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Tesco plc or Mothercare plc: which is the best recovery play?

Today I’ll be taking a closer look at two retailers who’ve suffered at the hands of the market in recent years, Mothercare (LSE: MTC) and Tesco (LSE: TSCO). Do either of these companies make for a good recovery play, or is there further pain on the horizon?

Return to profits

Specialist retailer for parents, babies and young children Mothercare has been under pressure for a number of years, with sales in steady decline since 2012. However, things could be about to change as recent results showed a return to profit for the Watford-based business after all those years in the red. Full-year results for the group, which also owns the Early Learning Centre chain, revealed a pre-tax profit of £9.7m, compared to losses of £13.1m posted in 2015. Revenues came in £31.6m lower at £682.3m, as growth in UK sales was offset by a decline in international sales. Despite the hiccup in overseas operations, the market has reacted well to the news with the shares on the rise since the results were announced on 19 May.

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I think the business could be turning a corner, with our friends in the City predicting 15% earnings growth this year, followed by an even better 27% improvement for fiscal 2018. The valuation looks tempting too, with shares in the small-cap firm trading on a very reasonable 13 times forecast earnings for the current financial year, falling to just 10 times for the year to March 2018. I believe the achievable growth projections and favourable valuation make Mothercare a strong candidate for contrarian investors looking for capital growth.

Not in my basket

Credit Suisse last week cut its target price for supermarket giant Tesco from 135p to 115p saying that performance at the larger stores is likely to be worse than reported and that margins should be permanently rebased lower. The Swiss investment bank kept its underperform rating on the Hertfordshire-based retailer, but values the shares at well below their current level of around 165p. In recent months, consensus earnings projections have been revised downwards. The FTSE 100 blue chip is now expected to deliver £545m in underlying profits in FY2017, increasing to £752m for the year to February 2018, representing healthy earnings growth of 141% and 38%, respectively.

However, at current levels the shares are trading on an expensive-looking 25 times earnings for the current year, falling to a still-expensive 18 times for fiscal 2018. The shares have given up a fifth of their value over the last 12 months, but in my view still look risky given the demanding valuation and optimistic earnings projections. Fierce competition from no-frills rivals Aldi and Lidl, and traditional competition like Asda, Morrisons and Sainsbury’s could make the road to recovery a long one. For me, Mothercare represents the better recovery play.

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Bilaal Mohamed has no position in any shares mentioned. 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.

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