Tesco is the worlds 3rd largest retailer and the UK retail sector leader. Its primary activity is based in the United Kingdom and the company is expanding into international markets, which are China, the Czech Republic, Hungary, the Republic of Ireland, India, Japan, Malaysia, Poland, Slovakia, South Korea, Thailand, Turkey, and the United States. The company’s group sale in 2010 was £62.5 billion in which the operational profit accounted for £3.5 billion. Currently, the company finally becomes the most profitable online grocery retailer in the world, and more than half of the company’s group selling space is outside the United Kingdom.
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The most attractive recent news about Tesco is its new CEO, Philip Clark, succeed Sir Terry as the retail giant’s boss on 2 March 2011. Within the same week, two pieces of news about Tesco’s further pushing forward in Southeast China and northern California were also announced respectively, which might lead to investors’ guess about whether this new boss, who was Tesco’s head of international and IT business, will take a more aggressive strategy for its international market. As we can see from the company’s market performance, the future of its international expansion is still full of uncertainty. The core UK food retailing segment still keeps 30% market share, however, the sales growth rate fell to a historically low level. The Christmas sales, especially non-food sales, in UK and Europe were negatively impacted by the bad weather last winter. The expansion in US market, which is loss making, was suspended in the past year and now, as the company announced, is restarted. The company’s operation and expansion is Asia seems promising, with high sales growth rates and fast new-stores-opening speed.
The company’s stock underperformed the FTSE 100 Index in the past year and keeps going down from the beginning of the year. In fact, all the five retailers we choose, most of which are the world’s largest, do not have satisfying stock performance recently. Bad news about the price rise from the suppliers’ side came this week bringing down the whole industry’s price. The current price of Tesco goes lower than our estimates and hits the bottom of the year. From January 2011, the company’s price decreased by a historically 10.58%. Investors’ worries about the current economic situation would be the main cause the sector’s underperformance. We expect an underlying earnings growth and hence a price growth of Tesco in a long-term perspective based on our forecast. The value of company will go up with the recovery of the economy, which is the external factor, and the growing internal operational performance. Therefore, we recommend a short term hold and long term buy.
Data source: Corporate Christmas sales reportThe latest supermarket giant Tesco’s 12-week total sales growth was 4.3% with the impressive double-digit growth in food segment. Giant player “Tesco” achieved positive strong performance in every business operation including food, non-food, and Tesco direct even though an unpleasant cold and wet weather especially adverse condition of snow over Christmas made things difficult not only for Tesco, but also its local crucial competitors like Sainsbury, Asda, and Morrison, Tesco’s operation and management were still well managed. It is undeniably that Tesco enjoyed an increase of like-for-like (LFL) sales compared to previous year; however, the rise in sales growth was inevitably suffering from the lift of petrol prices and the rise in VAT implying negative volumes if we assume progressive food inflation, which later may impede the stores’ growing space in the UK market.
Yet, the true story that people have to eat and the evidence of the top-line growth grants the UK operators to provide both defensive and growth characteristics to have more rooms of new spaces, develop product mix, and enhance continuing productivity improvement. Hence, giant supermarket like Tesco cannot just stop expanding business and market share, and as an efficient strong retailer, growing the revenue cost-effectively and profitably is far more important than winning the highest market share,
Europe: First time showing all positive LFL sales
Tesco operates in the Republic of Ireland, Poland, Hungary, the Czech Republic, Slovakia and Turkey, listed in descending revenues according to 2010 Annual reports. Although the customer expenditure suffers heavily from the recession, we have seen a solid sign of recovery in sales and profits in Europe. Shown in the Q3 report, till 27th November 2010, the performance of Tesco improves with sales up by 7.6%; compared to 6.4% from Q2 figures (Actual rates Ex. Petrol). Like-for-like sales achieve a growth at 3.6% (Ex. Petrol), which is 0.5% more than the last quarter, probably because of a strong improvement in Hungary and Turkey. Particularly in the third quarter, all European businesses succeed in acquiring positive like-for-like sales for the first time in three years. Thus we expect a continuing increasing trend in this region as the economies are slowly improving.
The main approach using by Tesco is to invest in new selling space. The company plans to double the space by 2014/15 to 4.1m sq meters. Part of the ambitious opening programme, Tesco has acquired 128 convenience stores in Czech Republic on 23rd December 2010, making the market share stable at 9%, which is the second position overall. Next we could expect this world leading retailer would push its plan further and expand its online models more in Europe.
In the non-food sector, Tesco is leading the clothing market. Building on the F&F brand, it opened up its own F&F Blue and F&F Basics in Central Europe. Tesco sold 68milions F&F items in this area and the clothing sales of the Tesco increased by 12% in 2010. Like-for-like clothing sales are also up by 14%.
US: When will Fresh & Easy be profitable?
One of the key decisions for Tesco’s new CEO, Mr Clarke, will be deciding whether to continue with the Fresh & Easy chain, which made a loss of £165m ($269m) last year. Fresh & Easy is designed as a small and convenient fresh food seller and this is its fourth year in the US. This totally different business format was criticized for would not meet US consumes’ habits when it was launched. Anyway, we think Tesco was extremely unlucky to enter US market before its economy fell into the worst recession since the 1930s.
The sales are growing at a promising rate over 38.5% in the third quarter 2010/11 which were mostly contributed from the Thanksgiving holiday. And during the Christmas and New Year holiday it grew up by 36.9%. However, Fresh & Easy still made a loss of £165m in 2009/2010 and a similar or larger loss would probably be made in 2010/2011. Tesco’s management predicts that it will reach profitability in 2012/2013. But this prediction is questionable since we did not see any signs that promise the profit. Even the US market leader, Wal-mart, had a historically rapid decrease in its sales growth rate in 2009/2010.
