|Shares Out. (in M):||8,126||P/E||26||0|
|Market Cap (in $M):||17,633||P/FCF||0||0|
|Net Debt (in $M):||4,265||EBIT||776||0|
|Borrow Cost:||General Collateral|
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Tesco is one of the top 4 grocers in the United Kingdom. Tesco is one of the world’s largest retailers with 476,000 employees and 6900 shops around the world.
Tesco’s reputation for reliable growth took a hit in 2012 when the company admitted that it had over-earned in its core UK business and that profits would need to be rebased. Since then, the company has planned to recover by investing in staffing its UK stores, recognizing that service level and store appearance had suffered in recent years. Tesco renewed its private label ranges and reassessed its space allocation, giving more space back to food categories. They have also launched a range of new “Farm Brands” which are good quality fruit and vegetables at very competitive prices – which certainly represented an incremental investment. CEO Dave Lewis – became CEO of Tesco in September 2014. Previously spent 28 years at Unilever. Current management team seems to be performing well in stabilizing the business, executing asset sales, and shoring up the balance sheet. However, our concerns are centered on the structural issues within the sector and the extremely inflexible nature of Tesco’s asset base.
What is happening?
In short, the traditional grocers are under siege by large, efficient competitors from below and by differentiated competitors from above. They are stuck in the middle, and the middle pie is shrinking. Operating leverage is now working in reverse, as negative LFL’s push margins lower. The companies’ competitive response came in late, and has focused primarily on price cuts and service improvements, each of which reduced margins further. There is no clear way for the incumbents to earn their traditional margin levels because the discount business model has changed the landscape permanently. The listed grocers are cutting capex, sharply curtailing growth – the extreme opposite to the discount operators. Fine tuning existing operations will not be enough to revive the sector.
Discounters – the rise of Aldi and Lidl is an ongoing phenomenon in the UK and they have been blamed for many of the problems at the traditional grocers. Cash strapped families who migrated to their stores during the financial crisis have stuck with them as the economy recovered. The quality was better than expected and the value even more so. Consumer perception changed and it became easier to save money especially given the ability to easily compare prices online. Aldi and Lidl saw a huge influx of customers and the persistent pricing differentials to the incumbents as an opportunity to exploit. Aldi and Lidl has stated the intention to remain at least 15% cheaper than Tesco. Matthew Barnes, CEO of Aldi UK, said “Whatever our competitors plan to do we know exactly what our response will be… We will not let them compete on price. We will not let them close the gap. We have reduced our gross margins … to ensure we compete and we will maintain that even if we have to reduce gross margins further”. Despite some market commentary, in 2016 the discounters are adding more sales and gaining more market share (albeit at a slower pace than earlier). I believe the gap on comparable products remains close to 20%. This is underpinned by the 500bps OPEX advantage that they have over the traditional grocers. Further risk comes from Asda, whose market share losses have accelerated as it has invested less in price than Tesco.
ASDA moving into position could hurt the industries profitability. WMT has said it will no longer tolerate sales declines at ASDA. This could signal a major price repositioning. ASDA’s heritage is price leader but it lost this to the discounters and has lost relative price position to the Big 4. Most successful retail turnarounds involve a return to heritage. ASDA may try to regain its price position with major industry consequences. WMT International CEO stated at WMT AGM that “he is disappointed with ASDA’s recent performance and that you can expect that we will shift the balance from protecting profits to protecting market share.” Circumstantial evidence is growing, but there is no firm evidence to suggest that ASDA is going to launch a major price repositioning in the UK, there is however logic of such a move and evidence to suggest that something is afoot. Tesco (UK) on average has 70%-75% of geographical overlap with ASDA. Moreover, ASDA recently submitted its annual accounts to Companies House for 2015. Its EBITDAR margins adding back licensing/loyalty fees Asda pays to Walmart) expanded by 50 bp to 8.1% in CY15 (this is a cumulative c.135 bp expansion in the last 3 years) suggesting that ASDA has room for investments i.e. to move on price. For context – the last time ASDA saw LFL sales growth (2Q15) was the last time it saw gross profit margin decrease. Therefore, in order to turn the negative LFL, ASDA should have to reposition itself on price.
