I warned in August about Tesco’s high debt levels and that it risked losing its investment grade credit rating (see “Aggressive accounting hides financial weakness”). At the interim results, the new management identified “strengthening the balance sheet” as one of their three priorities. As part of its post-Christmas trading update on 8 January, the company has said it will give more details on its future strategy. It is widely expected to announce the disposal of a number of non-core assets, and possibly some or all of its operations in Asia. However, the problem facing Tesco is that its debt is so high and its profits are currently so low that whatever it decides to do, even spinning off its Asian business, will not completely resolve its balance sheet issues and is unlikely to prevent a downgrade in its debt to below investment grade.
Rapidly deteriorating debt ratios
Based on the company’s own figures, Tesco has total net debt of more than £20bn, including capitalised lease commitments of £9bn and a pension deficit £3bn. In my view, if the company properly accounted for its operating leases, net debt would be even higher at around £25bn (see Tesco’s hidden debt).
Net debt may increase further by the year-end: the company’s retail businesses (excluding discontinued operations) generated free cashflow of just £90m in the first half of the year; and only because of a working capital inflow of more than £400m, probably from late payment of suppliers at the period end. It would not be a surprise if this working capital inflow reversed in the second half.
The company’s main debt ratios have deteriorated rapidly as profits have decreased. Group retail EBITDAR will fall substantially this year to around £4bn, resulting in an increase in the net debt/EBITDAR ratio from around 3x at the last year-end to around 5x (or 6x on my basis). Profits are unlikely to recover significantly next year, and may fall further. Cashflow will probably remain weak too, despite cuts to capex, as additional restructuring costs, including redundancy payments and possibly lease exit costs, are incurred.
Tesco has a number of businesses that are widely seen as non-core, including the garden centre chain, Dobbies, and the loss-making video-streaming business, Blinkbox. Another possible sale candidate is the customer analytics business, Dunnhumby. There has been speculation in the media that this might fetch £2-3bn (based largely it seems on comments from bankers). Such a valuation, which at £2bn would be 30x historic EBITDA, looks ambitious for what is a people business, which has very few assets, even if it has good growth potential from selling its services to clients other than Tesco. A figure closer to £1bn may be more realistic. Other options include the sale, or partial sale, of Tesco Bank, which has net assets of around £1.6bn, or some of its European operations, although the latter, in particular, would not be easy.
Selling any of these businesses, at least individually, would not, however, make a material difference to Tesco’s net debt. Relying on selling several businesses to reduce debt would involve significant execution risks, particularly as Tesco would be seen as a forced seller. A more substantial transaction would be the sale of all or part of its Asian business, possibly through a stock market listing. This could raise a much larger amount for Tesco in a single transaction, reducing execution risk. The business contributed trading profits of nearly £700m last year, although profits this year are likely to be lower, partly, but not entirely, due to currency movements. Values of around £8-10bn have been suggested for the business, which has operations in Thailand, Korea, Malaysia and India. The majority of the value is in Thai and Korean businesses. The suggested valuation range appears quite high, particularly given recent problems in some of the individual businesses. The main comparable, Singapore-listed Dairy Farm International (part of the Jardine Matheson Group), is trading at a lofty valuation (a current year P/E of around 24x according to Bloomberg), which is probably driving some of these valuations, although a direct read-across could be misleading. There would also be considerable interest in the individual businesses from both trade and private equity buyers. It is unlikely that Tesco will sell the whole of its Asian business to a single buyer.
Asian sale is no panacea
Listing the Asian business could perhaps raise as much as £6bn, if debt of around £3bn is included in the spin-off and 50% of the shares are sold (and assuming an enterprise value of £9bn). A listing would have a number of other benefits too: crystallising the market value of the Asian business, while retaining an interest in its future growth. However, it would still only be a partial solution to Tesco’s debt problems. The parent would lose access to the cashflow from the Asian business apart from dividend payments (even if it remained consolidated in Tesco’s accounts) and the diversification benefits this provides. With the UK business likely to generate minimal profits and cashflow, both this year and next (and possibly for longer), Asia is currently the biggest source of group profits.
A listing would also take time to prepare. The outright sale of one of the country businesses to either a trade or private equity buyer would almost certainly be a quicker alternative. Both would involve execution risks with no guarantee of achieving the mooted prices.
Furthermore, the parent would still be left with very high levels of debt. Net debt could still be around £13bn, even if it were raise a further £1bn selling Dunnhumby and other businesses. The long leases on its UK stores means it would retain most of the lease obligations, as well as the pension deficit. Its debt ratios would not improve significantly at least in the near term; I estimate the net debt/EBITDAR ratio would still be around 4.5x. Ultimately reducing the debt burden to a more manageable level would depend on improving the profitability of the UK business, mainly through cutting costs. However, this will take some time and margins are unlikely to return to previous levels.
Likely to lose investment grade rating
Currently, Tesco has the lowest investment-grade rating from all the main agencies. Comments made by the CFO, Alan Stewart, at the interim results, indicate that Tesco would be prepared to sacrifice its investment grade if necessary, at least in the short term. Asset sales would give Tesco time to turn around the UK business by easing the pressure on cashflow and refinancing, but it is unlikely to prevent a further cut in its rating. Longer term, Tesco may decide that it does not need to access the capital markets, if most of its debt consists of lease commitments and pension deficit.
Speculation about a rights issue has been hanging over Tesco for some time, although management largely dismissed the possibility at its interim results; an equity issue is not widely expected by the market. Rescue rights issues are obviously not popular with investors, who are forced to put more money into a company that has already proved to be a bad investment, and is seen as a sign of desperation. This would be particularly true for Tesco, if it were to launch one now. Nonetheless, it could seek to present a positive investment case, centred on growth in Asia and a recovery in the UK. If a rights issue is needed, there is no point delaying it: a cash-call later would be even harder to sell, with a weaker investment case, and would be even more damaging to management’s credibility.
However, even a rights issue would not provide a clear resolution: if Tesco were to raise £3bn through a rights issue and another £1bn from disposals, it would still be left with net debt of around £16-17bn and a net debt/EBITDAR ratio uncomfortably high at around 4x. A recovery in profitability would still be needed, although having full access to the cashflow from the Asian business would be a significant benefit.
There is no easy solution for Tesco to its current predicament. Having stretched its balance sheet during the good times, largely through long-term property leases, its precarious position has been exposed by the collapse in UK profits. It is unlikely to be spared the ignominy of being downgraded to below investment grade. Even large disposals may not be sufficient to decisively fix its balance sheet problems, given the loss of income they would involve. A rights issue at some point may still be necessary.