As one of Warren Buffett's few foreign holdings, Tesco is known to many US investors. In this analysis I will attempt to outline the key dynamics of this company and demonstrate why I consider it to be an excellent investment at the current market price. Readers should be aware that I have been a shareholder in Tesco PLC since 2006. In addition, since this analysis has been written for the Gurufocus value ideas competition there may be some unconscious element of positive bias, even though I have attempted to be objective. Therefore I would strongly advise investors to do their own further research before investing in this company.
Tesco is listed on the London Stock Exchange, stock code TSCO, and is also available on the US market as an ADR, stock code TSCDY. At the time of writing this article the share price in London was 395 pence and $19.59 for the ADR in the US.
Tesco PLC is the largest retailer in the UK and its core business is large format stores for food and other convenience items. In addition the company offers telecoms services such as mobile and broadband to UK customers as well as financial services including household and car insurance, personal loans and credit cards. In 2009/2010 the company achieved 31% of total sales in international markets. The market cap is 31.7 billion pounds (US$51.83 billion) and Tesco is now the world's third largest retailer behind Wal-Mart (first) and Carrefour of France. In the UK it has been reported that one out of every eight pounds spent in retail stores is spent at Tesco.
Quality of earnings
I would consider earnings quality to reflect the predictability, reliability and sustainability of future growth in earnings. In the case of Tesco, this is a company that largely sells consumer staples. In times of recession, although earnings may be affected, as during this last recession, the company is robust enough to sail through with only a moderate reduction in sales and profit growth. The newer financial services operations such as household and car insurance should hold up well in recessions although the personal loans and credit card business may be affected. Being non-cyclical, the telecoms business should also stand up well to economic downturns. Furthermore, with the company continually innovating and growing, as described below, this growth in itself offers some defence against recession.
This analysis will also explain how expansion into emerging markets should sustain earnings growth for many years.
Tesco's growth strategy for the future consists of two main aspects: the first is international expansion and the second is the development of new businesses in the UK which build upon the existing customer base and customer loyalty.
In terms of international expansion, this effort can be seen in the impressive growth of foreign sales. In 2005 foreign sales represented approx 24% of total sales revenue. By 2009 international sales had risen to 31% of the total, and if current growth rates continue, by 2015 international sales will reach approx 42% of total sales. This forecast is based on the growth rates from 2005 to 2009 which were 6.5% per year for the UK and 16% for international.
Tesco currently operates in the following international markets: Republic of Ireland, Poland, Hungary, Czech Republic, Slovakia, Turkey, South Korea, Thailand, China, Malaysia, Japan, India and the US.
Breaking down international sales into developed and emerging economies, results in 26% of total sales in emerging markets and 5% in the developed markets. These figures demonstrate Tesco's emphasis on emerging economies.
Tesco's strategy when commencing operations in a new market has been to initially set up a joint venture with a local partner. This strategy has been very successful, for example the joint venture with Samsung in South Korea and with CP foods in Thailand. By this means the company has reduced risk considerably while also exploiting the local knowledge and expertise of joint venture partners.
Currently the largest international contributor to sales is South Korea where Tesco has the number two position in terms of market share. In Thailand Tesco is the market leader.
Just to look at the Thai market one can get a picture of the enormous future potential in emerging markets. In 2009 sales revenue from Tesco Thailand totalled 2.34 Billion pounds, which compares to the UK total of 38.56 Billion (before sales tax). However if we look at the demographics of Thailand, the population is currently around 68 million compared to the UK population of around 62 million. The GDP per capita in Thailand is now around $7900 which compares to GDP per capita in the UK of $35,000. (CIA World Factbook 2009) We can see that as Thailand continues to catch up with the UK, due to the higher growth rate of the Thai economy, Tesco can look forward to continued growth for years to come.
When looking at the Asian markets another aspect is currency. The Thai currency, by many measures is currently quite undervalued. Where else can you buy a restaurant meal for under $2.00, rent a good hotel room in the centre of the capital city for under $50, and ride in a taxi for 30 minutes for under $5? Appreciating currencies in Asia compared to the US$, euro and other developed economy currencies is another factor which adds to the great investment potential of these markets.
