So, Philip Clarke is stepping down. That didn’t come unexpected, did it?
Dave Lewis, the new boss of Tesco (LSE: TSCO), doesn’t have much experience in the supermarket space, but if Mr Lewis gets his priorities right then the shares of the largest food retailer in Britain could be a bargain, particularly if weakness in their valuation persists.
Analysts estimate that Tesco stock is worth between 230p and 360p. It currently trades at £275p. Its fair value is 233p, in my view.
1) Assets Base
Tesco must shrink to preserve its core operations in the UK. I voiced concern about its Japanese and US operations well before they were sold.
The retailer has recently received the green light from state authorities to combine its Chinese operations with those of state-run China Resources Enterprise, retaining a 20% stake in a joint venture with sales of £10bn.
While the allure of growth has led many retailers to believe that Chinese expansion was worth heavy investment, for generalist retailers such as Tesco, China has not been the answer so far. The Chinese retail market is highly competitive, with the top 10 food retailers boasting tiny shares and very little pricing power. “Cannibalisation” is of paramount importance in Tesco’s strategy, but it has become a very expensive strategy in countries where operations are sub-scale.
(Elsewhere, the food sector in China is under the spotlight today — and for all the wrong reasons.)
Tesco should consider partnerships in Europe, too, before a full exit occurrs there. As I recently argued, European operations should be fully divested even at a paper loss. Strategic partnerships are a valid alternative, yet full attention must be devoted to the UK market, where web presence, the format of shops, and loyalty programs pose problems.
2) Return On Equity
Return on equity (ROE) is a key metric to gauge the performance of management. Tesco’s ROE before losses from discontinued operations stood at 12% in 2014. Tesco is struggling to grow its core business, so in order to boost its ROE, it can decide to cut costs — as it has done in recent quarters — or to raise more debt.
This is where things get complicated. High leverage for food retailers in the UK would be very risky, but Tesco’s payout ratio is under threat, while its net leverage is manageable. Raising cheap debt could be an opportunity.
3) Capital Deployment
Management should state their intention to preserve the payout ratio. Debt financing could be used to support dividend payments, whose sustainability has been questioned in recent days. Banks won’t pull the plug on such a key client if business prospects deteriorate.
Tesco may also state its intention to undertake shareholder-friendly activity. A £1bn debt-funded buyback would likely be accretive to earnings, and could be combined with targeted divestments. For instance, £1bn of proceeds from asset sales would help Tesco offset a rise in its net debt position, meaning net leverage would likely remain constant. This assumes a minimal loss of earnings from disposals. Such would be the case for ad-hoc divestments in Europe, which recorded a gross trading profit of just £238m in 2014.
The Press/Carrefour
“Tesco’s major strategic problem was no one was quite sure what it was for – it was marooned between the more upmarket offer of Sainsbury’s and Waitrose and the value offer of Aldi and Lidl,” the BBC reported in the wake of Mr Clake’s departure.
It’s not unusual to read such comments about Tesco these days. In truth, Tesco’s problems are much deeper and they started to show as soon as international expansion plans were implemented. The press has also drawn parallels with another troubled retailer, France’s Carrefour, since Mr Clarke resigned.
Carrefour, the third-largest food retailer in the world, has gone through several changes of leadership over the years. It had to shed assets, too. From a 10-year high of EUR57.4 in 2007, Carrefour shares plunged to a record low of EUR13.7 in 2012, but they have rallied to record a 100% performance since.
Tesco is a better business than Carrefour, so there’s no reason why its shares shouldn’t bounce back if the right strategy is executed.
