For the first time in five years, JP Morgan Cazenove feels able to recommend that its clients buy shares in supermarket giant Tesco PLC (LON:TSCO).
The Booker acquisition is transformational for Tesco, according to Cazenove, not least because it brings Charles Wilson on board as boss of Tesco’s retail and wholesale operations in the UK and the Republic of Ireland.
READ: Tesco gains as Barclays reinstates 'overweight' rating after Booker takeover
The acquisition also gives the retail giant a bigger addressable market; Caz reckons the majority of the wholesale market, valued at roughly £30bn, is new territory for Tesco.
Throw in £200mln of synergies by 2019/20, as per management guidance – although Caz thinks the synergies will reach as high as £265mln – and the blue-blooded broker has been persuaded to slap an ‘overweight’ rating on Tesco, with a price target of 265p; its sum-of-the-parts valuation is 307p.
JP Morgan Cazenove previously had no rating for Tesco as it was Booker’s corporate broker; prior to Tesco’s bid for Booker, Cazenove had an ‘underweight’ rating and 135p price target for Tesco.
Shares in Tesco currently trade at around 216p, up 2.7% on the day.
Cazenove is predicting Tesco – now with added Booker – will generate around £1bn extra in earnings before interest and tax (Ebit), £4.4bn of cumulative free cash flow and further net debt reduction of £2.2bn by 2020.
“Our estimates incorporate Booker and are predicated on a conservative terminal UK operating margin of 3.5% (inc Booker and synergies), resulting in group operating margin of 3.8%. Our group EBIT grows by c20% on average over the next three years,” Cazenove declared.
A slow-down in revenue growth represents the biggest risk to its ‘overweight’ rating, the broker cautioned.
“No deal is without execution risk; however, given the strength of both management teams and the decent shape of the two businesses, we see execution as an opportunity,” Cazenove said.
There is also a read-across to J. Sainsbury PLC (LON:SBRY), and it’s not a favourable one in Cazenove’s view.
“We believe a stronger Tesco does not benefit Sainsbury given their geographic and customer overlap. We see Tesco’s strategy (seeking growth within wholesale, focusing on food, online and convenience) as more defensive than that of Sainsbury (focus on non-food),” the broker concluded.