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Why Maintaining And Gaining U.K. Grocery Market Share Is The Only Way For Tesco’s Shares To Recover?

Summary

  • Increasing your net profit in the UK grocery market doesn’t translate to higher market valuation.
  • Tesco’s increasing fixed costs are hampering its investment plans to turn around its business strategies and compete with hard discounters.
  • Tesco’s future strategies are to reduce its range of products and focus on closing down loss-making stores.

Although Tesco (OTCPK:TSCDF) reported its worst annual results in its corporate history, one needs to take a step back and assess its impact in detail.

We know Tesco is being investigated by the Serious Fraud Office (SFO) (similar to the SEC in the U.S.), and could have caused Tesco’s management to be ultra-prudent in reporting this year results.

What did we learn from Tesco’s latest report?

Apart from the record statutory loss, Tesco’s results spring a few surprises:

1. The book value of Tesco has halved from £14.7bn ($ 22bn) to £7.1bn ($ 10.65bn).

2. As the book value has halved, Tesco’s net debt has risen to £8.5bn ($ 12.75bn), forcing Tesco’s net debt to equity ratio to surpass 100% (or 120% to be precise).

3. Tesco’s free cash flow is negative for the first time in five years, coming in at £1.5bn ($ 2.25bn). And is the reason behind the increase in total debt by £1.4bn ($ 2.1bn), with the cash balance (including short-term investments) declining by £700m ($ 1.05bn), also.

4. Tesco has a pension problem (more on that later).

Why the UK grocery market share indicator a more potent measure of share price performance, than ‘like-for-like’ sales?

Before we begin looking at the details of Tesco’s woes, let’s us begin with the stock market valuation of UK-listed groceries firms.

Graph 1 shows the market share of Sainsbury and Tesco since 1993

(Source: fooddeserts.org)

As you can see, Sainsbury’s (OTCPK:JSNSF) used to be a bigger company than Tesco but was overtaken in the middle of 1994. Tesco has since increased its market share and has doubled its lead by 2007, but has since seen a slight dip, as of late.

Sainsbury’s, on the other hand, saw a steady decline in its market share, despite better financial improvements when it came from a loss of £187m ($ 284m) in 2005 to a £716m ($ 1,088m) profit in 2014.

However, the importance of increasing your bottom line, do not necessarily increase the company’s stock valuation.

Graph 2 shows Tesco and Sainsbury’s share price since 1993

(click to enlarge)

(Source: Interactive Investor)

The chart looks a bit small to see, so let me interpret:

The red line represents Sainsbury’s stock price, and the blue line represent Tesco’s stock price, both are adjusted for stock splits and reverse stock splits.

Comparing Graph 1 and Graph 2, we observed the following:

Sainsbury’s UK grocery share declined from 19.6% in 1993 to 16.6% today, and its market capitalization has fallen, regardless of improving net profit numbers.

Tesco saw its share jumped from 18% in 1993 to 28.6% today, and its market capitalization has jumped in real terms.

(See table 1.)

Recently, Tesco’s UK grocery market share has declined by 10% from 31.3% in 2007 to 28.6% today. Meanwhile, Tesco’s share price has dropped by 53% in the same period.

I am pretty sure that some factors contribute to Tesco heavy fall in its share price, such as a deteriorating balance sheet, poor overseas operational performance, and an accounting scandal.

If gaining market share in the UK grocery sector is a pre-cursor to increasing the company’s stock valuations. Aldi and Lidl (both saw its UK grocery market share jumped by more than 1,000% since 1994) would provide you with a bigger stock market gain than Tesco.

However, Aldi and Lidl are both private businesses.

Table 1 shows Tesco and Sainsbury’s market capitalization value since 1992

No of shares issued in 1992

No of shares issued today

Share price in 1992

Share price today

Tesco

1.94bn

8.123bn

£2.71

£2.24

Sainsbury

1.757bn

1.92bn

£3.50

£2.68

Market capitalization in 1992

Market capitalization today

Gains/losses since 1992 (%)

Tesco

£5.26bn ($ 7.89bn)

£18.2bn ($ 27.3bn)

346

Sainsbury

£6.15bn ($ 9.2bn)

£5.14bn ($ 7.7bn)

(16.4)

The stark contrast here is Tesco’s stock has gained 346% (despite a fall of 53% in the last seven years), and Sainsbury’s stock is left nursing a loss of 16.4%.