Growth strategy within UK
Within the UK the strategy for growth involves developing new businesses to build upon the existing customer loyalty.
The first aim is to be as strong in non-food as in food in order to provide one-stop shopping facilities to customers. Following this aim, Tesco is increasingly selling goods such as clothes (often under own-brand labels), household items and electrical goods. The emphasis here is quality at an attractive price.
Tesco has also entered other businesses via joint ventures in order to capitalise on existing customer relationships. These relationships provide a sustainable competitive advantage. The first of these businesses began in 1997 with the introduction of financial services offerings by means of a joint venture with Royal Bank of Scotland. This business which offers household insurance, car insurance, personal loans and credit cards has continued to grow, culminating with the recent formation of Tesco Bank, following the buyout of Royal Bank of Scotland's 50% stake in the business. As an illustration of the success of this venture, Tesco has successfully sold debt to its own customers by means of 'Tesco bonds'. Tesco can now raise some of its debt finance at a cheaper rate than by going to the capital markets.
Tesco has also used existing customer relationships to build a telecoms business via a joint venture with O2 and can now offer mobile, fixed line and broadband services. The ease of organizing these services during the weekly shopping trip provides Tesco with a sustainable competitive advantage.
Another business which has been fast-growing and highly profitable is on-line shopping which also began in 1997 and recently developed into Tesco Direct.
Seventeen years of innovation
Following is a time-line showing how the business has developed since 1993:
1993 Introduction of smaller format 'Express' stores in key locations in UK
1994 Decision to expand into eastern Europe
1995 Introduction of Clubcard loyalty cards with the aim of building customer loyalty and collecting information on customer purchasing behaviour
1997 Introduction of internet home shopping, first store opened in Northern Ireland, and introduction of financial services linked to Clubcard, including savings deposits and insurance.
1998 Acquisition of hypermarkets chain in Thailand via joint venture with CP foods.
1999 Entered into joint venture with Samsung Corp to develop hypermarkets in South Korea
2000 Opened 48 new stores in UK. Opened 17 hypermarkets in Hungary.
2001 Entry into Malaysian market.
2002 In UK, acquisition of T&S Stores which owns 870 small convenience stores, to be converted to the Tesco Express format.
2003 Commencement of telecoms services in the UK, including mobile and broadband services – targeting existing Tesco customers.
2004 Purchase of 50% holding in Hymall's hypermarket chain in China which owned 31 stores plus 15 planned.
2005 In China an additional 12 hypermarkets opened to build on the existing 39.
2006 Purchase of 11 stores from Carrefour plus 27 small stores from Edeka in the Czech Republic. Purchase of 146 stores in Poland and 8 large stores in Malaysia. In South Korea 29 new stores opened. Launch of Tesco Direct to expand on-line sales in the UK.
2007 Fresh & Easy stores commence operations in US. A further 76 new stores opened in South Korea.
2008 Acquisition of remaining 50% of Tesco Personal Finance from Royal Bank of Scotland. Purchased 36 hypermarkets in South Korea. Entry into the Indian market via a joint venture with local partner Trent, to set up cash & carry stores.
2009 Opening of first 3 Tesco Lifespace malls in China with plans for a further 9.
2010 Further development of UK financial services operations with new systems implemented for Tesco Bank.
Since Tesco operates in 13 international markets in addition to the core UK market it is not possible for me to go into the competitive conditions in each market. I will limit this section to a brief consideration of the UK market and the Thai market as an example of one of the emerging markets Tesco serves.
Within the UK, Tesco's key competitors are Asda (a subsidiary of Wal-Mart), Sainsbury and Morrison. At 20 February 2011 the respective market shares were:
Tesco 30.3% Asda 16.9% Sainsbury 16.5% Morrison 12.3%
In recent years Sainsbury has been the notable winner in the UK market with consistent increases in market share. Over the last year (to 20 February 2011) Tesco has lost ground slightly, as mentioned below under headwinds.
However within the UK, Tesco remains the dominant player with market share almost double its nearest rival. I believe this dominance provides economy of scale advantages and a competitive moat difficult to duplicate.
