This article is mainly addressed to people already familiar with Tesco and ideally, but less important, with experience investing in the UK. It requires that background familiarity to better understand what I'm talking about, but just in case you are not, as a very fast introduction, I will say that Tesco is the third-world's biggest retailer and the first in the UK. If you do not know it, it might help to think of it as a UK version, similar, but with important differences, to Walmart, which I'm sure many more of you know of.
I will not get into an analysis of Tesco's financial statements or valuation ratios. Valuations based exclusively on financials, while necessary, are not enough, mainly because any educated investor can do them based on certain assumptions, but the hard work is getting those assumptions conservatively right and that can only be done by learning and understanding the drivers and dynamics of the business itself. I will try then to go a little bit beyond financials numbers and ratios into less obvious subjects in order to hopefully add some value.
I will mainly focus here on its assets, specifically its real estate properties. Tesco's capital expenditures are higher than what I would usually feel comfortable with, but this is not a usual case. I forgive it because it mainly buys its properties in order to put them to work as a retailer, or for example in China as a mall, and in the process increasing their value. This could be described as a real estate company with a retail operation, being by its combination more valuable than a pure retailer or a pure real estate company. The side effect is that its capital expenditures are therefore higher than its peers' mainly due to the fact that it invests in its expansion both in the UK and internationally in big part by buying properties at cheap prices and developing them.
The key though is that in the real world, not the accountancy world, real estate does not depreciate; it even usually appreciates above inflation in the long term, if it's bought correctly, not in the midst of a commercial real estate bubble, which was not the case. So the big capex is not a problem at all due to the fact that it owns most of its properties. Adjusting for this, i.e., if it only rented real estate, the capex would be quite small.
The stock price is therefore cheap compared to its earnings power and its underlying real estate, which is estimated to be worth more than its $25 billions of market capitalization! Book value is understated because of the real estate properties which are not reflected in the assets, showing them as much smaller than what they are and affecting the whole valuation of the company. Due to the unreal property depreciation charges required by law, the book value is stated as much lower than what it really is. For someone who wants to make money with the stock this has fortunately not yet been recognized by the stock market community and has therefore contributed to produce low market prices, quite nice for an entry point since you are buying a business with properties behind for much less than their worth.
But this fact means that if the company should be sold that value would emerge. Additionally, if one wants to absolutely limit the possible loss in a worst case scenario, it is interesting to consider the fact that the stock price downside is protected by the underlying properties behind, which act as a cousin limiting its potential downside to their real market value. The current market value of the properties is estimated to be 36 billion pounds, and the current debt is 6.7 billion pounds. Therefore Tesco has a market value cheaper than all its properties minus its debt. If that is not cheap then what is?
You can therefore at the very least value the company by that number obtaining already a big margin of safety because if the company had to be slowly liquidated and sell its properties at the estimated worth of 36 billions and pay all its 6.7 billion debt, the 29.3 billion left would still be higher than the current 25 billion of market value! I rephrase: a liquidation value bigger than a market value! Therefore the current market price is only justified by persistent negative earnings expectations, i.e., destruction of value or by substantially ignoring the properties or by not believing management of their estimated worth, or finally by a combination of any of them. But if those properties are just close to what management estimates then at the time that they will be adequately recognized by the market participants the stock will appreciate correspondingly.
A spin-off of its real estate would produce two companies which would add up to a much higher value than the current company, but relying on that is a big bet and not even necessary because eventually the real value should be recognized. A catalysts for that recognition could be for example the gradual and profitable sale of part of its properties putting in evidence their value. Tesco has already quite successfully started doing that and management has been clearly communicating it. If it was a real estate company the market would value it as such and recognize the value of it's properties, but perceived as a retailer the market seems to massively overlook them and just remembers them if they are told or better yet when their existing value is proved by their sale. This misappreciation combined with a focus on high capital expenditures could explain why it's p/e is 40% lower than its peers such as the world's biggest retailer Wal-Mart or even smaller players such as Colruyt in Belgium.
The company is expanding quite well internationally, specially in eastern Europe and even better in Asia. I have my doubts about the USA, but it still represents a very small proportion of their business so if it should write down their investments there it would not be a big deal. There could be some problems in Europe due to the recession, specially in nationalistic countries such as Hungary. If its economical problems escalate, international companies could be boycotted there, and as a consequence Tesco, an important foreign retailer there, could be affected. On the positive side it has several other potential growth drivers beyond the international expansion, such as its bank, its retailing operations, and its multi-channel products such as online sales, non food items, clothes, telecommunications, etc...
