of £900m for 2015.
Still, Tesco can only cut costs so far and ultimately, the company’s recovery will depend on its ability to lure customers back into its stores.
Attracting customers
When it comes down to sales growth, Tesco is making some progress. Indeed, although sales continue to decline, customers are returning to Tesco’s stores.
According to Kantar Worldpanel, during the 12 weeks to February of this year, 236,000 shoppers returned to shop at Tesco.
Moreover, according to Tesco’s recent trading update during the 13 weeks to the end of May, 180,000 customers started shopping with the group. Sales volumes during the period increased by 1.4%.
Making progress
With costs falling and customer numbers increasing, it’s clear that Tesco is making progress.
Although, the company still has a long way to go before its recovery really starts to gain traction.
For example, Tesco is struggling with a £22bn debt pile including rent and its pension deficit.
Asset sales are planned to help reduce this debt pile. The sale of Tesco’s South Korean unit, as well as the group’s pioneering customer-data-management business, Dunnhumby could raise as much as £6bn, a welcome cash infusion.
Additionally, management has agreed that the company will pump £270m a year into its pension fund to try and plug the deficit.
Time will tell
Over the next twelve months, Tesco’s recovery should start to play out. Cost savings will start to filter through, and asset sales will allow the company to pay down debt, reducing interest costs.
However, until the group shows concrete signs of a recovery, the market will remain sceptical. That’s why I’m wary of Tesco’s shares after recent gains.
Specifically, Tesco currently trades at a forward P/E of 25.5, a lofty valuation that leaves little room for error if things don’t go to plan.
