Tesco the banker of the sector

Archived article dated Monday August 4th 2008

Even in its non-core area of banking Tesco seems to be doing particularly well, especially when compared to the 'specialists' in the field - the big high street banks.

by Glynn Davis

It has built up a decent quality debt book with only a small number of loans in arrears and has a 4.3 per cent share of the motor insurance market in the UK.

The one thing the supermarket will not have liked about its Tesco Personal Finance (TPF) division is that it has had to share its growing returns with its joint-venture partner Royal Bank of Scotland. This is why it this week bought out its partner in a £950 million deal.

Unlike the big banks TPF does not have any exposure to those nasty things called corporate lending and mortgages so the City was fine with waving the deal through at almost 11x TPF's earnings for this year (double the level of the major banks).

What will have excited the financial community is the growth Tesco is forecasting for TPF with pre-tax profits expected to move up from a current £384 million to £1 billion. When taking a five-year timeframe this would give a Compound Annual Growth Rate (CAGR) of an impressive 21 per cent.

This growth will be fuelled by Tesco's plans to add additional products (something that it has not been that great at in the past but since the big banks are so poor there is still a good opportunity in this area), and the building up of its financial services in overseas markets where its brand is well known to consumers.

In a note this week Bernstein Research was pretty positive on Tesco and set a price target of 440p, compared with a current share price of 361.8p, which puts it on less than 11x the broker's 2009 forecasts.

More importantly it also looks attractively valued against its European rivals and it against these competitors that Tesco should today be compared as it is the only global operator among the UK's major food retailers. And in the current climate its international exposure puts it in a sweet spot - not only does it provide solace from the current domestic difficulties but it also enables Tesco to tap into the world's long-term growth markets.

This is why Tesco has added square footage overseas at 21 per cent CAGR over the past five years, which has generated (that same number again) 21 per cent CAGR in sales over this same period.

What has spooked the City over the years has been the Return on Capital Employed (ROCE) of only eight per cent overseas that has been poor in terms of the UK that delivers more than double this rate. But as Tesco gains a foothold in markets and increases its sales densities then this is open to improvement. An increase in sales per sq ft of 25 per cent would bump up ROCE to 10 per cent.

And of course, as the returns from the home market continue to come under pressure then the differential will be further reduced. What also adds to the ROCE in the UK is property values, which could account for a massive eight per cent of the 18 per cent achieved.

What is crystal clear is the conviction with which Tesco is expanding overseas with Bernstein predicting that the grocer's international operations will drive 59 per cent of profit growth and account for 41 per cent of group revenue over the next five years.

With these sorts of numbers bandied around it highlights just how limited the real long-term scope for growth is at the UK's other grocers and that Tesco is the only stock pick in the food sector for those playing the long game.

Tagged as: glynn davis | tesco

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