With the annual ISA contribution deadline just around the corner, I have been thinking about what shares I would like to own. One name that pops up quite regularly is Tesco (LSE: TSCO). It has a lot of characteristics I look for when buying shares, from a strong competitive advantage to proven cash generation power. Could now be the time for me to buy Tesco shares?
Tesco’s robust business model
I think the main attraction here is that it dominates a business area I expect to see sustained demand. People always need to buy groceries, even when the economy is weak and household budgets are constrained.
Tesco is by far the largest retailer in the UK. But for a long time it also had sizeable operations overseas. It has retreated from many of them. Last year, Tesco’s retail business in the UK and Irish Republic turned over around 13 times as much as its remaining Central European operation. By withdrawing from international markets and mostly focussing on UK heartland, Tesco has can now play to its strengths.
Tesco’s brand and loyalty programme help it attract and retain customers. Over 20m households have its Clubcard. But one risk all supermarket chains face is an increase in competition from digital rivals. This could lead to smaller profit margins across the industry.
On the other hand, this could also be an opportunity for Tesco to expand and develop fuller relationships with existing customers. Its Clubcard Plus programme has similarities to the wildly successful Amazon Prime. Tesco’s app has 9m regular users.
Challenging pricing environment
I reckon the retailer’s strong position and Clubcard programme help give it a clear competitive advantage. However, it faces risks that could affect the future value of Tesco shares.
A key one is the strong competition in retail. German chains Aldi and Lidl look set to continue growing for years to come. Discounters such as B&M have also peeled some shoppers away from supermarket giants. Price has been a key driver for this and Tesco’s response has included matching certain prices from Aldi. That might help retain customers but it may come at the cost of lower profit margins.
Last year, Tesco’s net profit margin was 2.5%. A decade before it had been 4.4%. That means profit margins contracted by over 40% in a decade.
With the economy struggling at the moment, price remains a very sensitive issue for many customers.
Share price valuation
Although Tesco looks like an excellent business, does it have the sort of attractive valuation that would make me want to buy it for my ISA?
At the moment, it does not. Tesco shares trade on a price-to-earnings ratio of 21. That looks expensive to me for a mature business I see as having limited long-term growth prospects (Tesco’s revenue has fallen over the past decade).
So, for now, I will not be buying.
