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Morningstar | We Increase Our FVE for Tesco to GBX 253 From GBX 230; Shares Cheap After Recent Pullback. See Updated Analyst Note from 09 Oct 2018

After incorporating Tesco's fiscal 2019 interim results (including consolidation of Booker) and taking a fresh look at our underlying assumptions, we increase our fair value estimate for Tesco to GBX 253 from GBX 230. Our estimate implies a forward fiscal 2020 price/earnings ratio of 18 times and enterprise value/EBITDA ratio of 7 times. We still expect a 3.5% average operating margin (including Booker synergies) over the next five years.

Our new fair value estimate reflects a more constructive outlook on Tesco's core food retail and wholesale businesses (Booker) in its largest market, the United Kingdom, which outweighs our lower top-line and bottom-line estimates in the international segment. Further, our fair value estimate implies a fiscal 2019 adjusted price/earnings ratio of  18 times , 6% free cash flow yield, and 2% dividend yield, in line with the respective average trading multiples of Tesco's U.K. peers.

In the U.K. and Republic of Ireland segment, we now expect less growth coming from online (to 3% from 5%), the result of a conscious decision taken by Tesco to rationalize the economics of the channel (higher minimum order and service fees), while we expect Booker sales to grow almost by 6% annually over the next five years (versus our earlier 5% estimate).

In the international division (17% of the group's fiscal 2019 expected sales), government-sponsored coupons that cannot be used in modern trade in Thailand and restrictions on weekend openings in Poland have reversed trends. We now expect sales in the international segment to decline 1.2%, with Asia mostly flat (negative 0.2% like for like and 0.3% new space contribution) and sales in Europe down by 2.3% (negative 1% LFL and negative 1.3% contribution from new stores) versus our earlier positive low-single-digit respective marks.

From its high of GBX 266 on Aug. 10, Tesco's share price has declined more than 20%, erasing its sector-beating year-to-date return. With shares at GBX 210 at the time of writing, the stock is trading roughly at a 17% discount to our new fair value estimate, an attractive buying opportunity, in our opinion. In the absence of any meaningful hard catalysts in the quarters and months ahead, we believe that the stock's dividend growth potential should be appealing to the patient long-term investor. We expect dividends to grow at a 15% CAGR over the next five years, with the company reaching its target 50% payout ratio (from 33% currently) by fiscal 2021.