The company mothballed 13 stores last year, primarily in Arizona and Nevada, hit by the US housing market downturn. The expansion of Fresh & Easy was slow down in the last year, and under-utilised capacity still charged large amount of expenditure of the business. The latest news on Fresh & Easy’s website said 10 new stores will be open before the end of April in northern California, which indicates the company starts to push ahead the expansion again.
Asia: Key focus for the international expansion
Tesco has its Asian business mainly in South Korea, Thailand, China, Malaysia, Japan and India with 1300 stores. Remarkable performance has been shown in the Asian markets driven by opening new stores and due to its constant progress for the growth of powerful brands in Asian markets. The profits in 2010/2011 have drastically increased by 24% with margin strengthening of 6.1%. The sales growth in the Asian Markets in the year 2010/2011 was 23.4%. This substantial growth was mainly due to the investments that were made during the recession period and are paying off as the economies of these nations are improving. Due to the unseasonably warm temperature in the Northern Asia, the LFL sales of Tesco have been 4.3% which is a little lower than 5% in second quarter. It has been able to grow its business by expanding its club card and other retail business in these nations. Amongst these countries, South Korea has turned out to be the most productive, with an organic sales growth of 23.3%, like for like sales of 3.2% and profits up 50.9%. China is considered as epoch-making opportunity for future. The performance of Tesco in other countries like Thailand, Malaysia and India has also been fairly good as the sales have increased in these countries in spite of the political uncertainty and sharp recession in 2009.
Asian markets will continue to be key focus for the international expansion of Tesco as they offer a significant long term opportunity. Tesco plans to open new space of 4.9 m sq ft (excluding shopping malls) by next year and build 80 shopping malls by the end of 2015. While theJapan quake might suspend the company’s expansion in Japan market which Tesco just entered 4 years ago and counts 5% of its Asian sales in 2010.
Porter’s Five Forces
Industry Competition Position
Average Score: 3+
Threat of New Entrants
High level of entry in retailing industry: although easy for independent retailers, quite difficult for big chain stores. Abundant capital needed for human resources and storage costs; long time devoted to establishing brand and relationship with suppliers.
Power of Suppliers
Little power for retailing industry: presence of rich substitutes and suppliers; but suppliers may gain powers during special periods due to unexpected bad weather or new launching government policies.
Power of buyers
Although customers’ bargain power in the store is low, they can easily change among retailers to without any switch costs. The customer loyalty is low. The high price sensitive drives customers to seek for promotions and price reductions.
Availability of Substitutes
What one store offers you will likely find at another store. Retailers offering products that are unique have a distinct or absolute advantage over their competitors.
Competitive of Rivalry
Competition among the main players in retail industry is aggressive and rational. Promotional activity and new space expansion are growing at a historical rate to gain more market share. But the possibility of an irrational ‘price war’ is low.
*Scoring range 1-5 (high score is good) Plus = getting better; Minus = getting worse*
We expect the sales growth rate to go up based on the assumption that the world’s economy will recover in the near future, and the VAT and food price inflation will keep around current level.
Cost of goods sold as a % of sales is decreasing during the last five years, so we estimate that the trend will continue in the future. On the other hand, Tesco provides more price reduction and promotion now, especially when the competition with Asda in terms of price is going on, so the decrease of cost of good sold rate will not be too large.
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Depreciation to sales is around 2% in past years. Since the expansion of the company is pushed forward in the US and Asian market, the fixed assets will grow up as well. We forecast the depreciation will go up with the expansion, too. And in 2010 year, some properties bought in the US were idle since the company suspended its expansion in the US market, so the depreciation to sales in 2010 will be higher than usual.
Because selling is essential to retail industry and promotion reached in a historical high level as Wall Street Journal reported, we estimate SG&A expense will increase as a percentage of sales.
We forecast that the EBIT to sales will increase very slowly because of the growing depreciation cost and SG&A expense. Therefore, the Net Margin may stay steady or go down marginally based on the increased interest expanse from the higher leverage level and the higher tax.
The company expanded its assets significantly in 2008/09 and then suspended the expansion in 2009/10, especially in terms of current assets. According to the recent news, Tesco pushes further into China and US market this year, therefore, we expect the amount of assets will be enlarged. And non-current assets grow as a percentage of total assets.
Working capital is calculated by current assets minus current liabilities. The change of working capital in future is at the historical average rate of 6.48%.
Residual Income Model
We employ residual income model (RI) to value Tesco. With residual income model, the value of equity is forecasted to be approximately GBP 46 billion with the price target of GBP 5.77. The cost of equity is used in the model rather than the group WACC since we base on the net income. The cost of equity is derived from assessing the group’s exposure by running the regression to obtain the group’s beta. FTSE all share is used as a market proxy and US 3-month T-Bill yield is taken as risk-free rate in the regression. Our estimation of the group’s cost of equity currently is 11.64%. The growth of income is assumed to be constant over the long period at 9.5%. However, the sensitivity analysis is provided for different percentages of cost of equity and growth rates.
Discounted Cash Flow Model
Using DCF model, we assume a terminal growth rate at 8% and cost of equity at 11.64%. Net debt will decrease based on Tesco’s current strategy to adjust its leverage, while net non-current assets will rapidly grow because of the international expansion strategy.
Multiples Valuation Model
There we use P/E as the multiple to estimate the prices of Tesco and its four peers. The expected earnings are obtained from Thomson One Banker. Expected earnings, expected value and number of shares outstanding are presented in millions. The expected value is calculated by timing peer average P/E with expected earnings
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