Supermarkets are often seen as reliable but fairly unexciting companies. Yes, shopper demand is resilient. But for the likes of Tesco (LSE: TSCO) – already the leading grocer in its key UK market – where are the growth prospects? The overall grocery market size is unlikely to explode. And being market leader can make it difficult to take market shares from rivals. Despite that, the Tesco share price has gone up 31% over the past year.
What is going on – and could this be a buying opportunity for my portfolio?
Why I’m happy to invest in supermarkets
To be clear, at the right price, I would be glad to put some money into Tesco shares.
Grocery retailing is a huge market with resilient long-term demand. As market leader, Tesco has economies of scale.
Its loyalty programme gives it very detailed customer understanding, it has a strong brand, and its customer base of regular shoppers is in the millions.
On the downside, this is a very competitive industry and that alone breeds low profit margins. Last year, Tesco’s revenues were just shy of £70bn. So while its net profit of £1.6bn sounds large in isolation, it equates to a net profit margin of just over 2%.
The question of whether to add Tesco shares to my portfolio therefore comes down to one of value. Even considering the low margins, I like Tesco enough to invest if I think the share price is attractive.
Tesco’s not looking like a bargain
Why has the Tesco share price gone up by close to a third in just 12 months?
During that period, rival J Sainsbury has gone up 13%.That is close to the one-year upwards move in the wider FTSE 100 index of 11%.
That makes the Tesco jump stand out even more. One explanation could be that, in an uncertain economy, investors have been looking for less racy, resilient parts of the economy to put their money into. But if that were so, I would expect the gap in the 12-month relative performance of Sainsbury and Tesco to be smaller.
Another explanation is that Tesco has been growing to a valuation that is comparable to peers. Sainsbury trades on a price-to-earnings ratio of 17. Even after its share price surge, Tesco’s P/E ratio is not much higher, at 19.
Still, for a supermarket retailer, that does not look like a bargain to me.
Solid, but not stellar
In fact, the Tesco share price is nowhere near attractive enough for me to make a move at the moment.
This month it hit the highest level it has been for 11 years, having more than doubled in under three years.
But that P/E ratio looks pricy for a company with limited growth prospects. First-quarter sales revenue growth (excluding VAT and fuel) was 4.6% year on year: perfectly respectable, but not stellar. Sainsbury managed a comparable 4.9% (excluding fuel) in a roughly equivalent 16-week period.
Rising wage costs, high levels of shoplifting, and international tariff disputes are all risks that could eat into the company’s bottom line. For now, I have no plans to buy Tesco shares for my portfolio.
