Will this global food business continue to beat Tesco plc?

Roland Head explains why Tesco plc (LON:TSCO) may never be able to match the returns from one of its major suppliers.

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Shareholders of global meat-packing firm Hilton Food Group (LSE: HFG) have seen the value of their shares increase by 112% over the last five years. The shares are up nearly 10% so far in 2016.

Today’s interim results suggest that there could be more gains to come. Sales rose by 9.1% to £631.9m, while pre-tax profits surged 26.7% to £16.7m. The interim dividend has been increased by 12.2% to 4.6p, while net cash rose sharply to £21.6m.

Investment in new factories appears to be paying off. Current forecasts suggest that earnings per share will rise by 16% to 32p this year. This puts the shares on a forecast P/E of 18.3, with a prospective yield of 2.8%.

That’s not cheap, but Hilton Food has a track record of consistent growth and appears to be a high quality business. This is best shown by the group’s high return on capital employed (ROCE). It had a ROCE of 29% last year. This represents the firm’s operating profits, relative to the capital invested in the company.

It means that if Hilton invested £10m in a new factory, investors could expect to see operating profit rise by £2.9m as a result of that investment. That’s very attractive.

The secret to beating the market?

Warren Buffett has previously said that ROCE is a better indicator of management performance than earnings per share growth. A company with a high ROCE can fund its own expansion and outperform the market without having to borrow money or raise cash from shareholders. Dividends can be funded from genuine free cash flow.

In contrast, a company with a low ROCE must borrow or sell new shares in order to expand. This was the trap Tesco (LSE: TSCO) fell into during its expansionary phase. Terry Smith, who manages the popular Fundsmith Equity fund, has previously said that Tesco’s falling ROCE was a clear warning that things were starting to go wrong for the retailer.

In a sharp contrast to its supplier Hilton, Tesco generated a ROCE of just 4.3% last year.

Should we write off supermarkets?

Tesco’s ROCE has fallen steadily from a peak of 19% in the late 1990s. The problem is that supermarkets are fairly capital intensive, thanks to the large networks of stores and warehouses they need to operate. Yet profit margins are low, so profits growth is slow unless one firm can steal market share from another.

But I expect Tesco’s ROCE to improve over the next couple of years as its turnaround continues.

Tesco currently trades on a forecast P/E of 25, falling to 18 in 2017/18. Dividends are expected to resume next year and a forecast payout of 3.3p per share gives a prospective yield of 2%.

I think that shareholders need to ask if the firm’s turnaround potential is already reflected in its share price.

Buy, sell or hold?

Hilton Food’s lean business model has generated consistently high returns for shareholders. In contrast, Tesco is lumbered with a very costly asset base and restricted opportunities for growth.

Although I expect Tesco to rebuild its reputation as a dividend stock, I think growth will be slow. I’d prefer to put fresh money into Hilton, which I rate as a long-term buy.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Roland Head owns shares of Tesco. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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