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Why the Tesco share price rose 7% in September

Shares in the UK’s largest retailer Tesco (LSE: TSCO) jumped 7% last month as investors speculated about the prospect of further cash returns from the retailer. Specifically, as the firm has neared the end of its turnaround, analysts have started to wonder if the group will use excess capital to buy back its shares.

Turnaround complete

Since 2014, when Tesco’s accounting scandal broke, management has been working flat out to try and turn the business around. And under the guidance of soon-to-be-former CEO Dave Lewis, the retailer has successfully returned to growth.

More importantly, Tesco’s cash generation has improved dramatically. Last week, the retailer announced that during the first half of its financial year, it generated £814m of cash from operations, up from £397m in the prior-year period.

In October 2016, soon after he took over as CEO, Lewis set out six targets which would mark the retailer’s return to health.

Generating £9bn of cash from operations was one of them, alongside restoring the firm’s profit margins to 3.5-4%, and cutting out £1.5bn of costs. Lewis is on track to meet the cash generation target and all of the others in 2019. Borrowing has also fallen markedly. Net debt declined 8% in the first half to £12.6bn.

Cash returns

Tesco’s cash generation and stronger balance sheet has ignited speculation among some analysts that the company will start to return more cash to shareholders. City analysts already have the company paying out a total dividend of 7.9p per share for the current financial year, giving a dividend yield of 3.3%.

However, there was also talk that Tesco might unveil a share buy-back programme to return even more money to shareholders. This speculation seems to be one of the main reasons why the stock outperformed the market last month.

Unfortunately, Tesco didn’t announce further cash returns alongside its results for the six months ended 31 August. That said, the group did unveil a 59% increase in its interim dividend to 2.7p.

Growing earnings

I wouldn’t rule out further cash returns from the company going forward. Based on current City estimates, Tesco’s dividend will be covered 2.1 times by earnings per share this year. That leaves plenty of headroom to increase the payout further or return cash to investors via another method.

As well as cash returns, management is planning to invest more in developing the business which should translate into earnings growth. Tesco is rolling out its new Clubcard experience later in 2019, and its wholesale food business Booker recently acquired competitor Best Food Logistics, which will add £1.1bn in foodservice sales to the group.

Before this deal, City analysts were forecasting earnings growth of 3% for fiscal 2020 and 11% for fiscal 2021. I expect the targets to be revised higher over the next few weeks as analysts plug the Tesco’s recent numbers into their spreadsheets.

The bottom line

Considering all of the above, I’m incredibly optimistic about the outlook for Tesco. I think there could be further cash returns on the cards for shareholders at some point as well as steady earnings growth. The stock’s current multiple of 14.5 times forward earnings is, in my opinion, a price worth paying for these qualities.

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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.