Bloomberg reported that yesterday that Tesco’s Chairman John Allan indicated that UK inflation could ‘nudge up’ 2-3% with food inflation a part of this. Allen indicated that in the coming months supermarkets are ‘very likely’ to increase prices due to the weakness of the GBP although Tesco would continue to ‘scrutinize’ supplier price increases. Consistent food inflation at lower levels (sub 2%) is generally a positive for food retailers as it allows price rises to offset operating cost increases and does not surprise the consumer, or drive a change in shopping habits. However, when food inflation has moved outside of a -1% to +2% range over the last 15 years, adj. for population growth, there has been a volume response above 0.3x inflation levels. At lower inflation levels (-1% to+2%) there does not seem to be a volume impact. But above 2% we can see a clear volume response. This behavioral change is key because although total sector volumes tend to only fall slightly in periods of high food inflation, since 2011, the last time food inflation went over 5%, the discounters had gained over 520 bp of market share (to end 2011). More importantly, even excluding the dramatic volume declines seen recently at Asda, the listed 3 saw annual volume declines for over 5 years straight until the end of 2015 (UK LFLs less price inflation per Grocer Price Index) taking operating margins from an average of 4.9% to 2.4%. Thus we can come to the conclusion that grocery consumers are much more price elastic at higher levels of inflation than headline data would suggest. Grocers will be unwilling to unilaterally pass price inflation through at the >5% levels implied by input cost pressures, hence implying an increasing risk of margin pressure resulting from withholding input costs from the consumer to protect market share and volume growth. Therefore, rising input costs mean the Big 4 likely need to make the uncomfortable decision of choosing between margins and market share.
According to the ONS, UK Food CPI was -2.1% in October, a slight increase from -2.4% in September. Interestingly, the food output PPI increased to +0.3% in October from -0.9% in September. This means that the gap between prices charged to consumers and the prices paid to producers for the food increased to 240bps in October from 150bps in September and flat in July. This suggests, that although food deflation is easing, retailers are unable to pass price increases to consumers.
Pension deficit should not be ignored
Because Tesco is a large, diversified grocer, it may seem ridiculous to mark-to-market the value of its pension assets and liabilities every six months given the outsized effect it has on the firm's equity. This most recent release is a perfect example. Between February and August of this year Tesco's pension deficit rose from £2.6bn to £5.8bn (post tax), an increase of £3.2bn, almost entirely due to a change in discount rate assumptions. All else being equal, this should equate to a reduction in equity value of 40p/share, or ~19% of market capitalization. Is that fair? Tesco itself includes this amount in its debt calculations. However, in the commentary accompanying the release, management downplayed these values and suggested the market should look only at the cash outlay it has agreed to pay in order to close that deficit. Tesco has a funding agreement in place with the trustees of £270m contribution p.a. in order to fund the UK deficit and meet the expenses of the scheme. The next triennial actuarial valuation will be conducted next March. There could be a link between the long term guidance just provided to the market, ahead of the renegotiation process, provided that Tesco needs strong arguments to re assure trustees and avoid any additional lump sum payments to the fund.
FCF is an issue
FCF stood at only £206m in 1H16/17 vs £504m in 1H15/16, despite still relatively low capex and taxes levels. It implies a £300mn YoY decline vs the underlying FCF seen in 1H15.
Long term margin guidance?
Margins have a chequered history in food retail so prudence is wise…
By giving the market a 3.5-4.0% UK margin ambition which we were encouraged to take as a target, Tesco has finally quantified what an ‘industry leading margin’ is. Unexpectedly however, the group has also tied themselves to a time frame (2019/20). The past is no guide to the future… The recovered margin for Tesco is a long way off peak but life is very different for Tesco. Price competition has been intense, sales densities are lower, non-food has become a burden, rent is much higher, and the wage bill is higher… Back in the good old days of 6% EBIT margin, Tesco would often talk about cost savings of a similar magnitude. Indeed, it was named the ‘pay to play’ as the idea was the savings were reinvested back into the proposition (including prices and things like wage inflation). In order to achieve the 3.5% to 4.0% margin, Tesco would need to retain 50% to 75% of the 1.5B cost saving ambition. In the context of wage inflation, rising input costs this seems challenging.
Using 5 and 10 year avg. EV/EBIT multiples applied to FY20E EBIT, the market may be pricing recovered EBIT margins of 4.2% at Tesco. Applying a 12.1x EBIT multiple (TSCO 5 year average 1 year forward EV/EBIT multiple) to the midpoint of FY20 margin guidance, and discounting it back to today would imply a valuation roughly 20% below where the stock currently trades. Price target of 150 pence is derived from an equal weighted DCF (8% discount rate, 1% terminal growth rate) and SOTP. Estimate that Tesco will earn a 2.6% EBIT margin in the UK (2021), and a group EBIT margin of 3.05% (2021).
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