Tesco (TSCO) 347.2p

Market cap: £23.75 billion

We believe leading food retailer Tesco (TSCO) is a great risk/return investment opportunity, comprising unappreciated defensive qualities at a time of increased economic uncertainty.

As we explain later in the article, Tesco has the potential to deliver substantial returns to shareholders based on its capital allocation policy of returning cash via share buybacks and dividends.

The UK’s leading grocer appears to have rediscovered its growth engine and looks set to outgrow the market by following its proven strategy of investing in price and analysing data to drive more customers to its stores.

The leveraged buyouts of UK competitors Morrisons and Asda means they are hampered by big debts and consequently have limited ability to invest in lower prices.

Meanwhile, Tesco has put a halt to the market share gains of German discounters Lidl and Aldi through its effective price-match strategy. Restrictive planning permissions also suggest future growth for the discounters may be harder to achieve.

This all adds up to a very benign competitive landscape and leaves Tesco in a good position to reinforce its leadership position.

At the company’s half year results (3 October), the retailer reported a 0.62% increase in market share to 27.8%, its largest share since January 2021. The company has delivered 15 consecutive four-week periods of market share gains.

Following a radical restructuring of the business and an accounting scandal a decade ago, the business today is a lot more focused. As a relatively mature business, Tesco generates lots of free cash flow.

Management has a clear policy to utilise free cash flow to drive shareholder returns through share buybacks and dividends. Since launching its first buyback in 2021, the company has so far returned £2.4 billion to shareholders.

In addition, Tesco has paid out £8.2 billion in dividends meaning total shareholder returns over the last three years equate to 42% of the current market capitalisation.

There is more to come. Following the agreed sale of its banking operations to Barclays (BARC) for £700 million in February, Tesco is set to return the proceeds via an incremental share buyback.

After the current £1 billion programme is completed by April 2025.

The deal with Barclays includes an exclusive 10-year strategic partnership which provides an opportunity to develop new and innovative products with Barclays under the Tesco Bank brand.

Tesco anticipates an adjusted operating profit contribution from the retained banking operation of between £80 million and £100 million per year.

The retail business is expected to generate free cash flow in the medium term of between £1.4 billion and £1.8 billion per year.

At the start of the article, we mentioned Tesco’s defensive qualities as a key attraction of the investment case.

Fund manager and founder of Latitude Investment Management, Freddie Lait, who owns Tesco shares, offers a counter-intuitive perspective in the event of the UK economy souring.

‘Given the explosive demand in takeaway and food delivery, we expect a recession would also see a major return to supermarket shopping,’ explains Lait.

We believe this scenario adds some additional risk protection and margin of safety to the investment case.

MID-DOUBLE-DIGIT SHAREHOLDER RETURNS

In the long-run, share prices track EPS (earnings per share) growth, so what is the outlook for Tesco?

Lait believes the company can grow revenue ahead of the market at a clip of between 3% to 4% a year in a benign 2% inflation environment, although it could be more if inflation is higher or in a recession scenario as explained earlier.

There is scope for some margin expansion, but Lait believes the company will instead invest in price to attract more customers.

This would imply profit growing at a rate of between 5% and 6% a year, which may appear unexciting at first sight, but we have to factor in share buybacks which are running around 4% a year, implying 10% growth in EPS.

Share buybacks reduce the number of shares outstanding, which provides a mechanical boost to EPS growth.

To arrive at total shareholder return we must add dividends. The yield on Tesco shares at the current price is roughly 4%. This equates to a shareholder return of just over 14% a year (1.1 x 1.04) in a base case scenario.

In a scenario where investors start to recognise the potential for Tesco shares, there is scope for the PE (price to earnings) ratio to expand. Lait notes that US retail giant Walmart (WMT:NYSE) trades on a PE ratio of 35 times, for example.

‘Obviously, the shares could easily re-rate up to circa 18 times. If this was to happen over the next five years that would add 40% to returns, or 7% per year implying a 20% annual total return to shareholders,’ concludes Lait.