Following a short-lived period of renewed hope during October, Tesco (LSE: TSCO) shares have since fallen to their lowest level in nearly two decades, prompting them to change hands for as low as 142p at the opening of December.
Whether or not you believe things could get any worse from here will probably depend upon a number of things, not least of which is your faith in Dave Lewis’s strategy to turnaround the business.
As a time-served heckler of all things Tesco my answer to the above question is probably always going to be a yes — things can get worse.
However, if you’re wondering what to do with your own Tesco shares, or perhaps even considering buying in for the first time, here are some points to consider.
Revenues, costs, debts & cash flow
Leaving aside all of the management sound-bites about volumes, price investment, value, and suchlike waffle, at the most basic level, Tesco’s financial problems begin with the fact that its revenues have been falling persistently, while its costs are still rising.
Its beleaguered balance sheet adds further to these woes and the associated risks for shareholders. At the last count Tesco had twice the level of debt as its shareholders did equity, while gearing was at 64%.
It also struggles to maintain a positive cash flow. It narrowly avoided red ink in the first half of 2015, after the proceeds of asset disposals provided the group with a lifeline.
In the corresponding period for 2014 it resorted to debt financing to sustain itself in the face of mounting paper losses and an ever more emaciated earnings profile.
Management has pledged to cut capex, to reduce costs in order to reverse some of these negative trends, and to begin repairing the damage caused by them.
So far they have reduced capex by roughly £500 million, which is halfway toward target, while progress on costs remains the elephant in the room — and a poorly defined one, at that.
An even bigger threat
Recent events could mean that Drastic Dave and Tesco’s problems are at risk of becoming a lot worse. At the moment it seems only a remote possibility but is, nevertheless, worthy of consideration by investors.
For those who do not already know, after receiving unusually large numbers of redemption requests, several US junk-bond funds found themselves forced to suspend redemptions last week because fund managers were unable to liquidate their holdings quick enough to meet demand.
Like mortgage-backed securities during the pre-crisis boom period, high-yield credits have been a popular vehicle for investors during recent years, prompting some to draw parallels with 2007/08 and the sudden closure of Bear Stearns.
The ‘good years’ in the high-yield market have seen some high risk and poorly rated companies borrow money, over similar durations, at rates that would be enviable to some sovereign governments.
With interest rates now officially rising, investors will certainly demand higher yields to hold junk, while buyers in some segments of the market could choose to walk away full stop.
Not to sound alarmist or anything…
Tesco’s debt is junk rated, it is a junk issuer and without access to capital markets or the ability to shed assets it could not survive at current levels of income and expenditure.
For all management’s talk about the funds that could potentially be raised from asset sales, here we are less than six months later with the’portfolio reshaping concluded’ and the few billion quid that was cobbled together already squandered on more ‘price investment’.
The balance sheet is hideous and management has already spent £175 million on debt interest and a total of £337 million on finance costs in the first half. This is a tremendous amount when your reported operating profits are just £354 million and your net cash generation from operations is just less than £600 million.
So with this and the aforementioned in mind, the questions that I’m going to leave hanging in the air today are:
- How do you think Tesco’s financial position will be affected if the junk bond market goes to pot and/or yields rise sharply?
- What does Tesco do if, in the event of more market turbulence, bond buyers say no and walk away?
- How many rights issues will you take up?
