Why I’d buy Tesco plc and avoid this FTSE 250 ‘growth’ stock

Roland Head explains why he’s betting on market-beating growth from Tesco plc (LON:TSCO).

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In recent years, many defensive stocks have been among the best performers in the market. Their consistent growth, high margins and steady dividends have been a welcome relief from the slumps seen in sectors such as outsourcing, oil and gas, mining and supermarkets.

One exception to this trend has been FTSE 250 consumer goods firm PZ Cussons (LSE: PZC). Shares in the owner of brands such as Imperial Leather, Carex and Sanctuary have fallen by 14% over the last five years, during a period when FTSE 100 rival Unilever has climbed 75%.

PZ Cussons’ shares took another hit this morning, slipping 5% after management advised investors that full-year profits should be “broadly in line with” last year.

Why no growth?

According to the firm, its core markets in the UK, Australasia and Africa are all experiencing “tough trading conditions”. Management has previously noted that inflation in markets such as the UK and Nigeria is forcing consumers to shop more carefully. Mid-market branded products are coming under pressure from cheaper alternatives.

However, I think it’s worth noting that PZ Cussons may have a growth problem if its own. The group’s sales have fallen from a peak of £883.2m in 2013, to just £809.2m in 2016/17. Last year saw sales fall by 1.5%, while adjusted earnings per share were down by 2.1%.

City analysts’ share management’s view that adjusted earnings per share are likely to be flat in 2017/18.

An increase of 6% is pencilled in for 2018/19, but to my mind, the forecast P/E of 18 and prospective yield of 2.7% suggest that this stock is already fully priced.

Total domination?

The acquisition of food wholesaler Booker Group by Tesco (LSE: TSCO) has recently been approved by the Competition and Markets Authority. I’ve been bullish about this deal since it was first announced, as I can see several big attractions for the supermarket (if not for its rivals).

The first is that by taking over the supply of goods to more than 3,000 convenience stores currently supplied by Booker, Tesco will significantly increase its share of this profitable and growing market.

The second attraction is that the combined group will become a major player in the foodservice business, supplying food to restaurant chains.

I expect these new businesses to provide several years of market-beating earnings growth for Tesco, as organic growth combines with cost savings and economies of scale.

Reasonably priced

The supermarket group rejoined the dividend list in October, ending a two-year suspension with an interim payout of 1p per share. Forecasts indicate a total payout of 3.28p per share for the current year, giving a prospective yield of 1.6%.

That’s not very exciting, but broker forecasts suggest that this payout — and Tesco’s earnings — should start to climb rapidly in the 2018/19 financial year.

Merging with Booker should add around £175m to Tesco’s profits, before any cost savings. Current broker estimates are for earnings per share to rise by 30% to 13.1p per share next year. A 58% increase in the dividend is expected, taking the payout to 5.2p per share.

These forecasts leave Tesco trading on a 2018/19 forecast P/E of 16, with a prospective yield of 2.5%. In my view this could be a good entry point for dividend growth investors.

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.

Roland Head has no position in any of the shares mentioned. The Motley Fool UK owns shares of and has recommended Unilever. The Motley Fool UK owns shares of PZ Cussons. The Motley Fool UK has recommended Booker. 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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