The outlook for the UK retail sector is highly uncertain at the present time. Inflation has moved to its highest level for a number of years and now exceeds wage growth. This could cause difficulties for UK-focused retailers such as Tesco(LSE: TSCO). However, with the company's turnaround strategy gathering pace and its valuation being exceptionally low, it could prove to be a strong performer within a gradually rising FTSE 100.
With Tesco moving to dispose of its international operations, the performance of the UK is likely to have a greater impact on its profitability than it has in the past. With UK consumers now seeing their disposable incomes fall in real terms since wage growth is lower than inflation, they are likely to become increasingly price-conscious. This means they may seek to trade down to lower-priced alternatives such as Aldi and Lidl. This was the situation during the credit crunch and could be replicated over the medium term.
Despite this, Tesco appears to have solid growth potential. While it may not benefit from improving operating conditions, the company is in the midst of a major turnaround which is expected to positively impact on its financial performance.
For example, it is becoming more efficient and its investment in customer service is starting to boost sales. This could lead to greater customer loyalty and improved margins over the next few years. In fact, the company is forecast to report a rise in its bottom line of 44% in the current year, followed by further growth of 31% next year. Both of these figures are considerably higher than for the vast majority of retailers, and investor sentiment could improve as a result.
Even though Tesco has strong growth potential over the next couple of years, its shares continue to trade on a relatively low valuation. It has a price-to-earnings growth (PEG) ratio of just 0.5, which suggests that it has a wide margin of safety. Therefore, it could be a strong performer that beats the FTSE 100 over the long run.
Also offering upside potential is DFS Furniture(LSE: DFS). The upholstery retailer announced on Thursday that it has completed the acquisition of sector peer Sofology for an initial enterprise value of £25m. The deal will broaden the company's appeal to customers and is expected to deliver a near-term potential synergy benefit of £4m annually. With Sofology having a network of 37 stores across the UK as well as a strong web presence, it means that DFS now has an even more dominant position within the industry.
Looking ahead, DFS is expected to post a fall in its bottom line of 16% this year, followed by growth of 6% next year. Clearly, its outlook is uncertain, but with a price-to-earnings (P/E) ratio of just 11.4 it could be worth buying for the long run.
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Peter Stephens owns shares of Tesco. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.