Tesco’s elephant in the room: pension deficits

The biggest surprise (as mentioned) is Tesco’s pension deficits, almost quintupling in the last four years (see below). That deficit will have to be paid off in the future.

2015*

2014

2013

2012

2011

Post-employment benefit obligations (£m)

4,842 ($ 7,354.1)

3,193 ($ 4,849.6)

2,378 ($ 3,611.7)

1,872 ($ 2,843.2)

1,356 ($ 2,102m)

Tesco’s pension dilemma has put it in a spot of bother because it is acting as a straitjacket to Tesco’s plans to turn its business around and compete against Aldi and Lidl.

The benefits contributions from Tesco haven’t been enough to plug the gap (as you can see below). I suspect Tesco will need to address this problem by having to pay even more money into its former employees’ pension pot.

Graph 3 shows the widening pension deficits in Tesco

(Source: Tesco’s annual reports. Assume £/$ : 1.50.)

The problem stems from the hubris of Tesco, by offering a discount rate much higher than the price inflation to staff members (see next graph).

Graph 4 shows the generous rate it rewards employees during the retirement phase

(Source: Tesco’s annual reports. Assume £/$ : 1.50.)

The real discount rate is the discount rate minus the price inflation. When the discount rate exceeds the price inflation at an increasing rate, then Tesco’s is obligated to contribute more to the pension deficits.

However, given real discount rates have decreased, Tesco should see a reduction in the pension deficit! As the SFO is still conducting its investigation to Tesco’s past accounts, the pension numbers can be verified subjectively.

Tesco’s other problem: operating lease

Some analysts would include operating leases as debt, but unlike debt it doesn’t charge interest, but like debt it must be repaid (if marked as ‘non-cancellable’). Currently, Tesco is paying out more than £1bn/annum, and regardless of its business environment, this has to be paid.

Total operating lease amounted to £15.2bn ($ 22.8bn). If we include that alongside Tesco’s total debt, it amounts to £25.2bn (after deducting cash and short-term investments).

Tesco’s increasing fixed financial costs

If we add up Tesco’s financing cost, operating leases, and pension/benefits contributions, the result would be shown visibility below:

(Source: Tesco’s annual reports. Assume £/$ : 1.50.)

Tesco is obligated to pay these costs, ahead of any dividend payments. And the semi-fixed financing costs have expanded by three times within six years, as Tesco’s profits move the other direction.

All this costs are putting a straitjacket on Tesco, especially at a time when it is fighting for survival against its rivals and rebuilding its brand around a very competitive UK grocery market.

Tesco’s efficiency drive: a tale of two sides

Ever since Tesco last management has touted about bringing back the concept of ‘looking after its customers’ by having more staff in its stores, one question remains, has it been successful?

2015

2014

2013

2012

Revenue, continuing operations (£bn)

62.3

63.5

63.4

63.9

Revenue per Sq. Ft. (£)

564

579.5

597.9

578

Wages and salaries as a percentage of Revenue (%)

N/A

11.45

10.85

10.73

Revenue per ‘full-time’ staff equivalent (£)

N/A

162,044

163,244

157,355

(Source: Tesco’s annual reports and presentation report)

2011

2010

2009

2008

Revenue, continuing operations (£bn)

60.5

56.9

53

47.3

Revenue per Sq. Ft.

586.4

597.5

598.5

615.3

Wages and salaries as a percentage of Revenue (%)

11.07

10.9

10.95

11.2

Revenue per ‘full-time’ staff equivalent (£)

158,357

155,289

145,598

136,809

Looking at the tables, we can see that Tesco’s employees have been successful in raising its productivity, with revenue per ‘full-time’ employee increasing steadily.

However, if we measure revenue against store space, then in the last six years, revenue per Sq. Ft. is down 10%.

How do Tesco compares to its global peers?

