I’m always on the lookout for investments to add to my Stocks and Shares ISA. Tesco shares have recently attracted my attention due to the company’s impressive free cash flow generation. I think this could support attractive dividends and share repurchases from the group in the years ahead.
Tesco shares on offer
When Tesco reported its results for its latest financial year in the middle of April, the company revealed that the pandemic had lead to at least £900m of additional costs.
These costs impacted profit margins for the year. However, management believes only about a quarter of these costs will be replicated in 2021. What’s more, thanks to a pandemic-driven increase in sales of 8%, operating profit only fell 13% at the group’s core UK and Ireland operations.
One number that really stood out in the figures was the company’s cash flow generation. Tesco reported a free cash flow of £1.2bn for the financial year. To put that into perspective, excluding the company’s £5bn special dividend last year, its regular dividend cost just £858m.
These figures suggest the company could afford to return an additional £342m a year to investors. This is the main reason why I’d buy Tesco shares for a Stocks and Shares ISA.
As pandemic costs fall away, the company’s free cash flow could increase further. Management has said the firm will look to return excess capital to investors. Therefore, it may unveil a substantial increase in its dividend in the years ahead.
And the stock is already a dividend champion. At the time of writing, Tesco shares support a yield of 4.6%.
Stocks and Shares ISA benefits
Any income or capital gains earned on assets held inside a Stocks and Shares ISA aren’t subject to tax. I think that makes these products the perfect vehicles in which to hold income investments. Tesco is already an income investment and, as my figures above show, the company has the potential to return even more cash to investors in the years ahead.
Of course, these figures are only estimates and projections. Although the company said it’ll return excess capital to shareholders, it hasn’t revealed how much. It also hasn’t confirmed that it’s not planning to pursue any acquisitions with the additional capital.
If management does decide to use some of the funds for other deals, I’ll reconsider my view of the business. Significant acquisitions often fail to live up to expectations, which means they’re usually a waste of money. I’d rather have the money returned to me as a shareholder.
Other challenges and risks that could impact the dividend potential of Tesco shares include higher costs and another wave of coronavirus, which would impact sales.
Still, even after taking these risks and challenges into account, I’d buy Tesco shares for my Stocks and Shares ISA with £5,000 today, considering the company’s dividend potential.
