After a tough few years, is now the time to buy Tesco shares?

Gabriel McKeown takes another look at Tesco shares and considers whether he should add the company to his new year portfolio.

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When looking ahead to 2023, I am keen to look for new companies to add to my portfolio. I often look at more obscure stocks, hoping to identify opportunities other investors have missed. Yet, this focus on unknown companies may need to be revised. A number of the most popular FTSE 100 staples have fallen considerably over the last year. This means that multiple high-profile companies could have entered value territory and may be ripe for my new portfolio.

This is especially the case with Tesco (LSE: TSCO). As one of the world’s largest supermarkets, so it is hardly a hidden opportunity. Yet the share price has fallen considerably over 2022, down almost 23%. Furthermore, it is down just under 28% from pre-pandemic levels, indicating that the market has begun to neglect the share. I am keen to explore this company in more detail. Analysing companies that sell goods or services I have purchased allows me to understand the business model far quicker than a company whose products I’m unfamiliar with.

Positive highlights

On the surface, there are elements about the share that are appealing. It now has a price-to-earnings (P/E) ratio of just 10.2, far below its three-year average of almost 17. Additionally, this level is forecast to remain relatively stable, rising to 10.6 next year. This is below the FTSE 100 median of over 15.

There are also a few core positives in the company’s underlying fundamentals. The current dividend is nearly 5% and can be comfortably paid using earnings per share (EPS). This is illustrated by a dividend cover ratio of 2. The elevated dividend appears fairly stable, as it is forecast to fall only slightly to 4.8% in 2023. Additionally the dividend cover remains the same.

Another surprisingly positive metric is free cash flow generation. The company is generating the equivalent of 120% of EPS per share as cash, which is significantly above its three-year average. Furthermore, the efficiency with which earnings are generated on invested capital is also reasonable, with a return on capital employed (ROCE) ratio of nearly 8%. This metric is also comfortably above its three-year average.

Core challenges

However, the negative share price performance for Tesco is motivated by the company’s challenging outlook. This stems from the fact that Tesco has very high debt levels at almost 94% of market capitalisation. Combined with slim profit margins, this could put pressure on the company in tough times. This explains why the share suffered during the pandemic years and why the current macroeconomic threats to the UK are likely to cause more damage.

A balance sheet already weakened by the pandemic is undoubtedly vulnerable to the combined risks of elevated inflation and reduced consumer demand following the cost-of-living crisis. This is likely why investors are not hugely keen to buy Tesco shares at this stage. If these factors continue, the damage will only increase. The dividend is likely the first area to go, and if EPS experiences the expected 4.5% decline, more is needed.

Therefore despite the reduced share price, I would not be keen to add Tesco to my portfolio at this stage. However, this view may change if broader economic threats begin to subside and core fundamentals strengthen over the year.

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.

Gabriel McKeown has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco Plc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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