Over the past six months, shares in supermarket giant Tesco (LSE: TSCO) have dived, falling nearly 20%, underperforming the wider of FTSE 100 by around 10%, excluding dividends.
After this decline, it might be tempting to buy into the Tesco recovery story. However, before you do, I think there are several factors you should consider.
Slow and steady
Firstly, while Tesco has recovered significantly from its accounting scandal in 2014, the company is still facing significant headwinds. Discounters Aldi and Lidl are still expanding, meanwhile, Asda and Sainsbury’s, two of the group’s largest competitors, are in the process of combining, which will ultimately create a force to be reckoned with, and could set off a new price war.
Even though the company has been able to attract customers back into its stores with lower prices and an all-around improved offering, it remains to be seen how the business will cope against the Asda–Sainsbury’s mega-merger.
Earlier this year, Tesco announced with much fanfare that it had achieved a pre-tax profit, before exceptional items, of £1.64bn in the year to 24 February, as total group sales rose 2.8% to £57.5bn. The operating profit margin hit 3% in the second half of the financial year, a significant step towards CEO Dave Lewis’s goal of increasing the operating profit margin to 4% by 2020.
Based on current trends, it looks as if the company will hit this target. But, as noted above, as yet we don’t know how the Asda–Sainsbury’s merger will hit growth. If the enlarged entity does decide to chase market share aggressively, Tesco’s operating profit margin target could go up in smoke.
Considering all of the above, I don’t think it is worth paying a premium for the Tesco share price. Unfortunately, at the time of writing, the stock is changing hands for 18.5 times historic earnings. City analysts are expecting the company to report earnings per share (EPS) growth of 28% for fiscal 2019, which puts the shares on a forward P/E of 14.3. That’s a bit cheaper, but it’s still above what I would be willing to pay for a low-margin retailer in an industry that’s only going to become more competitive.
Analysts believe EPS will grow a further 20% in fiscal 2020. If Tesco does achieve this growth, that means the shares can currently be picked up at a P/E of 12x fiscal 2020 earnings. However, a lot can happen in the space of two years. Investing today, based on what analysts believe will happen in two years’ time, might not be the best decision.
Finally, after slashing its dividend to zero in 2016, last year Tesco reinstated its dividend distribution.
Unfortunately, this year the company is only expected to pay out 5.1p per share, giving a dividend yield of 2.6% — around half of the FTSE 100 average of 4.3%. With risks growing, I think there are better income investments out there.
So overall, while Tesco has achieved a huge amount over the past three years, I’m not a buyer of the shares today. I think the company’s recovery could be short-lived. With this being the case, the shares look overpriced at the current level.
Do you want to retire early and give up the rat race to enjoy the rest of your life? Of course you do, and to help you accomplish this goal, the Motley Fool has put together this free report titled "The Foolish Guide To Financial Independence", which is packed full of wealth-creating tips as well as ideas for your money.
The report is entirely free and available for download today, so if you're interested in exiting the rat race and achieving financial independence, click here to download the report. What have you got to lose?
Rupert Hargreaves owns no share mentioned. The Motley Fool UK has recommended Tesco. 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.