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Smart Investor: bad-mouthed Tesco is a bargain
Ahead of a third quarter trading statement on Wednesday, our columnist explains why – contrary to popular opinion – Tesco is financially sound, highly profitable and very cheap.
Tesco is rarely out of the media headlines. Whether it is a columnist in a newspaper complaining about the ‘Tescopoly’ that is today’s food retailing industry, a local community which does not want a Tesco on their doorstep or a family which has found a dead frog in their Tesco salad, the company is always written and spoken about.
Fall from grace?
This year, much of the talk has focused on Tesco’s ‘fall from grace’, where profit growth has slowed (and disappeared for the first half of the current financial year) amid difficulties with the company’s US division and a lack of growth in its main market of the UK (which accounts for two-thirds of revenue ). Of course, exponential growth is impossible to achieve so, with shares now priced at £3.22, is FTSE 100-listed Tesco (TSCO.L) a worthy addition to your long term portfolio?
Jack Cohen founded Tesco in 1919 when he opened a market stall in East London, with his first product being Tesco tea. Since then the company has made a number of acquisitions, listed on the stock exchange over 65 years ago and pioneered the superstore outlet in the UK. Today, it trades in 14 countries, employs 500,000 people, serves millions of customers each week and, with a market capitalisation of £26 billion, is the 20th biggest UK listed company.
With all of the negativity in the UK media surrounding Tesco’s performance in recent years, you could be forgiven for dreading taking a glance at the P&L (profit and loss statement). However, Tesco has performed well and has delivered a net profit in each year, with the bottom-line growing at an annualised rate of 8.2% over the last five years.
Indeed, net profit of £2.8 billion in the year to February 2012 equates to a return on equity (ROE) of 15.8%, with ROE averaging 16.5% over the past five years. This is highly impressive, both when compared to Tesco's FTSE 100 peers as well as to sector peers. Clearly, Tesco is highly profitable and is performing well. Sure, profit growth may prove to be lacking in the current financial year but this is partly due to lower pricing and, as a result, lower margins. In any case, ROE is likely to remain impressive.
With shares having fallen from £4+ to their present £3.22, Tesco currently yields 4.6% from a payout ratio of 42%. This is a sensible payout ratio as it leaves the bulk of profit available to reinvest in the business but also means that the company ticks the income box, making it attractive for income seeking investors. Interestingly, Tesco is the 18th highest yielding stock on the FTSE 100.
As for its balance sheet, Tesco’s debt levels remain moderate, with a debt to equity ratio of 66%. This, combined with attractive levels of profitability, mean that interest cover is comfortable at 7.3. Clearly, Tesco is not posting such rich ROE figures via exceptionally high levels of borrowing.
Indeed, Tesco’s ability to generate such returns – even during challenging economic times – indicates that it has a generous economic moat. It appears to have a large degree of customer loyalty through being perceived as offering significant value for money, has an exceptionally efficient supply chain, a very low cost base, a more diverse revenue stream (in terms of geography) than rivals and also enjoys substantial barriers to entry.
Furthermore, with shares currently priced at £3.22, Tesco trades on a price to earnings ratio (P/E) of just 9.2 and a price to book ratio of only 1.5. Both of these figures show that shares are cheap at current levels, especially when the quality of the company is taken into account.
Of course, Tesco may not be a company whose products you purchase. It may not even be a company you particularly like. However, from a purely investment perspective, it is financially sound, highly profitable and very cheap at current levels. Regular readers will know that I consider myself to be a value investor who likes to use cost averaging when buying and selling shares. Tesco shares offer excellent value for money and are well-worthy of cost averaging, with shares being more attractive now than when I last wrote about the company.
Smart Investor holds shares in Tesco. Smart Investor last tipped Tesco on 20 July 2011. Since then, shares have delivered a total return of -14.3% versus 4.7% for the FTSE 350 over the same period.
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