The Motley Fool

Tesco PLC’s Property Time Bomb

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

TescoThe 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?

5 Stocks For Trying To Build Wealth After 50

Markets around the world are reeling from the coronavirus pandemic… and with so many great companies trading at what look to be ‘discount-bin’ prices, now could be the time for savvy investors to snap up some potential bargains.

But whether you’re a newbie investor or a seasoned pro, deciding which stocks to add to your shopping list can be a daunting prospect during such unprecedented times.

Fortunately, The Motley Fool UK analyst team have short-listed five companies that they believe STILL boast significant long-term growth prospects despite the global upheaval…

We’re sharing the names in a special FREE investing report that you can download today. And if you’re 50 or over, we believe these stocks could be a great fit for any well-diversified portfolio.

Click here to claim your free copy now!

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.

Within one year 7 1,334
Greater than one year but less than five years 49 4,676
After five years 153 9,911
Total minimum lease payments 209 15,921

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).

Is this little-known company the next ‘Monster’ IPO?

Right now, this ‘screaming BUY’ stock is trading at a steep discount from its IPO price, but it looks like the sky is the limit in the years ahead.

Because this North American company is the clear leader in its field which is estimated to be worth US$261 BILLION by 2025.

The Motley Fool UK analyst team has just published a comprehensive report that shows you exactly why we believe it has so much upside potential.

But I warn you, you’ll need to act quickly, given how fast this ‘Monster IPO’ is already moving.

Click here to see how you can get a copy of this report for yourself today

G A Chester has no position in any shares mentioned. The Motley Fool owns shares of Tesco.

Our 6 'Best Buys Now' Shares

Renowned stock-picker Mark Rogers and his analyst team at The Motley Fool UK have named 6 shares that they believe UK investors should consider buying NOW.

So if you’re looking for more stock ideas to try and best position your portfolio today, then it might be a good day for you. Because we're offering a full 33% off your first year of membership to our flagship share-tipping service, backed by our 'no quibbles' 30-day subscription fee refund guarantee.

Simply click below to discover how you can take advantage of this.