Tesco: Phase 2 - reset investor expectations

It’s always entertaining to see good people-management at work. As with a new Government, a new management needs to persuade the stakeholders that their predicament is substantially worse than previous team were letting on, but that with a little pain, the new team and plan (usually with a catchy name) will secure recovery by the time their contracts come up for renewal. This however requires a reset (down) in expectations, which usually is accompanied by the obligatory ‘kitchen sink’ job, followed by selected acquisitions with plenty of fair value adjustments that if handled correctly can often be written back to deliver the required ‘recovery’, albeit sometimes to below the original start point.

So far, we have had the ‘predecessor-trashing’ and now with the Dec 9 pre-announcement, we are being softened up for the reset in expectations. Management have given markets just one number (under £1.4bn for FY15 trading profit) and it is a bad one, suggesting a near -75% YoY collapse in H2 FY15. What we are not being permitted to see at this stage are the components of this performance; ie how much from a further deterioration in UK like-for-like sales or whether significant provisions and charges have been levied against this period that may not be recurring. Without these, markets will not be able to gauge properly the depth of the underlying margin trough or the businesses capacity to recover. For this (hopefully), investors will have to still await the planned announcement on the 8 January. By then, investor expectations ought to have tanked and markets will be grateful to suck up any plan that offers recovery even if to a substantially lower margin base than hoped for only a few months previously.

Enterprise Inns: Asset play or just value trap?

Enterprise Inns (ETI): With a share price at an almost 60% discount to NAV, this may appear to be a compelling asset play, albeit this argument might have also appeared valid when the discount was 30%,40% or 50%. As with banks in 2008, a balance sheet asset is only as good as the credibility it has that it can either be crystallised and returned efficiently back to shareholders or that the level of assets are a true reflection of their capacity to generate future free cash flow streams. For Enterprise Inns, the NAV of approx. 250p per share meanwhile drops to nearer 230p ps excluding intangibles (largely acquired goodwill) and this is the sum of 680p ps (£3.8bn) of fixed assets (mainly property) against an approx. 450p ps of liabilities (£2.5bn; £2.4bn being net debt). Assuming that the liability part of this remains stable (ie the group not being hit by refinancing, closure or other provisions), then the excess fixed assets over liabilities is £1.3bn (230p ps) or just 34% of fixed assets. With falling beer sales, pub industry revenues are in decline and with it, so have pub property values. Indeed, although ETI has been booking occasional small exceptional gains on estate disposals, the overall position is one where impairment charges of over £0.5bn (approx. 90p ps) have already been recognised by it on its portfolio over the past 4 years alone. With financial repression artificially supporting residential property values, there is a potential alternative use value that could provide a support, although at this stage there is little way for external investors to determine what this might actually be.

As an ongoing business, ETI’s valuation as an equity will need to take into account the lack of organic growth, notwithstanding the high cash costs of maintaining and upgrading the portfolio and the approx. £300m pa of EBITA, but nearer £250m pa on a cash basis (post capital expenditure rather than depreciation).   With an EV of approx. £2.85bn, ETI is therefore currently priced at approx. 11x cash EBITA and a normalised Op FCF yield of around 6%; the latter implying an annual discounted growth rate of around +4.5% pa. Against organic growth struggling to get to even half this level and no dividend support, this would seem ambitious. In summary a potential asset play on presently undefined alternative residential use as long as financial repression can sustain absurdly low current buy-to-let yields in the South of England, otherwise a ‘value’ trap.

In the meantime, the enthusiasm of the NAV is obscuring the growth rating being afforded the business. After several years of heavy investment in sprucing up the portfolio, organic revenues are beginning to stabilise, but still to well under the implied growth rating of the overall group.



Perhaps, markets are missing the future growth potential and scope for over-delivery? While always possible, this however is not reflected by consensus expectations where earnings moment remains broadly flat to down across 2014 (see below chart).



So, what we have is a business that may or may not have a potential asset backing which may or may not ever get distributed to shareholders, which is carrying a heavy financial leverage that is being serviced from flat to falling cash flow from an ex-growth business model but has still managed to command a premium growth discount.  Given the financial leverage, small reductions in growth discount have an amplified effect on the equity, so take the growth rating down by even 20% from the current +4.5% to even +3.6% and the equity component would face wipe-out!

November non-farm payrolls – Bah Humbug!

I can hardly contain myself with excitement. US non-farm payroll data for November is out and the headlines are that the +321k MoM additions (+314k for the more relevant Private sector jobs) “smashes forecasts” (Guardian) and that “The dollar has gone through the roof” (City AM). With another month of unemployment at only 5.8% (try to ignore the participation rate), this should get the President hot-footing it from the golf course to make another speech on how well his policies are working!

