Tesco’s share price has increased by around 40% from its low point in December last year. The renewed optimism reflects investors’ favourable response to the new chief executive, Dave Lewis and a growing belief that the UK business has reached a turning point. The current share price is discounting a rapid return to “normal”, as the company reasserts its still dominant market position. The implicit assumption is that a resumption of growth in the UK business will automatically lead to a strong recovery in profits, even if margins do not return to prior levels.
However, this ignores the underlying structural issues facing the UK business. Sales productivity, measured in sales per square foot, has consistently fallen since 2007. At the same time, Tesco is saddled with high legacy costs that will be difficult to reduce: rental payments have ballooned following a decade of sale and leasebacks. It risks losing out to more nimble competitors. The level of future profitability is unclear, but will inevitably be much lower than it has been historically. Given the deep-rooted problems and considerable uncertainties, the shares are expensive. I am short Tesco.
Figure 1 shows the main underlying problem facing all food retailers in the UK: sales volumes have not increased since 2008. After many years of continuous growth, supermarket operators had become used to ever increasing sales: between 1990 and 2007, sales grew by 6% per year and volumes by nearly 4%. Tesco, in particular, benefitted from a virtuous circle of new store openings and market share gains from both food and non-food retailers. There is some evidence that volumes have seen a small increase recently, although it is too early to call it a recovery.
Figure 1: UK non-specialised food stores retail sales
The overall sales value had, until recently, continued to grow at a reasonable rate (see Figure 2), as high food inflation masked stagnant volumes. For several years, retailers were able to raise prices and protect profit margins. Between 2007 and 2013, food inflation averaged around 5% per year (see Figure 3). Only in the last year has increased price competition led to falling prices.
Figure 2: annual change in UK non-specialised food stores sales value
Figure 3: annual change in UK food and non-alcoholic beverages consumer price index
The financial crisis led to a severe squeeze on incomes in the UK. In real terms, average earnings have fallen significantly since 2008 (see Figure 4), in part due to stubbornly high inflation. Earnings growth has finally turned positive with the recent drop in inflation.
Figure 4: annual change in real UK average weekly earnings (3 month average)
Aggressive store opening
Initially, it may have been reasonable to assume that the volume slowdown was a temporary issue and growth would eventually return to its previous upward trend. Until recently, all of the big four supermarket operators continued their rapid expansion. Tesco historically has been the most aggressive, increasing its total sales area by over 50% since the beginning of 2007 (see Figure 5).
Figure 5: Tesco UK sales area by store format
Note: Excluding Dobbies and One Stop
During this period, Tesco has focused on convenience stores and large stores; the share of traditional, mid-sized supermarkets has declined. However, despite rapid growth in the number of convenience stores, they only accounted for around a fifth of the sales area added since 2007. Most of the new space has been in large stores: the number of the largest Extra hypermarkets has more than doubled to 250 during this period including extensions to existing Superstores. Tesco has a higher proportion of large stores than any of its competitors. Over the last year, the performance of these stores has been particularly weak.
Tesco recently closed 43 loss-making stores in the UK and cancelled 49 new stores. The closures were limited, accounting for just over 1% of Tesco’s total sales area. Most were the smaller Express and Metro formats. They included only seven Superstores and no Extras, as well as five non-food Homeplus stores. The company has just announced plans to close the remaining six Homeplus stores.
Management believe they can improve the performance of the other unprofitable stores. The company is still planning to open a limited number of new stores. The total sales area at the end of the current financial year is expected to be similar to the end of 2014.
The discount chains, Aldi and Lidl, have had a significant disruptive influence on the UK grocery market in the last few years, successfully exploiting the opportunity presented by the big four’s higher prices. Their combined market share has increased from around 5% at the beginning of 2012 to 9% now. Tesco has been the largest net loser, although its market share, which peaked at around 32% in 2007, had already started to fall before the big rise in the discounters’ popularity. It has since fallen to just over 28%.
