Can Tesco's (LSE: TSCO) growth continue and are the shares cheap?
Capital appreciation is surely the goal of many investors. One method of achieving that is to buy companies with steady earnings growth. If bought when the shares are cheap, two drivers could move the share price up:
- growth in earnings, and
- an upwards P/E re-rating.
Highly successful fund manager Peter Lynch classified steady growers as Stalwarts, which he typically traded for 20% to 50% share-price gains. But whether buying for gains like that or holding for the longer term, we need to know if reliable earnings growth can continue, and whether the shares are cheap.
Seeking durable growth
Not all companies achieve stable growth, as you can see by the aggregate performance of those in London's premier FTSE 100 index (UKX), where the compound annual earnings-growth rate has been just 0.7% over the last five years:
|Year to June||2007||2008||2009||2010||2011||2012|
|FTSE 100 index||6608||5626||4249||4917||5946||5571|
|Aggregate earnings per share||537||503||427||397||527||557|
Consistent, cash flow-backed growth in profits is a promising characteristic in today's markets so, for this series, I'm examining firms with annual earnings growth between 4% and 20%.
One contender is Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US), which owns an international chain of supermarkets and which is the largest player on its home turf in Britain. This table summarises the company's recent financial record:
|Year to February||2008||2009||2010||2011||2012|
|Adjusted earnings per share||27.37p||29.06p||31.8p||36.45p||37.52p|
So, earnings have grown at an equivalent 8.2% compound annual growth rate putting Tesco in the Stalwart category.
My table shows a nice trend in earnings per share, but it's a case of "a lovely trend 'till the bend at the end", as current-year earnings are expected to come in around 32.5p - oops! What happened? Well, Tesco appears to have taken its eye off the ball in its important British home market, "running the stores too hot," which just means not trying as hard to please customers, I reckon.
The firm is one of the world's largest retailers with operations in 14 countries and employing over 500,000 people. Yet Britain is important to Tesco, as it accounts for two-thirds of global sales. The shares dropped around 25% back in January when profits slipped and the directors owned up to under-investing in the UK store portfolio. My local store looked scruffy and tired; perhaps it was a similar story around the country.
Right now, the directors' are re-focusing on the core UK market and a domestic investment program is underway. On 5 December, they also announced a strategic review of the firm's perennial loss-making US operation, Fresh & Easy, saying, "It is now clear that Fresh & Easy will not deliver acceptable shareholder returns on an appropriate timeframe in its current form." Many are speculating that a US exit is imminent. Maybe, but whatever the outcome, it seems that Tesco has a grip on its own socks again, both at home and abroad. The company has some catching up to do at home, but I think there's a fair chance that a return to steady earnings growth is in the tea leaves.
Tesco's earnings growth and value score
I analyse five indicators to determine whether earnings growth can continue and if the shares offer good value:
1. Growth: earnings slipped during 2012, cash flow and revenue has grown steadily. 2/5
2. Level of debt: net gearing around 41% with borrowing just under twice earnings. 4/5
3. Outlook and current trading: satisfactory recent trading and a cautious outlook. 3/5
4. Enterprise value to free cash flow: the firm's been under investing; I'm scoring low. 1/5
5. Price to earnings: a trailing nine and close to historic growth rate. 2/5
Overall, I score Tesco 12 out of 25. I believe this stalwart can restart earnings growth that out-paces that of the wider FTSE 100 but, given what is known, the shares seem to price the company fairly when compared to the FTSE's price to earnings ratio of around 11 and the firm's growth predictions.
During the current year, cash flow and profits have dipped. Positives include under-control debt and a reasonable outlook statement.
Right now, forecast earnings growth is 5% for 2014, and the forward P/E ratio is around 10 with the shares at 341p. Considering that and the other factors analysed in this article, I think that looks like a fair valuation.
Tesco is one of several steady-earnings-growing stalwarts on the London stock exchange, each with the potential to deliver significant capital appreciation when purchased at sensible prices.
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> Kevin owns some Tesco shares. The Motley Fool owns shares in Tesco.