Investors have been asking if it’s time to buy Tesco (LSE: TSCO) shares again after the rot set in a decade ago. The assumption by many back then was that yes, of course Tesco would soon be back to its winning ways at the vanguard of the UK’s supermarket sector… but, 10 years!
Tesco is finally turning the earnings tide back to growth, posting a 66% rise in EPS for the year ended February (though that was still way below pre-catastrophe levels).
And there are decent double-digit rises on the cards for this year and next, which even put the shares on a PEG ratio of just 0.4 — a level that often has growth investors salivating.
But despite that, I’m still not buying, for the simple reason that I think today’s valuation is too rich with the shares at 180p.
Too much optimism
Forecasts suggest a forward P/E of 18.5 this year with the dividend set to yield just 1.7%. Further progress would bring the P/E down to 14 by 2019, with the dividend expected to be yielding around 3% by then.
That’s very close to the FTSE 100‘s long-term average on both counts, and I reckon it would be a fair valuation for Tesco… had we already had the growth that’s already built into today’s price, but not with such hopes still two years away.
Also, those levels of earnings growth are dependent on Tesco’s ability to lift its operating margin rather significantly over the next couple of years. Last year we saw a rise in the underlying figure from 1.8% to 2.2%, but the company seems pretty set on getting those margins up to 3.5% to 4% by the 2019/20 year.
And that sounds like a very difficult thing to achieve to me.
I’ll tell you a company whose shares I like even less than Tesco’s — Wm Morrison Supermarkets (LSE: MRW).
Morrison shares have stormed ahead by 77% since December 2015, to 246p — and for the life of me, I can’t see any justification for it.
In its most recent update, Kantar Worldpanel suggested sales had increased by 3.8% over the 12 weeks to 18 June. But even if you think that’s sustainable (and I don’t), Lidl and Aldi are expanding massively faster than anyone else.
And that’s surely where the big competition for Morrison is increasingly coming from, with the market share of the cheap two rising while Morrison’s is still dipping.
Morrison did post a 40% recovery in earnings last year after years of falls, but EPS growth is expected to slow to 13% this year and 7% next.
Worth more than Tesco?
That’s way behind forecasts for Tesco, yet Morrison shares are valued significantly higher — they’d command a P/E of over 20 by January 2018, and still up as high as 19 a year later. The 2019 dividend would be lower than Tesco’s too, with a yield of 2.7%.
And even then, I don’t actually have a lot of confidence in those predictions, as they don’t seem to take into account the accelerating nature of supermarket competition right now.
I get the general feeling that the Great British investing public is still in a love affair with supermarkets and is irrationally overpricing them — and that’s when you can’t even buy shares in the sector’s two biggest growth prospects.
It’s an attraction I don’t share, and these two are firmly in bargepole territory for me.
A much better prospect
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Alan Oscroft has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.