It has been a great few years for investors in the UK’s leading supermarket Tesco (LSE: TSCO). Tesco shares have done very well. Indeed, the share price has more than doubled over the past five years.
But in recent days the price has wobbled. A trading update this week did not excite the City.
A solid business, run well
The investment case for Tesco is pretty straightforward, as I see it.
Groceries are a large market and, because people always need to eat, that is unlikely to change.
As the country’s biggest supermarket by some distance, Tesco has economies of scale. It benefits from a strong brand, large retail estate, well-established digital business, and its Clubcard loyalty scheme with over 20m members.
All of that is well and good but arguably Tesco’s strength is also its weakness.
Why? It has a solid business in an industry with low profit margins and modest growth prospects. As the market leader, it will struggle to grow by gaining market share like smaller, nimbler rivals can. Tesco’s growth prospects in the medium-term look mediocre at best to me.
So when I think about Tesco shares, I tend to believe they merit a valuation suitable for a mature, low-margin business that is attractive but with limited scope for growth.
I think share price momentum is fading
Set that against how the share price has soared in recent years and it can be hard to square the two.
One explanation is that investors saw Tesco as undervalued before, appreciate its defensive qualities, and have rewarded a strategic refocus on the core business in recent years, with the firm’s former global ambitions now stretching no further than Europe.
But the share price rise means that Tesco shares now sell for 17 times earnings. That looks expensive to me.
To justify a higher share price than that on a sustained basis, I think Tesco needs a more compelling growth story.
This week’s trading announcement, though, was fairly humdrum stuff. Like-for-like sales (excluding VAT and fuel) across the group in the first quarter were 1% higher than in the same period last year.
The Booker wholesale operation fared worse, losing sales, but while the grocery operation grew faster than that 1% headline for the whole company, its growth rate was still under 2%.
I see no compelling reason to buy now
I do not think that is a bad number. In fact, it is more or less what I would expect from a mature market leader in a mature category that has broadly stable demand.
But therein lies the rub as an investor. Priced at an attractive level – as it was five years back – that sort of stable company can be very attractive to me.
The costlier it gets, though, the less compelling I find it.
I see no specific reason to expect strong share price growth in coming years. Tesco’s yield of 3.3% — while slightly above the FTSE 100 average – is comparable to or even worse than many other businesses I think offer stronger growth potential.
So, I will not be buying any Tesco shares for my portfolio.
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Christopher Ruane does not hold any positions in the companies mentioned.