However, as an investor in Tesco, I am more concerned with the growth in the international markets (and especially the emerging markets) since this is where I believe future value lies. In terms of the UK, I believe future growth in earnings is likely to come from development of the financial services, non-food and on-line retailing operations.
The Thai market where Tesco is the market leader, illustrates Tesco's approach to international markets. The Thai operation was set up as joint venture with leading Thai food company, CP Group in 1998 and has expanded to become the market leader in Thailand. The two key competitors in hypermarkets in Thailand are Carrefour and the Big C chain which is owned by Casino of France. Recently the Carrefour Thai operation, consisting of around 42 stores has been bought by Casino which puts Big C in a position to challenge Tesco's market leadership.
In addition to hypermarkets Tesco owns a large network of small format 'express stores'. These stores are convenience stores selling items like milk, fruit, cleaning products etc. Tesco's main competitor in this format is the very large chain of 7-11 stores, controlled by the CP Group as well as the medium format Tops Supermarket stores.
In managing the Thai stores Tesco applies strategies and technologies developed in the UK, such as Clubcard, and then adapts them to the Thai local conditions. Thai consumers have very different tastes in food which is of course reflected in the product range offering. In addition the prices of many items, such as clothing items, are very much cheaper than in the UK, although of equal quality, which reflects the lower income level of the average Thai consumer.
|EPS (pence)||Dividends (pence)||Growth rate of eps||Return on equity|
|2010||34.51 (est)||14.34 (est)||18% (est)||XX|
Note that the financial year for Tesco ends on 27 February. This means that the financial year 2009 is in fact for 2009/2010. The preliminary results for 2010/2011 will be released on 18th April, however I have decided to go ahead and publish this report now, and use the analyst consensus estimate figure for 2010/2011 EPS in my discussion of valuation, since in any case detailed financial statements will not me made available till later. The analyst consensus figure for underlying diluted EPS for 2010 is available on the Tesco corporate website and is listed as 34.51 pence (22 analysts) with a high figure of 35.80 and a low of 33.01
Both the first half and third quarter results for 2010 have been promising with total sales increasing by 8.3% in the first half and by 8.8% in the third quarter. In the third quarter international sales increased by 15.7% with an increase of 23.4% in Asia.
From the table above the average growth rate in EPS for the ten years from 1999 to 2009 is 11.5%. We can also see that this growth rate declined markedly in 2008 and 2009, although based on the consensus EPS figure for 2010, this rate has bounced back over the last financial year to around 18%.
We can also see that return on equity increased from 1999 to 2007 and then fell back somewhat in 2008 and 2009. This is a pattern commonly seen, which of course arises from the financial crisis.
Tesco has been involved in a big expansion program, especially in international markets and has used retained earnings plus debt financing to fund these projects.
The balance sheet at 28 August 2010 shows short-term debt of 1.665 bn pounds, long term debt of 10.51 bn, offset by a cash position of 1.977 bn, resulting in net debt of 10.198 bn.
However the balance sheet also shows under current liabilities, customer deposits of 4.731 bn, representing the savings deposits customers have with Tesco Bank. Most of this money is lent back to Tesco customers with around half the outstanding amount due within 3 months. I therefore consider it reasonable to subtract the loans due from customers listed as current assets ( 2.462 bn) from the customer deposits figure, which results in a net debt position to Tesco customers of 2.269 bn.
Adding this 2.269 bn to the 10.198 bn calculated above results in a net debt position of 12.467 bn pounds. This compares to the total equity of 14.804 bn, resulting in a net debt to equity ratio of 84%.
In terms of the maturities of long-term debt, this is very much spread out with maturities going forward as far as the year 2057, with no very large debt repayments due in any one year. (1.5 bn is due in 2012)
In calculating the interest cover ratio, this can be done using the net interest figure (interest paid minus interest received) and this results in 10.6 times.
While Tesco's debt position is higher than I would consider ideal, the following factors should be considered:
Firstly Tesco is currently committed to paying down debt and has reduced debt (by early repayment) by around 1.5 bn over the course of last year.
Secondly, the equity figure on the balance sheet is understated since the property assets are shown at purchase cost less accumulated depreciation, as mentioned below, whereas in reality these assets have increased greatly in value. Taking into consideration that Tesco is now, year by year, gradually divesting this property, with large gains compared to book value, these property assets provide a buffer to the current leverage position.
