People need to eat – and Tesco (LSE: TSCO) is the nation’s biggest grocer, by far. So the business might seem like a license to print money. But, over the past year, Tesco shares have grown by less than 1%. Are they basically dead money — or might it make sense for me to put them in my Stocks and Shares ISA shopping basket?
Uncertain business outlook
One of the things I like about Tesco is precisely that strong position in a resilient market. Grocery retailing may be a fairly low margin business, but volumes can be huge. Last year, for example, Tesco alone reported revenues (excluding VAT and fuel sales) of £58bn.
But the business model does have challenges. Those low margins concern me. Pressure from the likes of German chains Aldi and Lidl as well as local discounters like B&M could see profit margins contract further in the coming years.
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On top of that, cost inflation is a big problem for retailers, especially when customers are price-sensitive. Passing inflation on in the form of higher prices can hurt sales volumes, but absorbing it as a retailer depresses profit margins. Tesco’s operating profit last year crashed 40% and its pre-tax profit more than halved, despite growing revenues.
I expect the UK grocery trade to continue facing challenges when it comes to profitability. For the current year, Tesco expects adjusted operating profit in its retail operations to be ‘broadly flat’.
I think that helps explain why Tesco shares have hardly moved over the past year: investors see limited prospects for meaningful profit growth at the supermarket giant.
Valuing the shares
But if profits fell last year and are set to remain at a similar level, is there a risk that Tesco shares will fall rather than stay roughly where they are?
I think so.
That means that if I bought Tesco shares today, they might not just turn out to be dead money – I could actually see the value of my holdings reduce over time.
Tesco’s post-tax profit last year was £753m. Compare that to its current market capitalisation of £19.6bn. Based on those numbers, Tesco shares currently trade on a price-to-earnings ratio of 26. That looks high to me for a dominant company in a mature industry with downward profit margin pressure and limited growth prospects.
Don’t forget the dividend!
That valuation alone is enough to put me off buying the shares at their current price and I have no plans to do so.
However, simply looking at the price of Tesco shares might not tell the whole story. After all, they have a dividend yield of 4.3%. So if I had invested a year ago, although the share price has hardly moved, my total return to date would be around 5%.
The company announced this week that its annual dividend would be held at the same level as last year. I think the lack of a dividend increase underlines that the business faces growth challenges.
A 4.3% yield is attractive to me. But I do not buy a share just for its dividend. The current valuation of Tesco shares is too high for my tastes, so the prospect of a dividend is not enough to sway me in my investment decision.
