Description

Summary

This is not a special situation, nor is it particularly exciting, but we believe an investment in Tesco plc offers an excellent risk/reward for those with a 3-5 year time horizon.  Tesco is one of the world's great retailers, offers good growth and improving returns, and trades close to a 20-year P/E low (10x NTM).  Total annual return should be low- to mid-double digits assuming a constant multiple (EBIT growth + dividend), and would be further enhanced should the market ever decide to reward high quality equities with higher multiples.  (We are in the camp that believes large cap, high quality is attractive relative to everything else.)

Very brief company overview

Tesco is the UK's dominant food retailer, with ~30% share of the grocery market.  Core UK retail represents ~60% of EBIT (the majority of this is grocery, some is general merchandise).  The UK is empirically among the most rational grocery markets in the world.  Four publicly traded entities (Tesco, Asda, Sainsbury, Morrisons) control ~75% of the market and private label penetration is high, resulting in a rational pricing environment.  Relative to grocers in the US, UK grocers exhibit significantly better margins (average margins actually expanded during the recession), higher asset turns (strict zoning constraints and high cost of land mean there is much less grocery selling space per capita), and thus better RNOA.  Tesco operates four basic formats:  hypermarkets ("Tesco Extra"), regular supermarkets ("Tesco"), small supermarkets ("Tesco Metro"), and convenience stores ("Tesco Express").  Over the last decade, sales have grown by an average of ~9%/year.  Operating margins have been remarkably stable over this period, with a range of 5.6% to 6.4%.  According to the UK Competition Commission's most recent study of the UK grocery market (October 31, 2007), Tesco now enjoys "significantly lower" COGS than its competitors, as well as operational economies of scale (distribution, central cost leverage, etc.).  Its basic competitive advantages in the UK are reminiscent of Wal-Mart in the US.

Tesco also has significant and growing international exposure, with ~75% of new space growth, >30% of revenues and ~25% of EBIT coming from outside the UK.  The largest markets by revenues are S Korea, Thailand, Ireland, Poland, and Hungary, but the company has also made significant investments in China, Japan, the US, and Turkey, markets that management call "High Potential."  International is lower return than the company average, but most of the infrastructure and logistics investments have been made, offering the prospect of improving returns going forward.  As one would expect, returns are highest in markets where Tesco has scale and where its stores are more mature.  More info on Tesco's international business can be found here:  http://www.tescoplc.com/plc/ir/pres_results/presentations/p2010/

The final ~15% of EBIT comes from an attractive UK retailing services business.  This segment includes online grocery (~50% market share), banking, telecom, and a customer data analysis business called Dunnhumby.  The overall services segment grows faster than core UK retail, has ~2x the margins, and ~50% higher returns.  More info on this business can be found here:  http://www.tescoplc.com/plc/ir/pres_results/presentations/p2009/

For further background on Tesco's history and end markets, I would point you to Tesco's annual reports and zeke375's VIC write-up on June 16, 2006.  If you have access, Morgan Stanley has published a good "Introductory Guide" on the company, dated August 9, 2010.

UK LFLs (like-for-likes, aka same-store-sales)

One reason the stock has languished is that UK food retail LFLs are near 20-year lows, despite a recent uptick in food inflation.  Major grocers' LFL growth was just 0.7% in 2H10 vs. a long-term average of 3-4%.  Part of this is a soft economy (volumes are weak) and part is that promotional activity is running near an all-time high as branded goods attempt to remain competitive with private label (PL has much higher market share in the UK than in the US).  The market is concerned that retailers will be unable to pass along higher food costs to a cash-strapped consumer and that the strong historic correlation between inflation and LFLs has broken down.

While it is hard to know when LFLs will pick up, we believe that eventually both branded goods and private label will need to raise prices to protect margins.  Several industry participants, including mgmts at Unilever and Danone, have recently noted reductions in promotional intensity.  Higher promotional activity in 2010 does not appear to have helped volumes and it seems that some companies are beginning to realize that.  At the very least, looking at a chart of promotional levels (as a % of all goods sold) vs. long-term historic levels suggests that promotional activity is unlikely to get worse.  Tesco's comps get meaningfully easier in 1Q of FY2/12 (the current quarter), which should help sentiment become less negative.  Note that historically, higher food inflation has benefitted the food retail sector's absolute and relative valuation (Bernstein has a chart showing this).  This has not happened this time around.

