- I expect Tesco to return +10% / year mid to longer term for an investor.
- Macro picture of the UK seems to be improving, possibly leading to rise in real wages. This should improve Tesco’s position compared to discount supermarkets.
- Company’s book value is understated and property portfolio provides some cushion even in a worst case scenario.
- In the future, revenue streams should become more diversified because of the growing businesses in developing countries.
I've been a Tesco (OTCPK:TSCDY), (OTCPK:TSCDF) stockholder for a while now and for the past year the results of the business have been quite disappointing. The market has responded and the past year's return stands at about -19%. That is quite terrible considering that we are in the middle of a bull market. Here I will try to evaluate Tesco's current situation and future potential.
Tesco is Britain's largest grocery and general merchandise chain and is also a huge player in global perspective. Tesco is a market leader in the UK and it has a bit under 29% market share. UK market is also by far the largest revenue slice for the company at 68% (trading margin 5.03%), next is Asia 16% (trading margin 6.71%) and Europe 14% (trading margin 2.57%). (Source: Tesco Annual Report 2014) Tesco Bank is just 2% of revenue, but actually last year it accounted for over 7% of the profit. However UK and Europe have performed very badly in recent years and Tesco is losing market share. The UK decline is especially quite alarming, because it is overwhelmingly the biggest revenue source for Tesco. The company has actually managed to keep the revenue from declining much so far, but downside has been falling margins and operating profit. The sources of decline are probably the economic downturn accompanied by falling real wages and perhaps more importantly competition, especially from the German discount supermarkets Lidl & Aldi.
However the economic outlook seems to be improving in the UK, even for the average consumer. Wages are catching up to inflation, unemployment is trending lower and gdp forecasts are quite healthy - over 3% year on year. It seems likely that the purchasing power of the consumer will also start to increase after a long period of stagnation. This could shift demand back from budget stores (Lidl & Aldi). The competition still remains and it is likely that margins will be permanently lower in the UK in the future. However I think that Tesco does have the necessary scale to fight back if the market share decline will continue at a rapid pace. I think others will face problems sooner, but a price war would no doubt keep the stock sliding further down.
Tesco is also focusing its capex more carefully and management has stated that capex should be under £2.5 billion for the next few years and 3.5-4% from sales after that. Hopefully investments will be made towards growing and profitable Asia. Also addressing problems in Turkey is on management's agenda. Turkey has very favorable growth prospects and demographics in the longer term, so if the current difficulties can be solved and Tesco can get the business profitable, it could be a very good long-term investment. Growth from Asia and other developing countries should mitigate the risk from UK dependence in the longer term, which is a sizable risk factor for now. Retail market will most likely grow much faster in the developing world than in developed countries (UK), so in time the revenue sources should become more diversified. Tesco also offers good yield, being over 5%. I think that the company can sustain the current yield, but the dividend will probably not be raised, at least by much, for a few years, because even with £2.5 billion capex the company cannot cover the current dividend fully. Some of it must be paid with debt. Dividends paid last year were £1.189 billion while net cash from operations was about £3.2 billion last year. (2014 Annual Report)
(Source: Tesco five year record)
Tesco has a large portfolio of real estate, which is valued to be worth at least £34 billion in the most recent annual report. This is however carried at £25 billion in the books, so the book value is understated. I calculate "true" P/B value, where I have corrected the real estate and stripped out goodwill. Property portfolio also creates some downside protection for the investment. If the retail business environment stays bad, Tesco could realize some of their real estate (sale-leaseback) and boost earnings. And for current price the properties come quite cheaply. If the stock drops below corrected tangible book, I would become very interested. In that case you could basically buy the properties at discount and get a profitable business on the side. Below is presented some comparison to Sainsbury (OTCPK:JSAIY) and Walmart (NYSE:WMT).
tangible P/B (Tesco & Sainsbury real estate corrected)
It seems that Sainsbury also offers good value. It has about the same dividend and is cheaper on PE and EV/EBIT metrics. I still think that Tesco might be the better bet, because to my understanding Sainsbury is even more reliant on the UK market, where competition is tense. Tesco has growing and profitable businesses in developing countries (China, Thailand, Turkey, Poland etc.), which I think will prove to be very valuable in the future, although now they are still quite a small part of the pie. Tesco is also slightly more profitable, having higher ROE. Walmart is presented here, because it shows the valuations that a huge large scale retailer can achieve. Maybe Tesco does indeed warrant valuations closer to Walmart's but probably not as high. ROE is nowhere near.
Next I have calculated equity (share in £) value with simplified DCF, where I use owner's earnings and assume maintenance capex to be equal to D&A. 4% sales growth is used. (Management believes the current capex plans to achieve mid-single digits growth, 2014 Annual Report.) Terminal value growth is expected to be 2%. I use trading profit, since it excludes restructuring costs etc. In the 2.5% / 4.5% margin the first 3 years is assumed to be intense competition with discounters (fall to 2.5%) and after that the margins stabilize a bit lower to 4.5%. I consider this to be a quite cautious and realistic scenario. In any case at current price (283.65 pence) I believe that a bit over 10% return is expected for an investor in Tesco, even if margins do decline somewhat. If they are able to maintain current margins, the upside is about 40% at 10% discount rate. Even if the trading margin falls to 3% (over 40% drop) and stays there to infinity, one would expect to have 8-9% return from current prices. So the downside risk seems to be fairly limited.
Two biggest long-term threats for the business are probably a prolonged price war caused by discount supermarkets and Amazon. However the discounters' winning market share have to stabilize at some point. Not everyone will shop in Lidl and Aldi nor want to buy the cheapest. If Tesco succeeds at refreshing its stores and improving the customer experience, the margin decline could be contained. Also it seems that the macro picture in the UK is improving after many years and I think this will be a bigger positive to Tesco than it is to Aldi and Lidl for example. If incomes are on the rise, consumers' sensitivity to absolute price might decrease.
I really don't have the expertise to analyze the threat of Amazon and internet shopping in the longer term. In groceries, at least, Tesco can respond easily because of the scale and distribution network. Tesco seems to address these changes in consumer behavior (at least in annual reports), for example highlighting the importance of multichannel approach.
At these levels I think that Tesco is at least a moderate buy. But in the current market it could be actually quite a good buy, because everything seems to be expensive. I think that it is realistic to assume +10% return and with quite low risk at current prices. Hefty dividend is also nice, more cash never hurts. Personally I will probably hold on to my position and maybe add if the stock drops lower. And last but not least, Berkshire Hathaway (NYSE:BRK.A), (NYSE:BRK.B) holds 3.98% of the company. That is quite encouraging. At least if I am wrong, I am wrong with the best.
Editor's Note: This article discusses one or more securities that do not trade on a major exchange. Please be aware of the risks associated with these stocks.
Additional disclosure: (Author holds a position in London listed Tesco (TSCO:LN). ADR is also available: Tesco (OTCPK:TSCDY)