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Tesco’s share price may see more upside this year

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As demonstrated by a steady recovery in its share price, investors are turning more optimistic towards the Tesco (LSE: TSCO) turnaround plan. The value of the supermarket giant’s shares has gone up by 39% over the past 12 months, including a 15% increase since the start of the year.

Margin growth

Tesco’s margin growth has much to do with the improving sentiment towards its shares. Last year, the group operating profit margin rose to 2.9% from 2.3% a year earlier, marking its third successive annual increase and putting the company on track to meet its 3.5-4% target by 2019/20.

Some analysts reckon that the company could meet its margin target even sooner and that its current goal isn’t ambitious enough. As pricing pressures ease and like-for-like sales grow, fundamentals in the sector are improving.

Still, I’m sure that many investors are nervous as the German discounters Aldi and Lidl continue to gain share in the UK grocery market. They’re planning hundreds of new store openings over the next few years at a time when the Big Four players have slammed the brakes on their own expansion plans.

Discount valuation

But shares in Tesco also trade at a discount to its smaller rival Morrisons (LSE: MRW). At the time of writing, Tesco trades at a forward price-to-earnings ratio of 17.1, while Morrisons is valued at 19 times its expected earnings this year.

I reckon this valuation gap seems unwarranted given Tesco’s improving financial performance and potential synergy benefits from its acquisition of wholesaler Booker. Cost synergies are expected to generate savings of £60m in the first year, and at least £200m annually three years on from the deal, which would add significantly to its bottom line.

A re-rating of its shares could come about from an increase in shareholder payouts. Its balance sheet is in a much better shape now, after net debt fell by nearly 30% to £2.63bn over the past year. And with growing free cash flow, this could mean an increase in its full-year dividend or a share buyback could be on the cards in the near term.

Morrisons

Morrisons also has a few catalysts of its own. The smaller rival is expanding in the wholesale supply business following a new supply agreement with SandpiperCl, and is seeking to lower its costs via investments in existing stores and infrastructure. It is already realising efficiencies in automated ordering and in-store administration, and this is beginning to show up in its margins.

Free cash flow in the year to 4 February 2018 dipped to £350m, from £670m last year, but the company still afforded a special dividend of 4p, which raised total dividends for the year up 85.8% to 10.09p. At its current share price of 235p, this gives it a combined yield of 4.3% for the year.

What’s more, City analysts are warming up to its shares. Out of 18 analysts covering the stock, four have ‘strong buy’ recommendations on Morrisons, up from just two three months ago.

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Jack Tang has no position in any of the shares 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.