After nearly five years of hard work, it finally looks as if Tesco‘s (LSE: TSCO) turnaround is starting to yield results.
Last week the company announced its highest pre-tax profit since 2014 of £1.3bn, up 795% from last year’s £145m and above analyst expectations of £1.2bn. Unfortunately, the firm has still has some way to go before profits return to their 2013-14 peak of £3bn, but CEO Dave Lewis and team seem confident that it will only be a matter of time before Tesco gets back to this high watermark.
Indeed, the acquisition of wholesaler Booker, which was completed last month, is expected to contribute around £200m in annual operating profit. Moreover, cost synergies are expected to total £60m in the first year rising to £200m per annum by year three as Tesco strips out duplicate functions and benefits from economies of scale.
Tesco’s fortunes contrast sharply with those of FTSE 100 stalwart Marks & Spencer (LSE: MKS).
Cycle of restructuring
It seems to me as if Marks & Spencer is in a permanent cycle of reorganisation. The company’s latest efforts to try and attract customers back into its stores include a management reshuffle at its fashion business. Former Halford’s CEO Jill McDonald, who took over as head of the clothing business at the end of last year, has appointed two industry veterans with experience at Old Navy and Sir Philip Green’s Arcadia empire to help “attract more families to M&S” by redesigning the clothing offering.
This is the fourth significant change in this division over the space of 10 years. And it seems City analysts have little confidence that this new team will be able to reverse the decline with Goldman Sachs recently advising its clients to sell the stock as “demand patterns have deteriorated sharply.” Competition from low-cost online brands was cited by the bank as being the principal reason for its recommendation.
Considering this view, even though shares in Marks currently support a dividend yield of nearly 7%, I believe it’s worth dumping the company in favour of Tesco, as the retailer’s recovery continues.
As Marks’ sales have stagnated over the past two years, Tesco has seen sales expand for nine consecutive quarters. The company expects to report further sales growth this year, including a £2.5bn boost from the acquisition of Booker.
City analysts are expecting earnings per share to grow by 22% for fiscal 2019 and a further 23% for 2020, which technically makes Tesco a growth stock. Meanwhile, Marks’ earnings are projected to decline 8% this year and 2% for 2019.
The one area where Tesco does not look like a better buy than Marks is on yield. The stock currently supports a dividend yield of 1.3%. Still, over the next two years, analysts are expecting the payout to more than double, which should give a yield of 3% by 2020. As earnings continue to grow, I expect Tesco to become one of the FTSE 100’s top income stocks.
So overall, Marks might look like a more attractive income investment, but the company is floundering, and its growth outlook is unclear. On the other hand, Tesco’s recovery is well under way, and over the next few years, earnings are set to multiply, which should lead to higher cash returns for shareholders, as well as capital gains.
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Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended Tesco. 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.