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Why I’d avoid Tesco and buy this superstock instead

Kevin Godbold

Back in September, I said in an article that “despite tasty-looking fundamentals, the shares of fluid power products distributor Flowtech Fluidpower (LSE: FLO) continue to mark time in a range around 125p to 150p, and I think that value is building up.” Now, the share price sits close to 175p, and today’s full-year and first-quarter results reports reveal the operational progress the firm has been making.

Consolidating the market

In a drive to consolidate the “highly fragmented” hydraulic and pneumatic industry in the UK and Europe, Flowtech completed six acquisitions during 2017. Revenue surged 46% compared to the year before and underlying operating profit moved up 22%. The firm managed to extract an increase of 58% in cash from operations and used some of that to raise the total dividend for the year by 4.9%. Meanwhile, the latest figure for net debt is around £13.2m, which is around one-and-a-half times the level of annual underlying operating profit, so manageable for the time being.

Chairman Malcolm Diamond said the firm’s acquisition activity strengthened our position with important pan-European and global branded suppliers, enhanced our technical strength, and reinforced our position in our current core geographies of UK, Ireland, and Benelux.” During the first quarter of 2018, the firm completed another acquisition, of Balu Ltd. However, the directors don’t plan any further acquisitions during 2018 and aim to concentrate on integrating the new businesses already added to achieve synergistic benefit and capitalise on the entrepreneurial and technical skills of the new operations.

Looking forward, we can expect both organic and acquisitive growth over “the short, medium and long term.”  And Flowtech Fluidpower continues to shape up well against popular quality, value and momentum indicators. I think the stock is more attractive than supermarket giant Tesco (LSE: TSCO), for example.

Turnaround, or long-term falling star?

When I look at Tesco today I see a falling star in a challenged industry. Others may see a turnaround candidate that is turning, and I can’t argue with the double-digit percentage earnings increases the firm has been posting lately, or with recent share-price progress. However, I think the valuation is ahead of itself.

Today’s share price around 237p throws up a forward price-to-earnings ratio of just over 14 for the trading year to February 2020 and the forward dividend yield is around 3%. But to me, what we are seeing with Tesco is an efficiency-driven rebound from a catastrophic earnings collapse and not a sustainable growth story emerging. I think the market should be much more cautious with Tesco’s valuation, perhaps setting the forward P/E at around seven and the forward yield near 6%.

Even then I’d be wary, because the threat from the rise of big-discounting competition, such as Aldi, Lidl and others, is relentless. The old way of doing business is dead and buried for Tesco and it will have to continue to adapt to survive. But will it thrive in the long term? I wouldn’t bet on that and see the most likely outcome as a managed decline of this once-mighty business. So, I’d avoid Tesco and buy shares in Flowtech Fluidpower instead.

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Kevin Godbold 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.