Tesco PLC’s Property Time Bomb

The property portfolio of Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) has for years been seen as one of its greatest strengths. And, after the company’s shock profit warning of 2012, commentators were quick to suggest that the value of the property would put a ‘floor’ under the share price.

So, how are things looking now that the shares have fallen to 275p (a level not seen in over 10 years) and the market capitalisation of the company has dropped to £22bn?

Buy the property — get the retail business for free

At Tesco’s last balance sheet date (22 February), the book value of the group’s property was recorded at £21bn — just a tad below the current market cap. You may be tempted to think that, in effect, the market is offering you the opportunity to buy the property with the retail business thrown in for free.

And the deal looks even better if you go to the annual report, because you’ll find Tesco telling you that the market value (as opposed to the book value) of the property “exceeds £34 billion”. Put another way, the shares are trading at a 35% discount to the property’s market value. Even if we knock off net debt of £6.6bn we’re still looking at a discount of around 20%.

Off-balance-sheet debt

But things aren’t quite as rosy as they might appear. Tesco has done stacks of sale-and-leasebacks on properties over the past decade. These deals released cash to help fund international expansion — or blow on international expansion in some cases, notably the failed attempt to enter the US. And, of course, the price of releasing cash from freeholds today is a rising rental bill tomorrow.

The table below shows how Tesco’s future minimum rentals payable under non-cancellable operating leases have risen over the past 10 years.

Now, these future liabilities are off-balance-sheet, but we should really treat the present value of these payments as debt, just like the credit rating agencies do. One rough-and-ready way to estimate this off-balance-sheet debt is to multiply the current annual operating leases expense by eight: so, £1.3bn times eight gives £10.4bn.

If we add the balance-sheet net debt of £6.6bn to the off-balance-sheet debt of £10.4bn, we get £17bn — or, half the market value Tesco reckons its property is worth.

Incidentally, the hidden debt (and, of course, the company’s deteriorating operating performance) has contributed to a series of downgrades from credit rating agencies. Even before Tesco’s latest profit warning, Moody’s had cut the supermarket’s credit rating to just two notches above junk.

The debt alone suggests Tesco is no asset-backed bargain at a market cap of £22bn. But the situation could well be worse, because there’s good reason to think the property may be overvalued, too.

Property valuation

The supermarkets’ race-for-space is over. Forget the news that Tesco is planning to build houses on some of its now unneeded landbank — that’s it’s a sideshow in the grand scheme of things.

The real story to focus on is those aircraft-hangar-like Extra stores that Tesco is currently padding out with Giraffe restaurants, gyms, children’s play areas and suchlike. This seems little more than a holding strategy, while the company decides what to do with the stores in the new consumer-is-the-destination world, where ‘destination stores’ already seem so last decade.

Analysts at Cazenove have painted a grim — but I think realistic — picture of the way Tesco’s UK property valuation is heading:

“The gap between the performance of large out-of-town stores and convenience stores continues to widen … This has direct and strong implications for the property valuation of the Extra stores (45% of the UK space). The company says that its UK real estate is worth £20bn based on the extrapolation of past sale and lease-back transactions to the entire estate. We believe it is likely worth less than half that value — the book value of UK land and buildings is £9.3bn and the alternative use value towards which several out of town stores are converging is a fraction of the book value”.

In short, then, the debt on the balance sheet, the off-balance-sheet debt, and the potential for hefty writedowns on property valuations, suggest to me that the asset floor under Tesco’s shares will prove to be some way below the current 275p (market cap £22bn).