Why there's 20% upside for Tesco shares

The chorus of supermarket watchers hopeful that Tesco shares can finally return to the 250p level last seen in 2014 grew a little louder today.

First up, Kantar Worldpanel's latest grocery market research showed Tesco and Morrisons neck-and-neck as the fastest growing of the big four supermarkets, with sales of growth of 2.7% in the most recent quarter.

Kantar said Tesco Extra superstores enjoyed particularly strong growth as these larger outlets helped to inflate the chain's average basket size to £31.09 - currently the highest value in the bricks and mortar market.

With Tesco showing this kind of momentum, analysts from Barclays Capital today reinstated their rating at overweight with a price target of 255p. This follows Jefferies adopting a 'buy' stance and 250p target price yesterday.

The upgrades come amid relief that Tesco has finally completed an exhausting battle to get competition and shareholder clearance for its £4 billion takeover of cash-and-carry chain Booker.

In the 13 months since Tesco shocked the grocery world with its recommended deal for Booker, shares in the UK's biggest supermarket chain have been stuck in the equivalent of the deep freeze.

Pressure on trading caused by rising living costs hasn't helped, but only in the past three months have shares managed to establish a foothold above the 200p barrier. At one point in late 2007, they were worth close to 500p.

Source: interactive investor         Past performance is not a guide to future performance

With the Booker merger now complete, the equity research team at Barclays has taken a closer look at the merits of the two businesses and the opportunities for Tesco to step up cash returns over the next few years.

Having seen Tesco reinstate its dividend in 2017/18 with an interim 1p pay-out in October, Barclays thinks there's room for annual dividend growth of 46% based on the group's stated 2 times target for dividend cover. This implies a yield of 4.6% for the 2020/21 financial year.

And even when deducting pension top-ups and dividend payments, Barclays believes that Tesco will be left with £1.1 billion of surplus cash each year.

"The medium-term opportunity for additional cash returns seems clear," they wrote.

Today's 255p price target is based on Tesco trading on a PE multiple of 11.9x in 2019, compared with 14.1x for the wider European sector.

A deterioration in Tesco's UK market share represents the biggest risk to the bank's investment case, although it is confident that sales and profits will be supported by this year's planned relaunch of Tesco's own label products. These account for 50% of the chain's overall sales.

Barclays notes that good progress is also being made towards meeting the Tesco 2019/20 EBIT margin target of between 3.5% and 4%, while it said the £200 million of synergies from the Booker deal look "eminently achievable".

The bank has been a long-time supporter of Booker, with an overweight rating on the cash-and-carry chain between December 2011 and the start of 2017.

They said: "We particularly liked the management team's relentless discipline around execution and cash generation."

More details on the Tesco and Booker performances will emerge next month when chief executive Dave Lewis unveils full-year results on April 11.