Baloncici
Summary
Following my coverage of Tesco (OTCPK:TSCDY), for which I recommended a buy rating due to my expectation that TSCO will see its valuation multiples if its business performance continues to improve, this post is to provide an update on my thoughts on the business and stock. I reiterate my buy rating for TSCO as I stay bullish on its ability to continue delivering capital returns given its strong balance sheet and positive fundamental performance.
Investment thesis
TSCO reported its 4Q24 results two days ago, on April 10, 2024, where it saw the same store sales growth [SSSG] of 4.8%, driven by UK retail SSSG of 5.8%, Ireland SSSG of 5.4%, and Booker SSSG of 2.5%. In Central Europe, SSSG was flat in the quarter, a positive turnaround from being negative last year. Overall FY24 group sales saw 3.7% growth to GBP68.187 billion, with group EBIT coming in at 4.1% margin (GBP2.828 billion), representing 12.7% EBIT growth vs. FY23. Net income came in at GBP1.68 billion, translating to an adj. EPS of 23.41 pence. TSCO also continued its streak of paying out dividends to shareholders at 8.25 pence in 2H24, summing FY24 DPS to a total of 12.1 pence. This set of 4Q24 results further solidifies my view that TSCO can continue its streak of generating strong cash flow to support share buybacks and dividends, and there are areas of focus here: Underlying demand; margin expansion; balance sheet strength.
On underlying demand, it was very encouraging to hear TSCO winning market share (TSCO saw share gains of 30 basis points in the UK over the past 12 months) in this time of difficulty, which proves that TSCO price leadership is showing its benefits. With inflation expected to maintain a mid-single-digit percentage (according to management estimates) range for the rest of the year, having price leadership would mean that TSCO can continue to capture further trade-down motions and also hold on to the share gains over the past few months. During the call, I think management has sort of hinted on this as they noted progressive improvement in customer sentiment, where volume growth has been consistently ahead of expectations. I see a virtuous cycle for TSCO over the next 12 months: TSCO being the price leader attracts more consumers in this tough macro environment, which incentivizes suppliers to continue promotions because they want to recover volume, which further strengthens TSCO’s price leadership. This should further TSCO’s ability to gain market share.
On margin expansion, the major highlight was the GBP500 million (this is about 18% of FY24 EBIT) efficiency program (further savings are expected to come from a broad range of initiatives, including waste reduction, shared services, warehousing automation, logistics, AI solutions, and high margin revenue streams like retail media and catering) announced during the call. This is a massive announcement, which means that TSCO has another GBP500 million in its arsenal to support its price leadership strategy, further improving its share-gain abilities. Importantly, this also pushes TSCO’s EBITDA margin to higher ranks amongst peers. By my math, GBP500 million equates to ~0.7% of EBIT margin, which means TSCO could potentially have the highest EBIT margin (4.14% + 0.7% = 4.84%). The market is most likely to rerate TSCO multiples because of this.
Own calculation
On the balance sheet, TSCO’s balance sheet is at its strongest ever since FY19, where net debt to EBITDA leverage now stands at 2.24x, a decline vs. 3.3x in FY23. I see this as a very safe level, as it is below the management-guided range of 2.3x to 2.8x. The implications of having a strong balance sheet are that: (1) TSCO can continue to invest in its price leadership strategy (on top of the cost savings benefits); (2) TSCO can continue to return capital to shareholders without worrying about a debt covenant trigger; or (1). By my math, if TSCO were to continue its buyback streak and dish out the consensus expected DPS, it would need ~GBP1.5 billion, which TSCO can certainly afford given the GBP4.7 billion cash and expected free cash flow of GBP1.77 billion in FY25.
Own calculation
Valuation
Own calculation
My target price for TSCO based on my model is 356 pence, with a total return expectation of 30%. My model assumptions are that TSCO will continue to see growth at 4% over the next 2 years, similar to FY24, given the inflation levels and TSCO’s price leadership strategy to gain share. With operating leverage and the cost savings program (which I assume will be fully realized over 5 years, 70bps/5=14bps a year), TSCO should be able to see modest margin expansion ahead. I am conservative on my margin estimates because the timing of cost realization is hard to predict and management could be more aggressive in holding onto price leadership (which is a margin headwind but revenue growth tailwind). Comparing to other supermarkets in developed markets like the US and Australia, where comps such as Walmart (WMT), Woolworths Group, and Coles Group tend to trend around the 20 to mid-20s forward PE level, I see potential for TSCO to reach the same height over time given that their growth profiles are not really that far apart (TSCO to grow mid-single digits) while peers to grow at mid-to-low-end-of-high single digits and that TSCO margins are very competitive against peers. For note, TSCO used to trade at >20x= back in FY15–FFY17, so there is definitely precedent to this. That said, it is tough to assume a strong re-rating in the near term, so I am modeling TSCO to revert back to its 5-year average of 12x forward PE if the financials play out as I expected.
Risk
The risk to my estimate is a further wage hike in the UK that will definitely eat into margins, as TSCO is unlikely to pass through all the cost to consumers if it wants to stay competitive. Given the inflation levels in the UK, there is a potential for another rate hike (after the one on April 1, 2024), which will put further pressure on TSCO margins.
Conclusion
In conclusion, my rating for TSCO is a buy. The company’s strong balance sheet and positive fundamental performance solidify this bullish view. TSCO recent results with SSSG growth and margin expansion further support this outlook. I believe TSCO price leadership strategy positions it well in the inflationary environment, potentially leading to market share gains, and with the cost savings program announced, I am expecting TSCO to achieve higher profitability as well. There is also a potential for valuation to rerate further upwards back to its 5-year historical average if TSCO continues this growth streak and reports margin expansion.
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