Latest results

Net debt/equity

Price to free cash flow

P/E

Price to equity

Market Cap. ($ m)

Wal-Mart (NYSE:WMT)

51%

14.6 times

15.96

3.13 times

255,395

Carrefour (OTCPK:CRRFY)

48.4%

N/A

24.35

2.28 times

25,278

Metro (OTCPK:MTTRY)

92.4%

8.51 times

130

1.97 times

11,905

Tesco

140%

N/A

N/A

2.51 times

26,936

Kroger (NYSE:KR)

209%

31.8 times

20.54

6.45 times

35,100

Costco (NASDAQ:COST)

-16.2% (net cash to equity)

33.8 times

28.9

5.11 times

64,000

(Source: Bloomberg.com)

Graph 5 shows Tesco’s like-for-like return in 2014

(Source: Tesco’s presentation report)

Tesco’s tangible assets are another play if they decide to close more loss-making stores. Details on that are sketchy at best, here are some comments Dave Lewis made about it:

The other thing that we talked about in terms of strengthening the balance sheet is we said in January, 49 sites exited, not going to be built out. We are exploring with Steve and others what the alternative uses of those 49 sites are, and there are indeed some, including residential, but more to come on that later in the year. But we’ve also since we were last together concluded a deal with British Land. And that basically, if I put it in essence, is a swap of assets plus about GBP80 million/GBP90 million of cash to Tesco, but importantly, regaining the freehold of 21 of our superstores.”

Tesco has tried its hands as a discounter and since January 8th, it has lowered some brands offerings by 25% in price (not promoting it) and saw volumes sold going up by 28%. It proves Tesco can have a business, but right now it is implementing price cuts.

Future takeaway

So, what now for Tesco, after that colossal loss of 2014/15 of £5,719m ($ 8,686.1m)?

In Dave Lewis’s transcripts to Tesco’s future strategies, we get an inkling of his intentions for 2015/16.

First up is Tesco’s pension deficits trouble, I explained before, the increasing deficits of its post-employment benefits are affecting the company’s future to invest what is needed to turn the business around. Right now, they have started a consultation with Tesco’s employees’ trade unions on the renegotiation of Tesco’s pensions.

Secondly, Mr. Lewis has made clear it wants to reduce the range of goods and services on offer to customers.

Currently, Tesco’s range is more than 3.5 times that of its nearest rival or 90,000 products; the aim is to reduce that range to 2.5 times.

However, if we compare that with Aldi and Lidl, they’ve had fewer than 2,000 products on offer.

I think Mr. Lewis is right to limit the range that Tesco sells to its people, and its consumers can identify with the Tesco brand and how it differentiate itself with its rivals.

Most importantly, the economies of scale of offering more goods have peaked, and it is turning to diseconomies of scale.

Let say Tesco offer 20 different lines of pasta, and only 5 of those are popular with Tesco’s customers, the rest are not selling. For that variety of pasta not selling, Tesco would encounter problems like:

1. Stock/inventories wastage;

2. Utilization of shelve space is inefficient to contribute to sales;

3. Logistic problems in getting all kinds of Pasta variety to arrive in store.

Aldi and Lidl, on the other hand, which has one or two types of pasta would find it easier to re-stock, cut back on wastage and see higher sales on the range.

The problems with Tesco’s range of goods are distinctly visible from the table below showing Tesco’s revenue per range vs. Aldi and Lidl.

Revenue

Number of goods

Revenue per product

Tesco

£60,500m ($ 94,235m)

90,000

£672,222 ($ 1m)

Aldi

£5,270m ($ 7,905m)

2,500

£2,108,000 ($ 3.16m)

Lidl

£4,000m ($ 6,000m)

1,600

£2,500,000 ($ 3.75m)

Clearly, Aldi and Lidl are three to four times more efficient and profitable in selling its goods than Tesco.

Lastly, Mr. Lewis has stated capital expenditure in2015/16 will be no more than £1bn.

Are Tesco’s shares a buy?

The restructuring process in Tesco has only begun, and it is too early to tell. For Tesco to see a stabilization of its share price, its UK grocery market share needs to be maintained.

For a recovery, it must gain market share from its rivals, as well as competing on par with Aldi and Lidl.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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