The Case For/Against Tesco

29th Aug '14 by Gray Woods

50 comments 23801 reads

I wasn't expecting to be writing on Tesco (LON:TSCO) again so swiftly, but they shocked me via their trading statement today, which in effect has seen the big changes all brought forward. Of note, the full year profit target has been slashed from £2.8bn to £2.4bn. A profit warning was half expected, but the real shock has been the size of the dividend cut:

"The Board is focused on maintaining a strong financial position in order to maximise its business and strategic optionality. Reflecting this and our current expectations for future performance, the Board anticipates that it will set the interim dividend at 1.16p per share - a reduction of 75% from last year's interim dividend."

75%. Wow, no wonder the shares are down near 7%. However, the move should save them about £280m if upheld, which is interesting considering they are also reducing planned capital expenditure for the year by £400m. So in one failed swoop, they've either decided Clarke's plans were no good, and thus cut them short; or they've built up some reserves for the new CEO to play with, or they're saying we need to preserve capital to protect our balance sheet. It is of interest that the £400m reduction of capital expenditure matches the £400m drop in expected profits, so I'm guessing a mixture of the three, with the dividend cut more about building up some financial headroom for the new CEO.

Speaking of the new CEO, they've brought forward his appointment by a month, with Chairman, Sir Richard Broadbent stating:

"Our new Chief Executive, Dave Lewis, will now be joining the business on Monday and will be reviewing every aspect of the Group's operations. This will include consideration of all options that create value for customers and shareholders."

This is a smart move, the Christmas trading period is of massive importance to the supermarkets, so giving Lewis more time to prepare for the build up is prudent to say the least. But in reality, the question is what can he really do. Aldi and Lidl have caught the imagination of the masses, and if you consider for years the newspapers have been focussing on the big four, highlighting the continued rise of food prices, the continued rise of profits those food rises brought, it's not surprising. Not only do Aldi and Lidl appeal to the people who were struggling to buy enough…

Unlock with Email

Unlock with Google

Already have an account?
Login here

Gray Woods

2nd Oct '14

It's quite obvious why he is still holding, if he starts selling, the share price will take a further battering on two counts, one, from his shares flooding the market, and two, because Warren Buffet is selling. The latter will do more damage, and both would cause him to lose even more money.

As long as he doesn't think the company will go bust (never say never, but very very unlikely, especially if you consider that their internet business must be worth over half the current share price value, and they have a property portfolio worth 190p a share). Anyway, as long as he doesn't think the company will go bust, his best hope for recovering his investment is to hold and wait to see what happens.

But so as to be clear, the fact he is holding means only that he doesn't think the company will go bust, nothing else, nothing more. No doubt he will be hoping that the share price will stabilise enough at some point for him to properly consider his options. When that happens, he will either elect to sell, or he will hold based on whatever Dave Lewis has managed to do. If Dave Lewis can get things back on track and clear up the horrific mess left by Clarke, then he may hold, or he may not.

I remember reading a story from one of his holdings in the 90's. Can't think of it's name, but a big house hold name company he bought into tanked by over half. He was forced to hold (i.e. he knew if he sold, he'd only do more damage, and risk losing more money), later, he talked how lucky he was that he was able to recover his money a few years later, by which point, the share price had not only stabilised, but had recovered to a little over his purchase price. He sold then with a profit. I'm not saying the same will happen to Tesco -- at current, I believe long run they will recover. All I'm saying is, because of the size of his investment, and who he is, he has little choice but to hold and hope Dave Lewis can turn things around.

The release of the interims on October 23rd will make very interesting reading. Hopefully, they will bring an end to the chaos, and allow a recovery to take off. I still have a small amount in (unfortunately, purchased a few days before the misstated profit news...), on October 23rd, I will decide what to do with that stake, keep it, increase it, or sell it. I'd imagine Buffet will be doing the same.

njstevenson

3rd Oct '14

As a disclosure, I wrote the Tesco's Hidden Debt piece linked above, on which the FT Alphaville article is based. I wouldn't want to compare Tesco to Enron. The two are obviously different. But the company has presented one story to shareholders and other readers of the annual report, and another to investors in the property bonds. In the case of the former, it has clearly tried to make the transactions appear as normal sale and leasebacks. The amount of debt involved is material. Without a rights issue or asset sales, it would not surprise me if the company is downgraded to sub-investment grade.

The company also has a long history of aggressive accounting: inclusion of property profits in underlying earnings, capitalisation of interest/development costs, using the pension cash cost rather than P&L expense etc, which have all boosted short-term profits. Their treatment may comply with accounting rules or be included in a non-GAAP figure, but it does raise questions about earnings quality and what else might be hidden. Therefore, the \recent announcement is not a complete surprise. It is hard to avoid the conclusion that, up to 2011 at least, this was driven by management bonuses based on EPS growth and return on capital.

