It’s that time of the week again, where I highlight one stock that is worth looking at. This week it’s Tesco (LSE:TSCO). I wasn’t initially going to do a piece on Tesco as it is well covered by commentators, but after reading their results on Wednesday I just had to write about it. Some things in the CEOs report concerned me and changed my valuation. Moreover these are things that most in the media will probably overlook as they focus on reported profits. As I haven’t written up a proper article on Tesco before, I’ll write a bit on the company too rather than focus just on the latest results.
Tesco is fairly simple to understand, although logistically very complex. I think of it in three main segments:
2. Property development
3. Tesco Bank
You’ll see why I think of it like this in a minute. They are most known for the supermarket business, which accounts for most of their revenue. This is split up across the world, but operates in each country in a similar way. Their supermarkets are the cash generators of the business. This cash is used to fund growth and is linked to the property development ‘segment’. They will purchase land for a new store, develop it and then perform a sale and leaseback to release capital for new expansion. Quite often they will make a profit on the purchase, development and sale which is why I see it as a separate segment.
But in the 2013 results announcement the CEO had this to say
“Second, following on from our announcement in April 2012 that we would be reducing the level of new space growth in the UK going forward, we have carried out an in-depth review of our property pipeline. We have reviewed all of the schemes included in the pipeline individually, assessing their viability and potential to deliver an appropriate level of return on capital employed if built out. As a result, we have identified more than 100 sites – the majority of which were bought between five and ten years ago, at a higher point in the property cycle – which we no longer plan to develop and have therefore written their values down. In addition to a number of other provisions, including for the impairment of schemes which still can deliver an attractive return, but one lower than originally anticipated, this has led to a total one-off UK property write-down of £(804)m.
The fundamental change in our approach to new space also has implications for our sale and leaseback programme. Two years ago, we reviewed the programme and announced a steady reduction in the level of divestments, in order to ensure that any property profits released were matched to the level of new profit created by development activities. Given that we have significantly reduced the amount of these activities going forward, we believe that it is appropriate to accelerate the scaling back of the sale and leaseback programme, such that it is unlikely to make a material contribution after the next few years.
Our reported underlying profit measure includes these property profits and therefore its growth over the next few years will be held back by this accelerated reduction. We will therefore adjust for this impact when using underlying earnings per share as the basis for our dividend policy.”
What that essentially means, is they are drastically scaling down this business, as the returns available are no longer attractive enough. In one way it is good to see a management that is focused on shareholder return and not growth at all costs. On the other hand he is right to say this will put a drag on profits going forward. This is why I think the valuation of Tesco has changed.
Take a look at the table below to see how much profit is generated by the property development business. More importantly, look at how much cash the sale and leaseback program generates.
Let’s also not forget, that this property development program is also part of the growth of the supermarket revenues. Without aggressive new store openings we are unlikely to see the pace of growth we have seen over the last 10 years. The CEO predicts mid single digit growth, this seems sensible to me based on history.
The development of property was contributing around 10% of pre-tax profits in the last few years, which is a sizeable amount. Free cash flow was considerably impacted by the sale and leaseback program, but is being scaled back because of reduced capital expenditure requirements.
Good news: There is some good news though, they have finally called it a day on their loss making US operations. The losses have been excluded in the 2013 results above, so the fall in profits is a permanent decline, don’t expect it to bounce back (cash flow however does include the discontinued operations)
Valuation and conclusion
It is difficult to say where Tesco will go from here. I think the CEO’s prediction of mid single digit growth seems sensible and am pleased with his focus on returns on investment rather than pursuing growth at all costs. At the current price it is at a PE ratio of 12.4 to the adjusted profits above. Using my PE ratio tool and say 5% growth a year for 10 years, I get a PE ratio of 14 as fair value with a 10% discount rate. But historically only around 50-70% of profits have been available as free cash. Even under a 70% scenario this reduces the PE to 10, making today’s price look less appealing.
But despite this I still think Tesco has some potential. It is embarking on a plan for organic growth in the UK market, and I still like the retail banking business which Tesco is involved in. And once the economy improves, the property development business may provide attractive returns again and they will resume the development, sale and leaseback program.
I personally am greatly reducing my holding in Tesco. Currently it represents about 15% of my portfolio but I am reducing this to 3-5%. I still think it’s a good long term buy but its valuation has fallen due to winding down its property development activities.