UK Growth

Tied to the previous issue, the market is also concerned that square footage growth in the UK supermarket space - currently running at ~5-6% vs. a long-term average of ~4% - at a time of weak consumption will hurt margins and returns for all participants.  Tesco itself is responsible for about ½ of this new space (as an aside, Tesco's mgmt took advantage of the economic downturn to invest ~£3 bn in property for expansion at reduced prices).  While industry expansion is a bit higher than we would like to see, we are not overly concerned for the following reasons:

1.      Almost half the new space will be dedicated to non-food categories (e.g., apparel, electronics, etc.), where the supermarkets are taking share from fragmented competition.  Tesco has just ~4-5% share of non-food and this is a bigger market than food.  CFO has commented that both apparel and electronics, each of which do ~£1 bn in revenues, could triple in the next 5-10 years.

2.      Some of the food space is in non-supermarket categories like convenience stores (Tesco has >1,000 "Express" convenience stores).

3.      The "Big 4" have gained share against the rest of the market for a long-time and should continue to do so given cost advantages (Tesco mgmt estimates its UK grocery share is more like ~20-21% using a liberal definition of all mom & pops, rather than the 30-31% you see in brokerage reports).

4.      The UK has the least grocery square footage per capita in Europe, at just ~60% of the overall average.

So actual space growth devoted to grocery is more like ~2-3%, and even some of this is re-branding of existing capacity (e.g., Asda's recent purchase of Netto stores).  This is not too dissimilar to long-term volume growth of ~1.5-2%.

UK Margins

The combination of the issues noted above have led to questions over the sustainability of Tesco's margins.  We are not terribly worried for the following reasons:

1.      We expect the UK market to remain rational, as it has been for decades.  The last serious price war was in the 1970s, when the market was far more fragmented than today.

2.      Tesco has consistently invested in price for the last 15-20 years - the period over which its highly stable margin record was established - and will continue to do so via its "Step Change" program, which takes just over 1% of opex out of the business each year.  Some of this can/will be used to support margins, if necessary.

3.      The services business is growing faster than core UK retail.  This business has 2x the margins of core retail, leaving management further wiggle room.

4.      As noted above, we are less concerned than some about LFLs and industry square footage growth.

5.      Tesco's valuation appears to discount these concerns.

Returns

A valid criticism of Tesco is that high growth in recent years has not been accompanied by improving returns.  Much of the company's capex has gone into immature markets like China that require basic infrastructure like DCs and where Tesco lacks the kind of scale that it enjoys in the UK.  Tesco mgmt takes a very long view and has been making the investments that it believes it needs to win the game over the long haul (this stands in contrast to some of Tesco's primary international competitors, e.g., Carrefour, which have chosen to take more of an asset-light approach).  Tesco's international (ex. US) pre-tax ROCE is ~9-10% vs. the UK at ~20%.  Within international, mgmt has a few charts that show that countries in which it has a #1 or #2 position (e.g., S Korea, Thailand), returns are ~30% above the overall international average, and that mature stores (>4 years) in those markets have returns ~70% above the overall average.  It is worth noting that ~1/3 of Tesco's overall store base is 3 years old or younger.

Mgmt believes that it is nearing an inflection point for overall returns and is targeting a 250 bps improvement in the coming years, though has not yet specified a time period.  Improving returns would most obviously come from maturation of international markets (capex will remain high, but a greater proportion will be spent on stores rather than infrastructure), a slowly aging store base (i.e., a lower proportion of stores <3 years old), increasing EBIT contribution from higher return services (~50% higher returns than the corporate average), lower losses in the US operation (mgmt expects breakeven in 3 years), slow but steady monetization of expensive UK property, and lower capital intensity (as a % of sales) following stepped up investment in 2008-09.  On the final point, Tesco made two ~£1 bn acquisitions during this period (Homever in Korea and a buyout of its 50/50 banking partner RBS) and made significant property investments in the UK and China while land was "on sale."  Overall capex/sales should fall to ~6% going forward vs. an average of 7-8% in recent years.  We believe that any evidence of improving returns will be helpful for Tesco's valuation, even if a few things don't go our way (e.g., UK LFLs remain low).  New CEO Philip Clarke has an opportunity to reaffirm and/or put more parameters around return targets at his inaugural results presentation in April.

Property backing and balance sheet

Tesco owns approximately 75% of its store base (both land and structure).  The net book value of this property at end-February 2010 was £22.4 bn, but in its 2010 Annual Report, management states that it believes current market value to be £34.6 bn.  Notwithstanding the fact that this figure has probably risen in the last 12 months due to additions and appreciation, this £34.6 bn represents ~110% of Tesco's market cap and ~88% of its EV.  While the property is integral to the retail operation and could not be easily monetized en masse, this level of hard asset backing provides a nice measure of downside support for the stock price.  It is also a decent hedge against a rise in general inflation levels.

