UK supermarket stocks are in buzz following the recent Morrisons deal. The sector is otherwise considered dull due to the slow growth nature of the mature companies operating in this industry. In contrast, technology companies tend to have robust growth.
I have been closely watching the supermarket sector for the past few months. One main reason was to add a stable large-cap stock from this sector to my portfolio. Here, I will explain why I bought Tesco shares.
The strong fundamentals
Tesco’s fiscal year 2021 revenue grew by 7.1% to £53.4bn. In comparison, its close competitor Sainsbury’s sales fell 0.3% to £32.3bn. The sales were strong as the company was able to increase its market share. Excluding Central Europe and the Tesco bank, sales were even stronger as it grew by 8.8% to £48.8bn. The lockdown was a boon to the company as it grew its UK online sales by 77% to £6.3bn.
I like companies that have good free cash flows. Tesco had a retail free cash flow of £1.2bn. It has a stable balance sheet. Net debt was £12bn, down 0.3bn from the previous year. The company’s sale of its Asian businesses helped to reduce its pension liabilities by £2.5bn. Its debt-to-equity ratio is 0.59. The ratio is good, in my opinion.
The company’s marketing efforts have been successful in increasing sales. The Clubcard prices, which were launched in September last year, are now extended to over 3,000 products. There are over two million Clubcard app users. Clubcard prices rewarding loyal customers are now available in all 1,844 Express stores. The Aldi Price Match has also helped the company to remain competitive.
The Tesco shares are trading at a forward price-to-earnings ratio (P/E) of 13, based on analysts’ next year earnings per share estimate of 18.28p. However, actual performance might differ from analysts’ estimates. Currently, Tesco is trading at a P/E ratio of 31.5 compared to the five-year average of 49.78. The shares are trading at a discount to their historical averages.
Tesco shares – risks to consider
Tesco’s business benefitted from the lockdown as people purchased goods online and grocery item requirements increased as people were at home. Now with the reopening, people will start spending money on restaurants and pubs. Also, there is a high level of uncertainty in the business environment with the rising number of Covid-19 cases.
The supermarket sector is highly competitive. Consumers can easily compare prices from one store to another. Discount retail stores like Aldi and Lidl are aggressively trying to increase their market share. This could put pressure on the company’s profit margins.
Conclusion
Tesco is a fundamentally strong company. It is a large-cap stock, which is usually considered more stable. I also like the company’s dividend yield of around 4%. However, I understand that dividends might vary each year, or even be cancelled. In my opinion, consumer demand is strong for the supermarket sector. I am happy to hold Tesco shares in my portfolio, the market leader in the UK grocery sector.