Finally, since the company has very reliable and predictable earnings, because the major products sold are consumer staples like food and personal goods, it is unlikely that even a major recession will seriously affect sales and profits. The company should therefore, have no difficulty making interest payments even under quite adverse conditions.
Standard & Poors rates Tesco long-term debt as A-, outlook stable.
The new (since March 2011) CEO of Tesco is Philip Clarke who has been with the company for many years. After completing a degree in economics at Liverpool University he joined the company's management training scheme and then went on to work in a succession of increasingly senior management positions. As he progressed in the company he led expansion into key foreign markets including China and India and became one of the company's most respected and highly paid executives.
Of course, the management of Tesco goes beyond one individual and there is also a very talented and experienced group of people that form Tesco's Board of Directors. I consider that the culture of innovation and growth, as well as the risk-adverse strategy of organic growth and entry into new markets by joint-venture rather than outright take-overs is likely to continue.
This willingness and ability to form successful partnerships via joint ventures has been a key reason for Tesco's success. For example, the opportunity that Clubcard offered to capitalise on existing customer relationships to develop a financial services business was recognised in 1997. However, rather than buying out an insurance company or trying to enter a new business alone, Tesco entered into a 50-50 joint venture with Royal Bank of Scotland to create Tesco Personal Finance. This operation has been very successful and in 2008 the financial crisis and subsequent near bankruptcy of Royal Bank of Scotland provided the opportunity for Tesco to purchase the remaining 50% of Tesco Personal Finance and to set up the new Tesco Bank.
In a similar fashion Tesco entered the South Korean market via a joint venture with Samsung Corp in 1999. Since that time Tesco has rapidly built market share and currently has the number two position. With local experience in place, in 2008 Tesco acquired a further 36 hypermarkets from a local operator, is now on course to become the market leader in this country.
In order for a popular, well-known company such as Tesco to be available at an attractive market price, which I believe it is, there is always some factor or a combination of reasons why investors may have some doubts about either the short or long-term future.
In the case of Tesco, in recent years there have been some headwinds. The first factor is that the retailer has lost ground in terms of market share over the twelve months to 20 February 2011. Tesco's market share fell from 30.4% to 30.3%. During the same period Sainsbury increased market share from 16.3% to16.5%. While this may not seem significant it most probably has affected the share price.
I would consider that, based on the company's past record and also taking into consideration the opportunities for growth presented by financial services and the on-line operation, that Tesco is likely to 'bounce back' once the economy eventually begins to pick up and gather speed. This may take another year or two. And even if UK growth remains lower than in the past, the increasing importance to sales and earnings of the international markets should more than compensate for more moderate growth in the UK.
Another factor is the departure of CEO Terry Leahy (in March 2011) who has been recognized as one of the most innovative and successful UK business leaders of the past decade. He is a very hard act to follow, and there may be some doubts that his replacement, Philip Clarke, will manage equal success. What I would say to this is that the new CEO has inherited a growth machine with infrastructure in place to last for many years. In addition a culture of growth and innovation has been built up in the company for two decades. I consider it unlikely that this will suddenly change.
There may also be some doubts about the wisdom of the decision to enter the US market with the Fresh & Easy format stores, being built from the ground up. These stores are still loss-making and it not yet clear that this operation will be a success. However, again, I consider this just a sideline to the overall operation of the company and it would not be difficult to bail out of the US market if this became necessary.
Lastly, an important recent factor is the increase in commodity prices which is expected to hurt margins of retailers such as Tesco that sell low-cost items. In the short term it may be difficult to raise prices, which may have an affect on this year's earnings figures.
All of the above factors are likely to have contributed to the relatively poor performance of the Tesco share price over the last 12 months, leading to what is in my opinion, a good opportunity for investment.
In attempting to calculate the intrinsic value of a company I consider the key factor to be the future growth rate of free cash flow, which is the cash which will be available to grow the company further (and thereby increase market value) and pay dividends to shareholders. The predictability and sustainability of growth is also critical in any calculation.
I personally do not use discounted cash flow models to calculate intrinsic value, although this approach may be successfully employed by others.
