Has Tesco become the most boring of the big four supermarkets? In less than 12 months chief executive-less Asda has found new owners, Morrisons is the target of a bidding war and speculation that private equity was running the rule over Sainsbury’s has led hedge funds to cut their short positions against the stock.
Amid the excitement, investors are getting impatient with Tesco. The shares have underperformed against their peers since the start of lockdown in March last year, despite delivering a 67 per cent total return and beating the FTSE 100.
Ken Murphy, the chief executive, has had a lot to contend with in his first 12 months in the job. But firming up cash allocation plans when the group announces interim results next month could help to bring more investors on side.
Murphy is clearly aware of the importance of shareholder returns, holding the dividend steady at 9.15p a share last year, despite Covid-related costs denting earnings. That ordinary payment is forecast by analysts to reach 9.61p this year. An anticipated recovery in profits and a strengthened balance sheet has raised hopes of additional returns.
Free cashflow of £1.38 billion was generated over the 12 months to the end of February and analyst consensus is for that to rise to £1.57 billion by next year. If the shares remain cheaply valued, a buyback will be more appealing to management and a re-rating could prompt special dividends instead.
Jefferies, the broker, has forecast that a £1.5 billion share buyback to take place over two years will be announced in April next year.
Shore Capital’s Clive Black reckons Tesco could comfortably return between 3.5 and 4 per cent of its market capitalisation a year at the group’s current earnings multiples while also covering the dividend twice over by adjusted earnings.
Disposing of the Asian business last year resulted in a £2.5 billion one-off contribution into the defined benefit pension scheme. That is expected to eliminate the need for further contributions, which had risen to £285 million a year.
The sale also gave shareholders a taste of one-off returns via a £5 billion special dividend and share consolidation. An exit from one or more of its three remaining central European businesses could result in further special returns.
Profit this year is expected to recover to a similar level to the pre-pandemic point. Elevated sales have naturally eased since last year, but remained strongly ahead of the 2019 level during the first quarter.
While the group will be without Covid-related costs this year, additional expenses could emerge elsewhere. Like its peers, the wage bill makes up a sizeable proportion of operating costs. As is characteristic of the supermarket sector, Tesco’s margins are thin, but an underlying retail operating margin that is superior to its peers, at 3.48 per cent last year, could give it some more breathing room.
The cost of lowering prices to compete with budget rivals is another ever-present risk to supermarket margins. Tesco is the largest player in the UK grocery market, according to Kantar, the data provider, but like the other big three supermarkets it has been losing market share to the discount grocers Aldi and Lidl over the past decade.
Tesco is a touch pricier than Sainsbury’s but a forward enterprise/ebitda multiple of just under seven is towards the lower end of the scale that the shares have traded at over the past five years. Takeover chances aside, the more likely prospect of liberal returns should be enough to snatch more investor interest.
ADVICE Buy
WHY The shares’ cheap valuation does not reflect good dividend and share buyback prospects as free cashflow looks set to recover
Severfield
Construction contractors have gained a reputation as low quality companies generating inconsistent earnings and crummy margins. Operating in highly specialised markets means Severfield, the structural steel group, does not fit that mould.
The group designs, fabricates and erects steel structures in ten main markets ranging from energy and transport to commercial offices, The Shard in London is among its most famous projects.
Inflation is a natural threat to profit margins, as are shortages of materials such as cold rolled steel to sales. Rising steel costs can be passed through to customers — higher labour and haulage expenses cannot. That’s not affected margins thus far and management has guided towards an operating margin approaching the historical average of between 8 per cent and 10 per cent this year.
Peel Hunt, the broker, has placed a 100p target price on the stock and forecasts a rise in adjusted pre-tax profits of £28 million for the financial year, beating the £24.3 million over the 12 months to March.
Efforts to diversify the order book away from the potentially choppier commercial office market look to be paying off. On a like-for-like basis business from the commercial office market sits just below 30 per cent of the order book, against a long-term average of between 30 per cent and 35 per cent and some way below a peak of 60 per cent four years ago.
That order book has benefited from a sharper rebound in tendering, albeit some at tighter prices given lingering uncertainty over demand in some markets. In the UK and Europe a sharp rise in new work won in recent months has left the order book valued at a record £376 million, of which £291 million is for delivery over the next 12 months.
A record of converting a high level of operating profit into cash balances bodes well for a further rise in the dividend, which analysts have forecast at 3.06p a share, or a prospective yield of 3.9 per cent. That’s despite the potential impact of steel price rises on working capital.
At only 11 times forward earnings, that income potential does not look fully priced into the shares yet.
ADVICE Buy
WHY A recovery in the order book should translate into a further rise in cashflows and the dividend