Finally, it would be unwise to rely on Tesco's own valuation of their property. This is based on notional rents that Tesco itself would be prepared to pay. Therefore the valuation is completely circular: the stores are only worth close to that value so long as Tesco stays profitable. The value has continued to go up in recent years (apart from 2014 when FX was blamed for the decline) despite the changes in the market. It is hard to believe the value now would not be materially lower than a few years ago. The properties open-market value (whether sold to other retailers or for residential development) would be much lower, almost certainly below book value.

Ramridge

Hi njstevenson - Firstly congratulation on a well researched and presented piece of analysis.
The only point I wanted to make by comparing Tesco to Enron is that under immense pressure to produce results, some companies resort to dubious accounting practices and in the extreme in the case of Enron downright illegal activities. The red flags for Tesco are there to see. For the avoidance of doubt I am not saying that Tesco have resorted to illegal activities. The weight of the many regulators have rained down on them and we will soon know what else (if any) they have been up to.
Regards

nigelpm

The only point I wanted to make by comparing Tesco to Enron is that under immense pressure to produce results, some companies resort to dubious accounting practices and in the extreme in the case of Enron downright illegal activities. The red flags for Tesco are there to see

Red flags? where? They've chosen certain accounting treatments that are completely within IFRS.

In case you weren't aware Enron essentially made up contracts and revenue went from $12bn to $100bn in a few years.

Tesco as covered by Kantar Worldpanel have around 28% of the Grocery market that is worth c.£180bn. That's £50bn revenue just from the UK. And the majority of their revenue. It would be incredibly difficult to make this stuff up with this almost external validation going on every month.

There is no way they can come anywhere close to Enron.

Yes, some of the accounting might be a touch less prudent than it could be but it's within IFRS which is now quite stringent given the Enron/banking sector collapse.

You are talking nonsense - sorry to keep repeating myself but you are very wrong.

For the avoidance of doubt I am not saying that Tesco have resorted to illegal activities. The weight of the many regulators have rained down on them and we will soon know what else (if any) they have been up to.

Huh? I thought you were comparing Enron to Tesco - now you are stating that they haven't resorted to illegal activities. Make your mind up!

I think it's fair to say Tesco haven't been most prudent in their accounts in this area. I'll give you that but some of your article is way off the market. As I've written above IFRS is quite tight now after Enron and banking collapses.

Remember their entire property portfolio is still valued at cost!

That will hugely outweigh the odd £bn they are "hiding" somewhere else.

valueinvestorshouse

sometimes it is not only the case of complying with the letter of IFRS (the law) but it is also about the spirit...

4th Oct '14

Ramridge, thanks.

Nigelpm, I'm not sure where you think my article is "way off".

There are two points. First, can you trust Tesco's numbers? The answer appears to be not completely. IFRS is strict, but as soon as you set specific rules some companies will try to find ways to get round them. At some point, the presentation becomes misleading even if you comply with the rules.

Second, in its financial statements Tesco's properties are valued at cost, but they also provide a market value, which is not in the financial statements and therefore is not covered by the auditors' report. Furthermore, I think it is highly likely that there will be significant writedowns in the property on the balance sheet. I'm not suggesting Tesco has zero value, but If you can't trust the numbers, how can you be confident what that value is? You might perhaps dismiss the odd hidden billion, if that was all, but it clearly is not.

First, can you trust Tesco's numbers? The answer appears to be not completely. IFRS is strict, but as soon as you set specific rules some companies will try to find ways to get round them. At some point, the presentation becomes misleading even if you comply with the rules.

Most companies will NOT try to get around them. It doesn't work like that in the real world.

Enron did (to bring them back in) and succeeded but it's very much the unusual rather than the norm.

Furthermore, I think it is highly likely that there will be significant writedowns in the property on the balance sheet.

Why do you think that?

You realise that IFRS compliance includes a check for impairment on PPE?

You'll also see that Tesco has historically written off amounts in the cost value here.

I'm not trying to paint a picture of a glorious world where no tries to make their results look as rosy as possible. Of course that goes on - my point is it is very much the 5-10% of the financials around the materiality level.

Hi njstevenson -

Any flaws in the following?