I also don't use multiples of free cash flow or normalised free cash flow in valuation, although some very respected investors use this approach. My reason for this is that I admit that I find it very difficult to decide just what variables should be included or excluded in the calculation.
I prefer to use EPS figures since I have been using these figures for many years and since, although not always accurately reflecting true earnings, they are the best way of reflecting true earnings that the accounting profession has been able to devise. When necessary I adjust EPS figures to allow for non-recurring items, currency effects, amortization and depreciation.
For me a key criteria is the forecast growth rate of EPS compared to the current PE ratio which is calculated using an adjusted (if necessary) figure for the most recent EPS. This of course is the PEG ratio. If we take the growth rate for the last ten years (11.5%) as an approximation for the growth rate going forwards, and using the analyst consensus figure for 2010 underlying diluted EPS of 34.51 pence, the PE comes to 11.4. The PEG ratio is therefore calculated as 11.4/11.5 or approximately 1.00. For a company that is also paying out healthy dividends (yield of approx 3.3%) the current share price looks very attractive.
Looking at the historic PE ratios, calculated on 27 February each year, results in the following:
|Share price on 27 Feb.||PE|
*The PE's shown in the table above have been calculated based on the share price on 27 February each year, which corresponds with the end date of Tesco's financial year. The PE for 2011 above is based on the analyst consensus figure for 2010/2011 EPS.
Based on the above data, the average PE ratio for Tesco for the thirteen periods from 1999 to 2011 is 16.1, which compares to the current PE of around 11.4
If we apply this average PE ratio of 16.1 to the 2010, analyst consensus earnings of 34.51 pence, this results in a potential share price of around 556 pence which compares to the current share price of 395, giving an upside of 40%.
Should 16.1 be considered as a fair multiple in calculating intrinsic or fair value? Possibly it is a little high, since I would rather err on the side of caution; so the potential share price of 556 is probably a bit over-optimistic. However I am confident that the current multiple of 11.4 assumed by the market is far too low.
Valuation - Property Assets
During the late 90´s and the early years of the last decade, Tesco continued to buy the freehold (land plus buildings) of its leasehold stores so that by 2007 the company owned outright around three quarters of these buildings. During this period there was a strong increase in the value of commercial property. However these properties are carried on the balance sheet at purchase price minus accumulated depreciation.
Beginning around 2007, at the peak of the property boom, Tesco began to sell off these properties, mainly on sale and leaseback arrangements, to generate cash which has been used to increase dividend payments or buy back shares.
Although commercial property values fell considerably during the financial crisis, the majority of these properties are still being carried on the books at values considerably below their market value.
In the 2009/2010 annual report the company states that these properties have a market value of 34.6 billion pounds. However on the balance sheet these assets are carried at only 20.68 billion. This difference between book value and market value amounts to 1.73 pounds (or 173 pence) per share which compares to the current share price of around 3.95 pounds (395 pence) per share.
Tesco intends to continue to sell off these property assets, and in some of these sales in recent years the properties have been sold at more than twice book value. Therefore there is much hidden value in Tesco's property assets which I don't believe is fully reflected in the current share price. However I am not suggesting that one can simply assume that Tesco shares are undervalued by 173 pence per share. As I am not an accounting professional, I would not like to attempt to put a figure on just what this value may be, I would simply say that this is another factor which adds considerably to the existing margin of safety.
(* Thanks to Gurufocus member Clemo69, for drawing my attention to Tesco's property assets in a comment posted on a previous Gurufocus article.)
I hope this analysis has demonstrated why I consider Tesco PLC to be an excellent company. Over the years the company has been ahead of the curve by taking early decisions to expand into emerging markets, to begin to offer on-line shopping in 1997, and to offer new services such as financial services and telecoms, which capture the existing customer loyalty.
The company has very predictable and stable earnings, due to the core business of grocery retailing and has the infrastructure in place to enable sustainable earnings growth for many years to come, especially in emerging markets.
In addition I hope I have demonstrated why I consider the company to be a good investment at the current share price. Not only are the shares undervalued in relation to the potential growth rate in earnings, but also I believe there is much hidden value in Tesco's property portfolio.