Shares of Tesco (LSE: TSCO) have been languishing below 200p since the end of January. How soon can they get back above that level? What are the company’s longer-term prospects? And are the shares worth buying today?
I think there are three key factors that will determine Tesco’s future.
1. Changing marketplace
The supermarket sector is in the midst of structural change. The days when people did one big weekly shop at their favourite out-of-town grocer are long gone. Food shopping has become much more of a pick ‘n’ mix affair. Online ordering and home delivery, the return of supermarkets to the high street via convenience stores, a renaissance in independent shops and farmers markets, and the growth of no-frills chains are all part of a rich tapestry of shifting shopping habits.
Tesco had over a third of the grocery market in its heyday but its share is now down to under 28%. There may be further erosion as budget chains Aldi and Lidl continue to expand aggressively, but Tesco’s turnaround under chief executive Dave Lewis appears to be gaining traction. I believe it can retain its position as the UK’s biggest supermarket, although with a lower market share and lower margins than it once possessed.
2. Turnaround on track
I saw a number of encouraging things in Tesco’s 2016/17 results last week, including group revenue and volume growth and the first like-for-like sales growth in the UK since 2009/10. I particularly liked the step-up seen in group operating margin from 1.8% to 2.3%, which encourages me to believe that management’s target of 3.5% to 4% by 2019/20 is achievable.
The consensus of City analysts for 2019/20 is for an operating margin at the bottom of the range on revenue of just under £61bn, and earnings per share of about 16p. At a current share price of 179p, this would give a price-to-earnings (P/E) ratio of 11.2.
If Tesco meets the City consensus forecasts, I would expect the trailing P/E three years from now to be more like the FTSE 100 long-term trailing average of 16, which would require a share price of 256p. This would be 43% higher than today’s 179p, and give a total return of over 50% including forecast dividends. I see this as an attractive proposition for a blue-chip giant, particularly as it’s based on an operating margin at the bottom end of Tesco’s ambitions. If the margin proves to be nearer the top end, the upside for the stock could be considerably higher.
3. Booker prize
Finally, the third key factor for Tesco’s prospects is its agreed takeover of food wholesaler Booker Group, which is subject to shareholder and regulatory approval. Tesco has the support of most of its biggest investors, although two have come out against the deal on the grounds of ‘valuation’ and ‘distraction’.
My view is that Dave Lewis has done an excellent job of getting Tesco back on track and that management is to be trusted on the timing, rationale and price being paid for the acquisition of Booker. Having said that, it was after the announcement of the deal that Tesco’s shares fell back below 200p. So, while I rate the stock a ‘buy’ today, the question of the Booker acquisition may weigh on the price for a while yet.
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G A Chester has no position in any shares mentioned. The Motley Fool UK has recommended Booker. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.