Warren Buffett, a famous north american investor, recently added, I just read about it 2 days after I initially bought (note I'm joking by introducing Warren Buffet as a famous investor, I guess it would be hard to find 1% of the readers here who do not know him but I have been writing this for hours and couldn't resist the joke plus I wanted to light up a bit what otherwise would seem a too serious and dry subject). Unfortunately for those as me that want to accumulate cheap, and are happy with a falling stock, he seems to have put a floor on the stock price. He is now more than a 5% owner, making it one of its biggest recent additions. Also there has been some inside buying by some directors, at least 3 that I know of added after the recent slump in the share price. Worse like for like Christmas sales in the UK affected the market price, it seems like this was a total surprise, and it's the first time it happened in several years, the market did not like it, I think it over reacted though, and Warren Buffett seems to think the same. He enormously increased his holdings there, he said months before that he would if the price dropped and he immediately did it when it recently crashed. Admirable consistency and sign that he views the recent drop as a temporary problem of no structural or fundamental consequences but more as a buying opportunity.
The UK business seems to need more investment than what it has had, or at least more focus, it seems that sales are slowing and that customers and employees are less happy and less well treated than a few years back, this can clearly be seen online in places such as twitter, also competition has caught up quite well. So the key is not to let the UK deteriorate, since that's the cash cow part of the business. Nonetheless, given its management, I have faith that they will manage to address the problems. There are several positive factors such as its earnings; its historically low p/e and the real estate huge margin of safety due to its market value; the stable and generous dividend; the future of the emerging expansion; the many other growth drivers already mentioned; such as bank; non-food; on-line sales; the relatively not big and falling debt. Due to that I am sure that the current cheap price offers quite a good risk reward that more than offsets the temporary head winds and offers a great entry point in a safe and big company.
Disclosure: I just added more Tesco, this time for costs considerations, to avoid the UK stock transaction tax, high UK commissions and currency costs, I did it via the USA ADR (TSCDY.PK): 70 shares @14.9 on Tuesday, February the 14th, equivalent to 210 UK shares. I am now holding the equivalent of 460 UK shares and 250 shares for my mother in law, whose money I manage. All in all at an average price of 314 UK pence. It represents a relatively small 1.3% position of my portfolio but it could become much bigger.
Cheers!
Juan
I will not get into an analysis of Tesco's financial statements or valuation ratios. Valuations based exclusively on financials, while necessary, are not enough, mainly because any educated investor can do them based on certain assumptions, but the hard work is getting those assumptions conservatively right and that can only be done by learning and understanding the drivers and dynamics of the business itself. I will try then to go a little bit beyond financials numbers and ratios into less obvious subjects in order to hopefully add some value.
I will mainly focus here on its assets, specifically its real estate properties. Tesco's capital expenditures are higher than what I would usually feel comfortable with, but this is not a usual case. I forgive it because it mainly buys its properties in order to put them to work as a retailer, or for example in China as a mall, and in the process increasing their value. This could be described as a real estate company with a retail operation, being by its combination more valuable than a pure retailer or a pure real estate company. The side effect is that its capital expenditures are therefore higher than its peers' mainly due to the fact that it invests in its expansion both in the UK and internationally in big part by buying properties at cheap prices and developing them.
The key though is that in the real world, not the accountancy world, real estate does not depreciate; it even usually appreciates above inflation in the long term, if it's bought correctly, not in the midst of a commercial real estate bubble, which was not the case. So the big capex is not a problem at all due to the fact that it owns most of its properties. Adjusting for this, i.e., if it only rented real estate, the capex would be quite small.
The stock price is therefore cheap compared to its earnings power and its underlying real estate, which is estimated to be worth more than its $25 billions of market capitalization! Book value is understated because of the real estate properties which are not reflected in the assets, showing them as much smaller than what they are and affecting the whole valuation of the company. Due to the unreal property depreciation charges required by law, the book value is stated as much lower than what it really is. For someone who wants to make money with the stock this has fortunately not yet been recognized by the stock market community and has therefore contributed to produce low market prices, quite nice for an entry point since you are buying a business with properties behind for much less than their worth.
