Should You Buy Tesco PLC After Sales Beat Expectations?

Shares in Tesco (LSE: TSCO) rose by 6% when markets opened this morning, after the UK’s biggest supermarket reported better-than-expected Christmas sales.

The group said that like-for-like sales rose by 1.3% in the UK, and by 2.1% across the whole group over the Christmas period. City analysts had been expecting sales to fall by more than 2% in the UK.

Is the tide turning?

The question for investors is whether the Christmas surge can be sustained. Tesco also reported a 0.5% fall in like-for-like sale for the third quarter, which ended on 28 November, this morning. It was only during the six-week period following this that sales started to rise.

Another point worth noting is that much of the improvement is being driven by Tesco’s international stores in Central Europe and Asia. Third quarter like-for-like sales rose by 3.3% in Europe and 2.4% in Asia, helping to offset a 1.5% fall in the UK and Ireland.

What about profits?

Today’s trading update was all about sales, not profits. However, chief executive Dave Lewis did confirm that the group is on course to meet full-year profit forecasts.

That seems reasonably reassuring to me as it suggests that the firm’s profit margins are holding up reasonably well in the face of price cuts. Tesco’s financial year ends on 28 February, so there shouldn’t really be any surprises from now on.

Based on the latest forecasts, earnings of 4.5p per share are expected for 2016. This puts Tesco stock on a chunky forecast P/E of 36 after this morning’s rise. Although that seems far too expensive for a big supermarket, this year’s earnings are expected to mark the low point for the firm.

A 90% increase in earnings to 8.6p per share is expected for 2016/17, putting the shares on a 2016/17 forecast P/E of 19. A dividend of 1.33p per share, giving a potential yield of 0.8%, is also forecast for next year.

It’s clear that a partial recovery is already priced into Tesco’s share price. The market doesn’t expect this company to fail. For this reason, I don’t think that today’s results alone are enough to justify a buy. Investors need to consider what might come next before deciding whether to buy shares in Tesco.

Potential earnings growth

At its peak between 2010 and early 2014, Tesco was generating average earnings of about 30p per share. I’m not sure that we’ll see that level of profit again for some time. Supermarket operating margins are likely to be permanently lower than they were historically and sales growth will be slower.

However, a more efficient and slightly smaller Tesco could be surprisingly profitable if its £9bn debt mountain can be brought under control. Reduced debt costs would boost profits and help justify a higher share price.

In my view, it’s likely to be another one or two years before Tesco’s earnings and dividend performance may become strong enough to justify big gains in the share price.

But I don’t think we’re going to see a disaster. I think Tesco looks reasonably attractive as a long-term buy-and-hold stock at current prices, especially if like me, you’re looking for a future income from dividends.

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Roland Head owns shares of Tesco. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.