The Tesco (LSE: TSCO) share price hasn’t taken part in the stock market rally we’ve seen over the last year. While the FTSE 100 is up by 30% from last year’s lows, Tesco shares are largely unchanged.
I think the UK’s largest supermarket offers good value at current levels. I’m considering buying the shares for my portfolio, as I think they could provide long-term income and growth.
A return to growth?
The coronavirus pandemic triggered a period of intense activity and upheaval for supermarkets. I think it’s fair to say Tesco and its peers had never faced anything like it before.
Tesco seems to have coped well. The group doubled its home delivery capacity and launched the ‘Aldi Price Match’ promotion in March. According to Kantar market research data, this saw Tesco take market share from Aldi for the first time in 10 years.
The company’s large stores also enjoyed a comeback. In recent years, supermarkets have been regretting some of their largest stores. But Tesco says the return of the weekly shop resulted in strong sales growth at these stores.
Although Tesco’s sales benefited during the pandemic, profits didn’t. Management expects to report additional Covid-19 costs of £810m for the year to 29 February. These costs will hit profits, but I expect the situation to improve steadily during the current year.
City analysts share my view. They expect Tesco’s pre-tax profit to rise from £1,285m in 2020/21 to £1,873m in 2021/22 — a 45% increase.
Why I think Tesco’s share price is cheap
It’s not often a FTSE 100 company is expected to report such a dramatic surge in profitability. And it’s true that this should be a one-off gain as the business returns to normal operations.
Even so, I don’t think Tesco’s share price reflects the group’s expected recovery. The pandemic hasn’t just affected the company’s store operations. Its wholesale business, which supplies restaurants and cafes, has been hit hard by lockdown too.
If Tesco’s profits rise as expected this year, my analysis suggests the retailer’s surplus cash — known as free cash flow — should also increase. If I’m right, then new CEO Ken Murphy will be able to afford to rebuild the dividend quite quickly.
Broker forecasts suggest a payout of 10.7p for 2021/22. That gives the stock a forecast dividend yield of 4.7%. That’s a lot higher than the FTSE 100 average of 3.1%.
I’d buy Tesco for my ISA today
I reckon that Tesco shares would be a good fit for my Stocks and Shares ISA. I expect the UK’s largest supermarket to provide a reliable income and steady growth over the coming years.
Tesco and its main rivals were caught out by the rapid growth of Lidl and Aldi and they remain a threat. But I hope those days are past and Tesco has the measure of the big discounters. Of course, they won’t take Tesco’s resurgence lying down but I think it’s unlikely to allow them to continue expanding as fast as they have in the past.
At a share price of 225p, Tesco stock is valued at 11 times forecast earnings. I’d be happy to buy the shares for my portfolio at this level.