From time to time, Tesco looks to monetize bits of its property assets via sale and leaseback transactions.  Deals are usually structured as a 50:50 JV between Tesco and a property company (e.g., British Land) or a pension fund (most recently, Tesco's own).  These deals have yielded >£5 bn of proceeds over the last 15 years.  At one point, there was a thought that some of these funds would be used to repurchase shares, but in practice, the funds have been used to reinvest in the business and pay down debt.  In any event, it is a real source of shareholder value that many other companies with property assets either can't or won't realize.  Looking ahead, we expect sale and leaseback transactions to yield pre-tax profits of £200-250 mn per year, on average.  This represents ~6-8% of current operating pre-tax profits.

A final interesting fact about Tesco's property is that it earns ~£350 mn in annual rent from third parties who rent space around its stores.  With millions of customers visiting Tesco properties every day, it is easy to see why this space would be attractive to third parties.  This ~£350 mn (and growing) is nearly half the rental income of Unibail-Rodamco, Europe's largest retail landlord with a market cap of $20 bn.  And it is more than the rental income of Macerich, which has a market cap of $6.4 bn.

Tesco should finish FY10/11 with ~£7.5 bn of net debt and ~£5.2 bn of EBITDA, putting net debt/EBITDA just under 1.5x.  If you capitalize operating leases and adjust for pension, this figure rises to the 2.5-3x range - still quite comfortable for a business with this stability and asset backing.  The rating agencies look at the leverage on this basis and rate the company A3 (Moody's) and A- (S&P).  We believe an investment in Tesco is safe.

Valuation

As mentioned in the intro, Tesco shares are trading near a 20-year low on most metrics.  At 390p/share, the stock trades at ~8.5x NTM pre-tax operating profit (excludes property monetization).  This pre-tax coupon of nearly 12% compares very favorably with "safe" government bonds, especially considering that this coupon should grow ~8-10% annually for the foreseeable future (revenues +7-8% w/ modest margin accretion from maturation of international and services). 

On a P/E basis, Tesco trades at ~10.8x NTM consensus EPS and closer to 10x after making adjustments for a non-cash pension charge and assuming the company books £250 mn in pre-tax property gains (given recent history and mgmt comments, we would consider property gains recurring rather than exceptional).  This compares to its historic trading range of 10x to 23x NTM EPS, with an average of ~15x.  Tesco's current multiple is in line to slightly below its UK and US peers, despite higher current returns, high potential for future improvement in returns, and more exciting long-term growth potential (international, services).  10x earnings strikes us as eminently reasonable considering that a large portion of the company's assets are immature and thus under-earning their potential.

Relative to the market at large, Tesco currently trades at ~0.95x the NTM P/E multiple of the MSCI Europe.  This compares to its 5- and 10-year averages of 1.19x and 1.09x, respectively.  Note that the market multiple is currently ~22% below its 10-year average. 

On a cash flow basis, the stock trades at ~6.6x NTM operating CF.  Note that Tesco operates with negative net working capital of ~£3 bn, equivalent to ~5% of revenues.  As the company grows, we estimate a NWC benefit of ~5% of incremental revenues, or about £220 mn/year.

The stock does not look great on a FCF basis, but that is because the company is reinvesting the majority of its cash in growth.  Assuming net capex of ~6% of sales, or ~£4 bn in 2011/12, the FCF yield is ~2.5% (equity basis, fully taxed).  On a maintenance capex basis, assuming D&A is a reasonable/conservative proxy for maintaining the business in a steady state, removing the benefit of NWC (even though with modest inflation and volume growth it would still be slightly additive), and excluding property gains, the FCF yield would be ~9%.  It is likely that true maintenance capex is somewhat below D&A.  Mgmt has never disclosed this figure (at least to my knowledge), but reasonable assumptions get you to ~1.5-2% of revenues rather than the ~2.3% implied by annual depreciation.  Under these assumptions, the FCF yield would be more like ~9.5-10.5%.  Even taking the more conservative estimate, we find the 9% post-tax yield highly attractive given the stability and competitive advantages of the business.

Given its involvement in operations ranging from UK grocery to banking to online to higher growth international, some sell side analysts have put together sum-of-the-parts type valuations on Tesco.  These aren't terribly useful given that Tesco isn't looking to monetize any of its interests, but what these valuations generally highlight is that after marking each of the UK assets to direct peers, the implied valuation for Tesco's international assets is very low, in the range of ~50-60% of revenues.  International grocery assets in attractive economies typically sell for >100% of revenues (see Carrefour's recent sale of its Thai business, which was not particularly well run and had just ~20% property backing, for ~120% of revenues).  A reasonable SOTP valuation for Tesco yields something north of 500p/share, or 30+% upside to the current price.

Leaving aside the possibility of a higher multiple, which we think is probable as trading conditions and returns gradually improve, we believe an investment in Tesco offers strong downside support and a potential annual return in the low- to mid-double digits.  Keeping it simple, this is comprised of ~8-10% EBIT growth and a 4% dividend yield.

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