Tesco 26 Nov 09

Stocking up on food… and non-food items

Earlier this month Members will be aware that we described the match up between retailers J Sainsbury and Tesco as akin to David versus Goliath. Whilst we foresee J Sainsbury increasing its UK market share, this will obstruct not the Tesco juggernaut. Having seen its own UK market share increase for the first time in 2 years, the world’s third largest retailer is currently succeeding on all fronts and with exposure to both the developing world and non food revenues on the up, long term earnings look extremely secure.

Retailers have been amongst the hardest hard hit by the global financial crisis. Food though is hardly a discretionary item and whilst the more value orientated consumer has traded down brands, supermarkets have been able to catch the eye with compelling discount non food offerings. Like J Sainsbury, Tesco’s adaptability on the shop floor has prevented a mass exodus to the aisles of serial discounters such as Aldi and Lidl and the retail behemoth has demonstrated terrific resolve whilst many around it have crumbled.

For those unaware, Tesco is the largest British retailer by both global sales and domestic market share, with profits exceeding £3 billion. It is currently the third largest global retailer based on revenue, behind Wal-Mart and France's Carrefour, but second largest based on profit, ahead of Carrefour. Over the years the company has evolved from a grocer as is now regarded as a general merchandising retail chain.

Whilst streamlining and job cuts have been at the top of most boardroom agendas in 2009, Tesco’s results for the 6 months to the end of August show the retailer bucking the trend. Not only did the company manage to increase both revenue by over 9% to £28 billion and trading profit by 14% to over £1.55 billion, the company has created 6,500 jobs in the process.

Tesco’s pre-eminence on the UK supermarket scene has rarely looked in danger since it usurped J Sainsbury’s lead position back in the 1990’s. Although J Sainsbury continues to chip away at the company’s market dominance, Tesco’s burgeoning global exposure will more than offset any damage to earnings that may result.

That said, latest indicators suggest initiatives implemented (most notably the re-launch of its Clubcard scheme) are helping stabilize Tesco’s UK market share. According to latest data from the market research firm TNS Worldpanel, the company’s market share rose to 30.7% in the three months to November, up from 30.6% in the same period last year. Encouragingly, Tesco's sales growth rate was 4.7%, compared with market growth of 4.4%.

Although the latest data shows J Sainsbury still growing faster than Tesco at 5.6%, it is understood that the latest four-week data now places Tesco ahead… we will await formal confirmation. Either way, as the global economic recovery gains traction we expect both concerns to claw back market share from the discounters who have performed so well during a recession.

And whilst there is no doubt that Tesco remains the UK market darling, we believe its shares have yet to fully digest the implications of a successful expansion into the developing world.

Earlier this month, the company announced that it has signed an agreement to set up the first in a planned series of joint ventures to develop shopping malls in China. This joint venture will comprise three shopping malls in the cities of Anshan, Fushan and Qinhuangdao, each of which includes a Tesco hypermarket as the anchor tenant. And what’s more management plan to open 18 new hypermarkets in China in the twelve months up to February 2010.

Tesco is entering the Chinese market much later than Carrefour, Wal-Mart and Germany’s Metro all of whom have been operating hypermarkets in China for at least a decade. Encouragingly, Tesco can base its strategy on the mistakes made by others before them and in our view their diverse offering will see a rapid accrual of market share.

Asia generally is proving a bright spot for Tesco. Last year’s acquisition of Homeover in Korea is proving earnings accretive whilst Thailand and Malaysia are also making significant bottom line contributions. In Europe, the company has navigated Ireland’s economic quagmire successfully and Poland and Hungary have also posted impressive numbers.

Tesco has posted strong market share gains across a number of international territories. In the United States despite prolonged weakness in the California, Nevada and Arizona economies Tesco’s Fresh and Easy brand is continuing to make progress. Although loss making, the stateside expansion has benefiting from the transfer of some of its most promising UK employees and encouragingly sales for the 6 months to the end of August were over 70% higher year on year.

Tesco’s traditional role as a grocer has helped it successfully navigate the global recession however its increasing non food exposure leaves it perfectly placed to cash in as global economic recovery gains traction. With robust performance in both electrical and clothing, non-food sales rose 8% to £6.2bn, with 4% growth in the UK placed in the shade by 16% growth internationally.

As with J Sainsbury, Tesco provides investors with exposure to the rapidly changing financial sector. With rivals wounded, there has arguably never been a better time to set up a bank and we expect Tesco Bank’s earnings contribution to grow. With the Tier 1 capital ratio at the half year of 12.6%, there will be no capital adequacy concerns which haunt many in the industry.

From a financial perspective, Tesco has a robust property-backed balance sheet. Net debt is on-track for £8.5bn by year-end with further reductions planned in 2010/11. Cash flow from operating activities (excluding Tesco Bank) totalled £2.3bn (up from last year’s £2.2 billion) and hence management has been able to increase the interim dividend by 9%.

All factors considered Tesco will bolster our exposure to the defensive nature of food whilst also providing exposure to a global economic recovery.

The retailer’s offering is truly diverse and is expanding at rate of knots; its developing telecom arm is now offering Apple’s iPhone. Should low food price inflation impact food profits in the quarters ahead, Tesco is well placed to offset given its growing non food range. And whilst the group continues to bolster its online presence in mature markets, its entry into China and (even more embryonic) India tells investors that long term earnings are underpinned by robust developing world growth.

Switching to the charts, although the stock declined 42% from the November ’07 high of 494p to the low of 156p reached in March of this year, this decline is far less severe than that which was endured by most stocks during the same time period. This relative strength is impressive.

A look at the daily chart for the past two years shows us that since bottoming on the 7th of March, Tesco has risen steadily in a solid uptrend that has seen the stock gain 53% in nine months, recently clearing resistance at 400p to hit a 2009 high of 435p. This 400p level should provide support on any sell off while the 2007 highs of 494p are in sight. From a technical perspective Tesco’s share price performance has been impressive over the past few years. A performance we expect to continue.

From a valuation perspective, the shares trade on undemanding forward price multiple of around 15 times (this drops to 13.5 times in 2011) whilst being ably supported by dividend yield of almost 4%.

Accordingly we recommend Tesco as a buy to all members at 429p.


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