Jefferies upgrades Tesco and Morrisons to 'buy' as stronger pound aids UK grocers

Analysts at Jefferies upgraded their recommendation for shares of Tesco and Morrisons on Monday from 'hold' to 'buy', explaining that the pound has rallied against the dollar by well above 10% over the past year, while discount supermarkets' new store applications have fallen 25% in the past 2 years.

The analysts believed that after a cautious 15 months the time had come to review their stance on the UK grocery market due to the aforementioned factors and the fact that "wage challenges, whilst ongoing, are on a different scale relative to the position the industry found itself in two years ago."

The analysts added that a margin-focused Tesco, together with Asda's focus on free cash flows, made for a rational competitive backdrop, meaning that "the sector may be rediscovering its low Beta mojo at exactly the time when investors need it most."

Jefferies therefore revised its target price for Tesco up to 250p, while also highlighting the strongly accretive nature of the company’s merger with Booker for its free cash flows over the medium-term.

The above also assuaged the analysts' near-term concerns that investors were being overly optimistic on Tesco's stand-alone prospects.

Indeed, Jefferies analysts expected Tesco’s stand-alone EBIT margin to fall short of the company's 3.5-4% ambition - instead penciling in a margin of 3.3%.

In the same research note, the broker revised its target price for Morrisons up to 265p, with the analysts explaining that Morrisons was best placed for outperformance, given that its opex challenges were seen moderating by the most when compared to its peer group.

Analysts at Jefferies also believed Morrisons "should be capable of delivering appreciable sales gains by further building sales densities in stores and by expanding its nascent wholesale activities," projecting sales would increase by between between 3.3% to 4% each year until 2019/2020.

Morrisons dividend per share was also seen rising to 5.93p for 2017/18.

"We believe we are now trading through the peaks of UK CPI pressures. The obvious benefits of reducing input headwinds and of a less defensively minded consumer should provide a more helpful backdrop to grocers from here. Whether this will be supercharged by more modest discounter openings remains to be seen, but we are hopeful. MRW and TSCO upgraded to Buy."

As of 1528 GMT, Tesco’s shares were up 0.35% at 202.70p and Morrisons’ shares were up 1.35% at 225.70p.