There's a lot of optimism surrounding Tesco's (LSE: TSCO) recovery strategy, which is evident from the company's growing capital expenditure budget and management's bullish margin expectations. As such, there's growing expectations that Tesco can reverse its trend of falling profits and declining revenue. But the company still has a lot to prove to shareholders, and here are three things you'll want to watch closely this year.
Growth in like-for-like sales
Tesco's like-for-like sales figures are an important guide to its retail performance. That's because this measure strips out the sales generated from new stores (or the sales lost from the closure of existing stores), which gives us a better picture of how the underlying business has been performing relative to previous periods.
Tesco's like-for-likes have steadily increased over the past year, but the company needs to show it can keep that trend going. Looking forward, this could become more challenging, as rising inflation and weak wage growth is expected to eat into real household disposable incomes this year. With such a macroeconomic backdrop, consumers may consider shopping more often at the German value price chains. Additionally, this could spark a new price war across the supermarket sector, which would be good news for consumers, but terrible for shareholders.
According to its most recent sales update, Tesco's like-for-like sales seems to be losing momentum. In the 13 weeks to 26 November, they rose 1.5% across the group with UK growth of 1.8%. However, during the Christmas period (the six weeks to 7 January), group growth was only 0.3%, with the UK up 0.7%, as the removal of the Clubcard 'Boost' promotion led to lower general merchandise sales. This reflects the price sensitivity of customers and the difficulty the company faces in improving its margins.
Tesco's margins have come under intense pressure in recent years, but CEO Dave Lewis reckons its margin outlook could turn around soon. He was even confident enough to share his margin targets, which is something he has avoided doing since he took over the job in 2014.
By 2019/20, he expects to deliver group operating margins of 3.5%-4%. That's significantly lower than the 6% margin that Tesco enjoyed in 2011, but it's almost double today's margin of 2.18%.
Lifting the margin to around 4% is easier said than done. We'll need to watch out for the impact of rising food inflation, which could also cause shoppers to become more price-conscious. Marmite-gate last October has shown us the challenges Tesco faces from cost pressures and the difficulty in raising prices enough to boost its margins in the future.
Increase in free cash flow
Beyond margins and earnings, Tesco also needs to show that it can generate robust free cash flows, the amount of cash it generates after accounting for capital expenditures. This represents what the company has left over to pay for dividends, cut back on debt and spend on acquisitions. On that score, it generated free cash flow of only £203m in the first half of its 2016/17 financial year.
The company is planning to nearly triple capital expenditure this year, and so free cash flow needs to improve considerably before it will be in a position to resume dividend payments.
Jack Tang has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.