Today’s first half results from Tesco (LSE: TSCO) show that the supermarket chain is making encouraging progress with its strategy. But do they suggest now is the right time to buy it for the long term or not?
Tesco’s top line rose by 3.3% in the first half of the current financial year. It was boosted by like-for-like (LFL) sales growth of 0.6% in the UK and 1% abroad. UK volumes were up 2.1% and transactions increased by 1.6%. This was despite a challenging operating environment that has seen the supermarket price war escalate yet further. In fact, Tesco has cut prices by 6% versus the same period two years ago and it seems likely that continued food price deflation will be a feature of the supermarket sector.
However, Tesco has a clear strategy to cope with this outlook. It intends to deliver operating cost reductions of £1.5bn, which should improve operating margins. Tesco will improve its distribution system and operate a simpler store model to boost operating margins to between 3.5% and 4% by 2020. Of course, it has made excellent progress on operating profit in the first half of the current year, with it rising by over 60% when exceptional items are excluded.
Is the future brighter?
Looking ahead, Tesco is expected to record a rise in earnings of 145% in the current year. It’s due to follow this up with growth of 37% next year, even though the outlook for the UK economy is highly uncertain. On this topic, the Bank of England expects the unemployment rate to rise to 5.5% over the medium term. This could cause a further shift in demand from consumers toward no-frills operators such as Aldi and Lidl. In this scenario, Tesco’s sales could suffer.
However, Tesco offers a sufficiently wide margin of safety to merit purchase at the present time. Although its price-to-earnings (P/E) ratio is sky-high at 30.4, its stunning growth rate means that its price-to-earnings growth (PEG) ratio is far more appealing. It stands at just 0.8, which means that even if its sales come under a degree of pressure and miss forecasts, Tesco’s share price could move upwards at a rapid rate.
Tesco hasn’t announced a dividend for the half-year period. However, it’s due to recommence dividends later this year and continue with them next year. Its forward dividend yield of 1.3% is hardly appealing at the present time, but its payout ratio has scope to increase. Next year, Tesco’s payout ratio is forecast to be just 28%. This means that it could more than double without putting the company under financial strain. Further profit growth could positively catalyse dividends too.
While Tesco isn’t yet fully turned around, its strategy is showing signs of delivering on the company’s potential. With a low valuation and excellent growth potential, now is a good time to buy Tesco for the long term.