“ For analysts at Nomura the latest 'profit warning' from Tesco puts that company's credit metrics effectively into 'junk' territory, as per a research note issued on 29 September. As regards the company's fundamentals, if one takes the better part of the firm's £250m profit warning at face value then that means its operating margins in the UK, on an EBIT basis, would come in at 2.8%. The key metric is the company's gearing they point out and, in turn from the above, they estimate that the retailer's net debt to operating earnings (adjusted EBITDAR) comes in at 3.65, whereas the threshold for 'junk' in the sector comes in at 3.5. “ (source: http://www.coutts.com/news-and-insights/newsitem/i...

We know Tesco’s current disclosed balance sheet net debt = £6.6bn (latest accounts). If we add the £2bn of off balance sheet debt, the ratio comes to
(1) Adj EBITDAR = 6.6/3.65 = 1.81bn
(2) net debt to operating earnings (adjusted EBITDAR) including off balance debt of £2bn = (6.6+2.0) / 1.81 = 4.75

If the threshold for ‘junk’ is 3.5 then we may have to invent a new word for this level.

P.s. And that's without any adjustment for the pension fund deficit of £2.6bn.

Nigelpm, just to be clear by "get around" I didn't mean that they necessarily break the rules, but they will structure transactions with the accounting treatment in mind. Why do you think almost all the supermarket leases are classed as operating leases (off balance sheet) rather than finance leases (on balance sheet)?

I am primarily a research analyst/investor. I originally started looking at Tesco when Phil Clarke was replaced to see whether there was value in the company. It fairly quickly became apparent there wasn't. At that point I would normally move on to the next potential investment. The only reason I wrote the research piece on my blog and a more detailed one on Seeking Alpha at the beginning of September ("Tesco: Aggressive Accounting Hides Financial Weakness") was because I thought Tesco was seriously misleading investors. This was clear before the recent announcement.

Yes, I am aware that Tesco is required to test for impairment. It is based on the company's cashflow forecasts for individual stores. This clearly gives Tesco some discretion on timing. The auditors may check the numbers, but values are based on Tesco's own projections (including estimated long-term growth of 2-5%).

The accounting issues relating to commercial income may prove to be 5-10% of profits, but if you add up all the other things going on it is a lot more than that.

The rating agencies include the present value of minimum future lease payments and the pension deficit in their debt calculations. I wouldn't try to back out the numbers in that way as it not clear how they've arrived at their metrics.

I stand corrected. Thanks.

So based on some high level calculations above looks like they might be stretching their leverage ratios. But what is your view guys on whether they will go for the rights issue?

I did some back of the envelope run through their cash flows (hopefully more reliable than EBITDA...) and although they do have large shortfall it seems to me they can just make it by cutting dividends and reducing capex.

more calculations here: http://www.valueinvestorshouse.com/does-tesco-need-rights-issue/

I guess the question is how much of the capex is committed mid to long term and is therefore not flexible. that would put them in asset disposal scenario as an alternative to the rights issue.

Any thoughts?

Yep, capex is going to collapse as their expansion plans are pulled and already have been to some extent.

You have to consider from an investment perspective that the shares are now 57% below their highs of £4 and weren't excessively valued at that point.

A huge amount of bad news is priced in.

They aren't Enron and aren't going bust - the time to buy might have been yesterday.

Hi valueinvestorshouse -

Provided Tesco comes out of the recent investigations with a clean bill of health, I am inclined to believe that it will start an asset disposal programme. It owns Dobbies Garden Centres, a stake in Harris + Hoole coffee shops and the Giraffe restaurant chain, as well as Tesco Bank and Tesco Mobile. Not clear to me how much they would need in order to strengthen the balance sheet to a decent degree.
The worst scenario is that the investigations take months, as different regulators (plus the parliamentary select committee) are queueing up to take their turn.

They could start the asset sale tomorrow if they wanted. They are separate businesses - I very much doubt they need to resort to any of this though. All will be revealed over the next few months and a share price of £1.70 will be looked upon as a gift from the gods ;-)

Tesco's new tablet has just been released... http://www.engadget.com/2014/10/03/tesco-hudl2-vs-hudl/ The sooner Tesco get out of markets like this, and refocus on their core business, the better. But, I guess it's at least decent...

9th Oct '14

By the way. Per 2014 annual report:

http://www.tescoplc.com/files/pdf/reports/ar14/download_annual_report.pdf

per page 14:

Property
The market value of our property across the Group currently exceeds
£34 billion, with the most significant driver of the reduction since last
year being the impact of foreign exchange rates.

The point here being that PPE in total is valued at £24bn in the accounts at cost - my point above really that using cost for PPE is prudent.

The Case For/Against Tesco

Unlock the rest of this article with a 14 day trial

About the Author

Gray Woods

50 comments

Unlock the metrics for all these stocks and more...

Unlock the metrics for all these stocks and more...