Join our community of smart investors

Take a look at Tesco

Shares in Britain's largest supermarket look interesting.
June 22, 2018

With Britain’s largest supermarket chain having successfully completed its game-changing acquisition of wholesaler Booker, we’re turning our attention back to Tesco (TSCO). The company has been in recovery mode for the last four years in the wake of a high-profile accounting scandal, promising those investors willing to take a punt on the shares that operating margins would reach 4 per cent by 2020. Now, with former Booker chief Charles Wilson on the Tesco management team, and improved trading conditions in the grocery sector, we believe the shares are worth buying.

IC TIP: Buy at 256p
Tip style
Growth
Risk rating
High
Timescale
Medium Term
Bull points

Booker merger complete
Exiting online non-food business
Good grocery backdrop
Medium-term targets credible

Bear points

Competitive environment
Integration risk

Let’s start with the big picture. Recent Kantar Worldpanel data shows that grocery continues to be the one bright spot in UK retail. While general retailers scramble to minimise disruption from erratic weather and an early Easter, the UK grocery market grew by 2.7 per cent over the 12 weeks ended 20 May. Much of this is related to an inflationary pricing environment bringing about the end to years of fierce discounting. The data showed sales at Tesco rose by 2.2 per cent, and an extra 170,000 customers visited its stores. True, Tesco lost 0.1 per cent of its market share over the period, but it still remains Britain’s largest grocer with 27.7 per cent of the market.

It can’t be ignored that the sector is undergoing radical change. Not only has Amazon galvanised the need for a strong online operation, the potential tie-up between Sainsbury’s (SBRY) and Asda could push Tesco into second place.

And while the Booker deal has provided Tesco with significant pricing power and control over the supply chain, it still needs to adapt to changing events to remain competitive. It’s hardly surprising, therefore, that the group plans to close Tesco Direct – which sells general merchandise products online – to focus solely on its food business in the UK. The lossmaking division was fighting in an increasingly competitive space, but will now officially close on 9 July 2018. Analysts and investors have responded positively. The decision marks the first official move by Charles Wilson as part of the Tesco board, and the eradication of Tesco Direct losses should help underpin full-year forecasts. 

Expectations are also rising that Tesco will achieve the medium-term goals it laid out in 2016. Margins managed to reach 3 per cent in the second half of its recent financial year, bolstering hopes that Tesco will make its 4 per cent target on time. However, some sector analysts remain cautious, especially over the projected £200m-worth of savings from the tie-up with Booker.

Encouragement can be taken from first-quarter trading to 26 May 2018, showing a 1.8 per cent rise in group like-for-like sales, including a 3.5 per cent increase in the UK and Republic of Ireland, while underlying sales at Booker grew by a whopping 14.3 per cent. Around 3,000 Booker products are now fulfilled from the Tesco Magor distribution centre, while the Middleton site is set to lend additional support during what’s expected to be a busy summer. 

The serious damage done to profits by the 2014 accounting scandal left Tesco's shares trading on s recovery multiple (ie, a very high price/earnings ratio). We're now starting to see evidence that earnings can rise to justify the hopes reflected in that earlier high PE ratio, with the earnings recovery to date making the rating now look more readily palatable. If improving cash flows manage to bring total indebtedness (net debt, plus lease commitments, plus pension deficit) then falling finance costs could also prove a big plus for the bottom line. Indeed, total indebtedness fell £4.4bn last year to £12.3bn. In Shore Capital’s view, this "de-leveraging" could even lead to substantially better shareholder payouts, with dividend cover halving to two times EPS by 2021.

TESCO (TSCO)   
ORD PRICE:256pMARKET VALUE:£25.1bn
TOUCH:256-256.1p12-MONTH HIGH261pLOW: 165p
FORWARD DIVIDEND YIELD:3%FORWARD PE RATIO:13.5
NET ASSET VALUE:107p*NET DEBT:25%
Year to 28 FebTurnover (£bn)Pre-tax profit (£bn)Earnings per share (p)Dividend per share (p)
201653.90.445.2nil
201755.90.847.6nil
201857.11.2811.83.0
2019**58.31.6215.15.0
2020**59.72.0119.07.6
% change+2+24+26+52
Normal market size:10,000   
Beta:1.10   
*Includes intangible assets of £2.66bn, or 27p a share
**Shore Capital estimates