Most consumers can now choose between several different supermarkets, including convenience stores. At the same time, shopping habits have changed: many shoppers have abandoned the traditional large weekly shop for multiple smaller shops. The growth of internet shopping has also reduced demand for large stores. It would be easy to conclude that the UK has too many supermarkets. Perhaps more accurately, there are too many for the operators to earn the high, above cost of capital returns, which they had done previously.
It is hard to see these trends reversing. The majority of people will still do most of their shopping at large stores, but the discounters, convenience stores and online will gain further ground. The discounters continue to open new stores at a fast rate even as the big four have cut back on openings. Tesco’s chief executive has defended the company’s exposure to large stores, saying he does not view the company’s “big stores as a big problem”, but as “an opportunity…to think about how we use the space differently”. Nonetheless, in future, the main issue is likely to be managing a gradual, long-term decline in sales.
Declining sales productivity
In recent years, Tesco’s UK business has experienced a significant drop in sales productivity. Between 2007 and 2014, sales per square foot decreased by 8% (see Figure 6). The 4% drop in like-for-like sales over the last year suggests that this figure fell further in 2015 to around £22, lower than in 2004. Given the high inflation during this period, the decline in real terms is much bigger, probably around 30%. The fact that the final quarter of 2015 was the first in five years with positive like-for-like volume growth shows the scale of the task facing the company. A single quarter of volume growth, achieved through aggressive price-cutting, does not represent a trend. Furthermore, like-for-like sales growth is still negative due to lower prices.
Figure 6: Tesco UK average monthly sales per sq. ft.
Source: Tesco, author’s estimates
Unreliable historical profitability
The decline in sales productivity will have had a big impact on profitability. Moreover, it coincided with a major step-up in the number of sale and leaseback transactions. Property rental costs increased from £0.3bn in 2007 to £1.4bn in 2015 (see Figure 7), reducing Tesco’s overall trading margin by around 150bp. Most of the leases were entered into when expectations for future growth and profitability would have been much higher, and the company was perhaps more interested in maximising earnings growth by boosting profits from property sales. The leases on the larger UK stores are usually for 20-30 years with rent increases typically linked to inflation. Tesco’s rent bill will, therefore, continue to rise even though it has halted further sales. The leases are a significant financial burden for Tesco and will be a considerable drag on future profitability.
Figure 7: Tesco property rental costs
Tesco was initially able to mitigate the impact of lower sales productivity and higher rental costs by raising prices, maintaining its UK trading margin at around 6%. Though ultimately this was unsustainable, resulting in last year’s margin collapse. In my original article on Tesco in August last year (Aggressive Accounting Hides Financial Weakness), I highlighted some of the methods the company used to boost its preferred profits measure. The majority of these were below the trading profit line. It is now clear that the company was also artificially increasing short-term trading profits. The overstatement of commercial income (which it now seems was even larger than previously disclosed) may have been the most egregious example. However, it is evident from the speed of the margin decline and comments made by the new management that this was not the only reason for the collapse. Tesco’s historical profitability is not a reliable benchmark for future expectations.
Leased stores reduce flexibility
Despite the substantial number of Tesco’s stores that are currently loss making, management have indicated that further closures are unnecessary. They expect the profitability of these to stores to improve as trading improves.
Nonetheless, the high proportion of Tesco’s UK stores rented on long leases significantly restricts its flexibility. Leased stores bear the additional burden of paying rent. The costs involved in terminating the leases may make it uneconomic to close stores, even if they remain unprofitable. The equation for Tesco’s freehold stores is somewhat different. Provided they generate positive cash flow, their value may still be higher than their alternative use value, even if in accounting terms, they are unprofitable due to depreciation expenses.
Between 2007 and 2013, Tesco sold and leased back a large number of its stores, booking substantial profits in the process. Most of these leases will have long unexpired terms. Around half Tesco’s future lease commitments are for periods beyond ten years (including certain leases that the company has the option to cancel if it buys back the properties). Historically, the company provided only limited disclosure on its property portfolio, obfuscating the real position. However, the company disclosed that, at the last year end, it owned just 40% of its UK property, a much lower proportion than previously thought. Management said they would like to increase this figure. However, it is unclear how the company could do this to any meaningful degree given its already stretched balance sheet. In general, it is hard to see why lessors would want to renegotiate leases that have long unexpired terms. In some cases, notably with Tesco’s property bonds, the rental income is required to repay debt; renegotiating the terms would be impossible unless the bonds are redeemed.
