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The Tesco share price looks cheap to me: here’s why I’d buy

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Tesco fruit and veg
Image source: Tesco

The Tesco (LSE: TSCO) share price fell after the company published its annual results last week. The market didn’t seem impressed, perhaps because new CEO Ken Murphy didn’t promise any short-term measures to juice up the share price.

Personally, I was impressed by the numbers. Tesco’s profits were bound to take a hit last year, due to £892m of extra costs from Covid-19. But my sums suggest that as life returns to normal, the UK’s largest supermarket should stage a strong recovery.

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It’s all about cash for me

For me, what really matters is whether an investment can generate reliable, rising cash returns.

I admit that supermarkets, including Tesco, have delivered a mixed performance over the last decade. Tesco’s share price history since 2011 tells the story — it’s not been pretty.

However, I believe former chief executive Dave Lewis has transformed Tesco into a focused, disciplined cash-generating machine.

Last week’s accounts showed that the retailer generated £1,187m of surplus cash during the year to 27 February. Although that’s 30% less than in 2019/20, this was still enough to fund the dividend (£700m) and a £300m reduction in net debt.

Given the events of last year, I think that’s a strong result. I expect Tesco’s cash generation to bounce back quickly this year, providing support for dividend growth.

Why has Tesco’s share price fallen this year?

I’ve seen a lot of talk about Tesco shares falling this year. Actually, I don’t think they have — at least, not much.

What’s really happened is a bit technical, so bear with me. In February, Tesco returned £5bn in cash to its shareholders, through a special dividend of 50.9p per share. This money came from the sale of the group’s Asian business.

Taking such a large sum of cash out of the business would have made the stock fall by around 50p (about 20%). To prevent this, the company carried out a share consolidation. What this means is that the number of Tesco shares in issue was reduced.

The aim of this consolidation was to cancel out the effect of the special dividend, so the share price would stay the same. Each shareholder received 15 new shares for every 19 old shares they owned (which were cancelled). This was all done automatically.

I don’t think Tesco’s share price has fallen much this year. After adjusting for the share consolidation, I see Tesco stock down by just 4% since 1 January. No big drama.

Why I’d buy

At the time of writing, Tesco’s share price is hovering around 225p. I think that offers decent value, but as with any equity investment, there are some risks.

We don’t yet know how shoppers’ habits will change after the pandemic. Tesco’s big stores worked in its favour last year. But before the pandemic, the opposite was true. Many shoppers were switching to more frequent shops in smaller local stores.

Competition is also likely to remain tough. Aldi and Lidl lost out last year because they don’t do home delivery. But both discounters are continuing to open new stores. I expect many of them will be located close to Tesco supermarkets.

Despite these headwinds, I think Tesco’s size will continue to work in its favour. With the stock offering a forecast yield of 4.8% for the year ahead, I’d put these shares in my trolley today.

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Roland Head has no position in any of the shares 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.

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