Shares in UK retail grocery giant Tesco (LSE:TSCO) have had a standout performance so far in 2023. Up 23% year to date, the shares have outperformed the FTSE 100 by 25%. This growth has certainly caught my eye and got me asking the question: is now the time to add this stock to my portfolio?
What I like
Tesco shares currently trade on a price-to-earnings (P/E) ratio of 14. Upon initial glance, this seemed a little steep for my liking. However, comparing this to closest competitor J Sainsbury, which trades on a P/E ratio of 86, I see value. Marks and Spencer also trades on a similar ratio, and the FTSE 100 average P/E is currently 15.
Tesco also pays a healthy dividend, currently yielding just under 4%. This is again above the FTSE 100 average, and as an avid income investor, this certainly ticks one of my key boxes.
Aside from paying dividends, Tesco has also been putting its free cash flow to work to buy back shares. Since October 2021, the grocery retailer has purchased over £1.5bn of its own stock.
Share buybacks are a big green flag for investors, as they signal a company’s confidence in its own stock. Additionally, by reducing the number of outstanding shares, buybacks can enhance earnings per share, making the remaining shares more valuable.
A final positive I like about Tesco is its brand strength. It remains the UK’s leading supermarket by market share, currently serving over 27% of customers. In addition, its popular Clubcard Price initiative — along with Aldi price matches on over 650 items — has helped increase this market share by almost 0.5% in the last year.
What concerns me
Tesco’s current net debt stands just shy of £10bn. In its half-year results, the company reported £2.7bn in free cash flow. This means it only has the capacity to pay 27% of its debts per year, assuming cash flow remains constant.
Rising interest rates amplify this concern. As rates rise, variable rate debt arrangements also creep up in cost. At £10bn, even tiny rate fluctuations can lead to hundreds of millions in additional costs. For the last decade interest rates have hovered at historic lows. The outlook for the next decade is quite the opposite.
Tesco currently operates with wafer-thin margins of 2.3%. Low margins are problematic for a company with high debt payments because it leaves the business with less income to cover these financial obligations. This also puts pressure on new growth initiatives and shareholder returns.
Would I buy?
Tesco’s high debt and low margins do worry me. However, I think there is a lot to be excited about when looking at this stock.
I find fair valuation, a robust dividend, effective cash management, and a top-tier brand name to be significant positive indicators. Therefore, if I had any spare cash lying around, I would be topping up my portfolio with Tesco shares.