But this fact means that if the company should be sold that value would emerge. Additionally, if one wants to absolutely limit the possible loss in a worst case scenario, it is interesting to consider the fact that the stock price downside is protected by the underlying properties behind, which act as a cousin limiting its potential downside to their real market value. The current market value of the properties is estimated to be 36 billion pounds, and the current debt is 6.7 billion pounds. Therefore Tesco has a market value cheaper than all its properties minus its debt. If that is not cheap then what is?
You can therefore at the very least value the company by that number obtaining already a big margin of safety because if the company had to be slowly liquidated and sell its properties at the estimated worth of 36 billions and pay all its 6.7 billion debt, the 29.3 billion left would still be higher than the current 25 billion of market value! I rephrase: a liquidation value bigger than a market value! Therefore the current market price is only justified by persistent negative earnings expectations, i.e., destruction of value or by substantially ignoring the properties or by not believing management of their estimated worth, or finally by a combination of any of them. But if those properties are just close to what management estimates then at the time that they will be adequately recognized by the market participants the stock will appreciate correspondingly.
A spin-off of its real estate would produce two companies which would add up to a much higher value than the current company, but relying on that is a big bet and not even necessary because eventually the real value should be recognized. A catalysts for that recognition could be for example the gradual and profitable sale of part of its properties putting in evidence their value. Tesco has already quite successfully started doing that and management has been clearly communicating it. If it was a real estate company the market would value it as such and recognize the value of it's properties, but perceived as a retailer the market seems to massively overlook them and just remembers them if they are told or better yet when their existing value is proved by their sale. This misappreciation combined with a focus on high capital expenditures could explain why it's p/e is 40% lower than its peers such as the world's biggest retailer Wal-Mart or even smaller players such as Colruyt in Belgium.
The company is expanding quite well internationally, specially in eastern Europe and even better in Asia. I have my doubts about the USA, but it still represents a very small proportion of their business so if it should write down their investments there it would not be a big deal. There could be some problems in Europe due to the recession, specially in nationalistic countries such as Hungary. If its economical problems escalate, international companies could be boycotted there, and as a consequence Tesco, an important foreign retailer there, could be affected. On the positive side it has several other potential growth drivers beyond the international expansion, such as its bank, its retailing operations, and its multi-channel products such as online sales, non food items, clothes, telecommunications, etc...
Warren Buffett, a famous north american investor, recently added, I just read about it 2 days after I initially bought (note I'm joking by introducing Warren Buffet as a famous investor, I guess it would be hard to find 1% of the readers here who do not know him but I have been writing this for hours and couldn't resist the joke plus I wanted to light up a bit what otherwise would seem a too serious and dry subject). Unfortunately for those as me that want to accumulate cheap, and are happy with a falling stock, he seems to have put a floor on the stock price. He is now more than a 5% owner, making it one of its biggest recent additions. Also there has been some inside buying by some directors, at least 3 that I know of added after the recent slump in the share price. Worse like for like Christmas sales in the UK affected the market price, it seems like this was a total surprise, and it's the first time it happened in several years, the market did not like it, I think it over reacted though, and Warren Buffett seems to think the same. He enormously increased his holdings there, he said months before that he would if the price dropped and he immediately did it when it recently crashed. Admirable consistency and sign that he views the recent drop as a temporary problem of no structural or fundamental consequences but more as a buying opportunity.
The UK business seems to need more investment than what it has had, or at least more focus, it seems that sales are slowing and that customers and employees are less happy and less well treated than a few years back, this can clearly be seen online in places such as twitter, also competition has caught up quite well. So the key is not to let the UK deteriorate, since that's the cash cow part of the business. Nonetheless, given its management, I have faith that they will manage to address the problems. There are several positive factors such as its earnings; its historically low p/e and the real estate huge margin of safety due to its market value; the stable and generous dividend; the future of the emerging expansion; the many other growth drivers already mentioned; such as bank; non-food; on-line sales; the relatively not big and falling debt. Due to that I am sure that the current cheap price offers quite a good risk reward that more than offsets the temporary head winds and offers a great entry point in a safe and big company.
Disclosure: I just added more Tesco, this time for costs considerations, to avoid the UK stock transaction tax, high UK commissions and currency costs, I did it via the USA ADR (TSCDY.PK): 70 shares @14.9 on Tuesday, February the 14th, equivalent to 210 UK shares. I am now holding the equivalent of 460 UK shares and 250 shares for my mother in law, whose money I manage. All in all at an average price of 314 UK pence. It represents a relatively small 1.3% position of my portfolio but it could become much bigger.
Cheers!
Juan
