Investment View: For now, it's best to steer clear of Tesco's problems

Our view: Hold

Price: 343.6p

Many of the retail sector's biggest beasts post results this week, with Next, B&Q-owner Kingfisher, Home Retail's Argos, Laura Ashley, Dunelm and SuperGroup all updating the market.

However, the City will have to wait until 3 October until the king of the retail jungle, Tesco, unveils its half-year figures.

The results will not be pretty for the country's largest retailer and the main focus of investors will be on its domestic business, which still accounts for more than 60 per cent of the group's operating profit and sales. According to recent industry data, Tesco's UK operation has seen the first green shoots of recovery after a troubled period of falling underlying sales and the group's first profit warning in 20 years in January.

The grocer – which has operations in 13 countries from Malaysia to the US – is set to post an 8.5 per cent decline in its half-year trading profit to £1.62bn, according to Shore Capital. This will largely be the result of Tesco's operating margin falling to 5.2 per cent, which itself is due to the supermarket chain investing £1bn in its UK business in 2012-13 to turn around its performance.

Beyond these shores, Tesco has also been hit by a slowdown in sales in China, restrictions on hypermarket opening hours in South Korea and slow progress at its banking division, which could all further dent its half-year figures.

Despite these fires across the retailer's £72bn empire of grocery, non-food and services, the last few months have been much kinder to investors in Tesco. While its shares remain a country mile from the 385p before the profit warning on 12 January, Tesco has recovered by more than 15 per cent since dipping below 300p at the end of May. However, Tesco's shares still only trade on a modest forward earnings multiple of 9.9, which is broadly in line with rivals Morrisons and Sainsbury's. This has tempted new and existing investors, including Warren Buffett, the legendary Sage of Omaha, to pop Tesco shares in their shopping basket since that dark day in January.

Much of this improved sentiment has been driven by an uptick in Tesco's performance, according to the closely-followed Kantar Worldpanel data. It said the UK's biggest grocer grew sales by 5.1 per cent over the four weeks to 5 August, which was ahead of Asda's 4.9 per cent growth, 2.7 per cent at Sainsbury's and Morrisons' 1.4 per cent. While the figures only provide a brief snapshot of the market, they suggest that the £1bn investment plan of Philip Clarke, Tesco's chief executive, to spruce up its stores, improve its fresh-food departments and increase staffing levels is bearing fruit.

For potential investors, another attraction of Tesco is that it has grown its dividend each year for more than a quarter of a century and its shares offer a healthy yield. The grocer also provides the security of a burgeoning services business, such as in mobile phone contracts, a huge online operation and a lucrative global estate of freehold properties.

Nevertheless, we cannot currently recommend buying Tesco's shares in the short-term, particularly after the recent spike. This is partly because we want to see more concrete evidence that Mr Clarke's recovery plan is truly working, such as a healthy rise in UK underlying sales.

At a sustained level, this may not happen for some time, given the continued squeeze on consumer spending. Most recently, Tesco's like-for-like UK sales fell 1.5 per cent for the 13 weeks to 26 May, despite targeting customers heavily with pricing promotions since the launch of its Big Price Drop in September 2011.

The impact of government regulations in South Korea is also a concern, as the country is easily Tesco's biggest operation outside the UK.

Another potential cloud is that Mr Clarke will eventually have to make a decision about whether to persevere with, or axe, its loss-making US business, Fresh & Easy, which has been set a delayed break-even target of February 2014.

That said, we remain long-term investment fans of Tesco, noting its impressive record of delivering value for shareholders and its unassailable 30.9 per cent share of the UK grocery market. But for now we think it is fairly priced and should be left alone for a while to come. Hold.

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