In March, Tesco announced a deal with British Land, one of its principal joint venture partners, to dissolve most of their joint ventures and divide up the assets. Tesco regained full control over 21 superstores while British Land received several shopping centres and retail parks (including Tesco stores). The transaction is a sensible move by the company. However, the stores involved represent a relatively small part of its estate, increasing its UK property ownership to around 42%. Moreover, the opportunities for similar transactions are limited.
A large property write-down had been widely expected with Tesco’s full-year results, although the actual amount was even bigger than anticipated. The company recorded a fixed asset impairment charge of £3.1bn on just its UK property assets, reducing their value by nearly a quarter to £10.5bn. It now estimates that their market value is equal to their book value. Tesco also made a provision of £0.6bn for onerous leases in the UK. As with the freehold properties, the value of the leases on Tesco’s rented stores has fallen significantly.
It would be easy to dismiss the property write-down as a one-off, backward-looking charge that does not affect cash flow. However, it reflects the changed market outlook in recent years and a reduction in future cash flow expectations. Furthermore, the lease provisions will result in a future cash outflow.
The write-down should also end any remaining belief that the value of the company’s property assets underpins its share price; a view encouraged by the previous management’s misleading disclosure of property values. The losses wiped out more than half its shareholders’ equity: over a decade’s retained profits. Tesco now trades at 2.6x book value.
Future profitability unclear
In the last year, Tesco’s UK profits have completely collapsed: it made a loss in the second half, even before one-off charges. The profit outlook remains completely opaque. Not surprisingly, management provided no guidance for the current financial year, preferring to focus on improving the operational performance. Their “aspiration” is to achieve profits at a similar level to last year, which assumes a significant improvement over the current run-rate.
To date, Tesco has identified total annual cost savings of around £400m, mainly from reducing central overheads in the UK. However, these represent less than 1% of UK sales. Moreover, the full benefit will not flow to the bottom line, as the savings will offset price reductions and improvements in customer service; for example, in-store headcount has increased in recent months.
The company is reliant on volume growth to improve its trading performance, with price competition unlikely to ease in the near term. A return to modest growth may help stabilise the current position, but the company will struggle to generate sufficient growth to reverse years of falling sales productivity and negative operating leverage. The property write-down will provide a modest incremental, non-cash boost to profits by lowering the depreciation charge. Other charges and provisions may also benefit short-term earnings to some degree.
The long-term profitability of Tesco’s UK business is clearly lower now than it was historically, although estimating a sustainable level is difficult. Management have not given a long-term margin target, beyond saying that its margin should be higher than the industry average, whatever that might be. Whether this is true remains to be seen. Industry margins are likely to be lower than in the past (at their recent results presentation, Sainsbury suggested an average of around 3%). The big four supermarket operators all face similar issues. However, some of Tesco’s problems are more severe: it has a greater proportion of leased stores, more large stores and higher financial leverage. Its cost base is structurally higher, which may outweigh any advantages of scale.
Tesco’s overall performance is highly geared to a recovery in the UK business. A UK operating margin of around 3% would indicate underlying EPS of around 18p, putting it on a P/E multiple of around 13x, albeit at some uncertain future date. Such a margin level implies a return on capital of around 9% for its retail business following the write-down and other charges: a reasonable if unspectacular level.
Freed from the requirement to maintain margins and pay dividends, the new management team can focus on improving the company’s operational performance. However, there is no single, easy solution: Tesco’s problems are deep-rooted. They are not just due to the increased popularity of the discounters but go much further back. It is impossible for the company to reverse the sale and leaseback transactions, which have left it with a considerable financial burden. Tesco’s sum-of-the-parts valuation may provide some support for the share price, although it remains unclear which businesses it will ultimately sell, or whether it will achieve the mooted prices. Tesco currently looks expensive: its share price already prices in a successful turnaround despite the considerable uncertainties. I currently have a short position in Tesco.