Tesco (LON:TSCO) has reported an encouraging set of results that has seen a return to full-year profits and the first quarter of UK sales growth in three years. Operating profits of £944m for the year beat estimates of £937m, and a strong Easter has helped Tesco report a quarterly increase of 0.9% in UK like-for-like sales.
CEO Dave Lewis’s turnaround plan after eighteen months in the job appears to be gaining some traction. Tesco shares have jumped over 25% from the beginning of the year, and these full-year results support the idea that the worst of the accounting scandal and supermarket price war is behind them. Shares have fallen around 3% following the results after Mr Lewis issued cautionary guidance on profits, saying it “won’t be a smooth line.”
The return to profitability last year has mainly come as a result of the sale of “non-core” assets like Tesco’s South Korean business Homeplus and reduced costs by closing 43 stores and stopping development of another 49. The asset sales are all welcome in alleviating Tesco’s debt pile, which has been cut to £5.1bn from £8.6bn in August, and minimising the need for a rights issue.
There is room for more asset sales; Tesco could still sell Giraffe, Harris and Hoole coffee shops or Tesco mobile, but this has so far been ruled out by Mr Lewis. Sainsbury’s purchase of Argos and Morrisons teaming up with Amazon has changed the landscape. Now that it is on surer footing, Tesco should perhaps turn to acquisitions and partnerships to develop an edge over competition instead of asset sales.
The risk is that with market share still being lost to discounters Aldi and Lidl as well as “big four” rival Sainsbury’s, the share price momentum peters out. UK grocery sales are increasing at 1.1% year-over-year according to Kantar, but that doesn’t make up for the sector’s 1.5% price deflation.
Signs from last quarter are that sales are beginning to stabilise, but to return to its former glory, Tesco needs to increase margins. This is difficult when prices have been slashed to compete with the discounters, and suppliers already complain of being squeezed to their limits.
Successful efforts to cut prices and repair both Tesco’s balance sheet and reputation increase the odds that we’ve seen a bottom in the shares. The question is whether there’s room for any more upside from here.
At an adjusted EPS of 5p, Tesco is trading on a 12mth fwd P/E ratio of 22, which means a strong recovery has already been priced in. The shares are priced very reasonably compared with historical earnings. The trouble is that historical earnings aren’t too likely for a supermarket industry in the middle of a protracted price war.
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