So what’s all the excitement about?   Yes, November has broken above the +300k level which nowadays is a pretty rare occurrence and on a MoM basis, the pickup in what should be higher added value areas such as Professional & Business Services, Construction and Goods Producing should auger well for incomes, albeit the evidence for that is unfortunately still rather tenuous with average weekly hours of 34.6hrs up by only +0.3% both MoM and YoY from October’s and last November's 34.5hrs and with average hourly earnings of $24.66 per hour up +0.37% from October's $24.57 and up by +2.1% YoY from last November's $24.15 per hr.



Notwithstanding the brouhaha, the year on year performance remains disappointing given the $80bn pm of QE ‘goosing’ for most of the period. Over 12 months, private sector employment growth of +2.3% has only just exceeded overall population on a percentage basis, but has struggled to match the absolute increase. From the below table, one can also see a mixed profile by industry. Normally high value added areas such as Prof & Bus Serv have done well at +3.7%, but the normal premium end of this in Financial (at +1.4%) and Legal (not disclosed but flat), have been struggling, so it looks like recruitment has probably been at the lower end of the scale. Temporary Help meanwhile leads to pack with an +8.5% YoY increase, with Leisure, retail and Service industries providing the main absolute drivers to YoY growth – more burger flipping and check-out jobs!



Where’s the growth driver?
With around two-thirds of economic growth coming from personal consumption, one has to wonder where this is going to come from. The 99% still look fairly maxed-out on their student loans, mortgages, auto loans etc and with property prices settling back the prospects for equity withdrawals and other forms of debt fuelled spending can’t be that good. Recent oil price falls and lower ‘gas’ (petrol/diesel) prices have been used to talk up consumption stories, although the offsetting inflation from food and health seem to have been borne out in the grim ‘Black Friday’ sales data (down over 10% YoY and not a function of online which seems to be flat).

Bah Humbug!
While it may seem unseasonal, it is worth taking a quick look at the numbers. With the public sector ultimately funded by the private sector, private sector income growth is a crucial component to overall GDP prospects. A +2.3% YoY increase in private sector employment with an average earnings up only a miserable +2.1% pa (annualised, less on a rolling 12 month basis), means total private sector incomes must be up by under +4.8% or by +$0.238 tn to $5.24tn. Against the approx. +4.0%/+$0.683tn increase in overall US GDP to $17.56tn over the same period, private sector income growth only provided 35% of this increase. How much of the remaining growth (of $0.445tn) can be directly attributed to the near $1tn of QE during the period will no doubt be cause for debate, but with sub-inflation income growth, more wars and more deficits a few more disappointing retail announcements and markets will be clamouring for “moar,moar moar”.

Airlines and oil prices

With fuel costs representing 45-50% of an airline’s operating costs and 35% of its revenues, it would seem self-evident that a significant movement in oil, and therefore fuel prices, would have an equally dramatic effect on margins; in particular when the industry’s margins are often the wrong side of 5%. The oil price however is a tide that raises or lowers all boats equally, albeit the same rate of price change will have a much more pronounced percentage impact on the less competitive and therefore lower margin players. As such, this might suggest a strategy of “buy the dogs” in the current falling oil price environment, although this would be a mistake. The problem is that margins are determined by the relative operating efficiency of the carriers and that ultimately any change in fuel as a cost component will be competed away. This is why there is such a poor correlation between the transport industry’s historic operating margin performance and its principal cost item, fuel (see below chart). Chasing the low margin airline stocks on the basis of a quick margin boost from low oil prices therefore is the wrong play. Instead, use the oil fueled rally to dump the dogs.

No negative correlation as one might have expected!

If you need to see what really drives airline margins, look no further than the macro environment. US private sector employment provides an accurate proxy for US corporate investment and US economic cycles and also for airline margins, as can be seen in the below chart. Oil prices provide a useful broker story for the muppets, but it is the bigger picture of the broader economy that really drives the industry. In this context however, the oil price movement cuts both ways. Is the recent collapse in oil prices a lead indicator of slowing demand and therefore a precursor for a negative headwind which will impact cyclicals such as airlines or something else? Certainly the involvement of Saudi Arabia in pulling the rug from under the oil price after meeting with Romney suggests an element of “get Putin” behind this, although this would not have been possible if the underlying growth out of the BRICs had not been softening and Europe not been sinking back into recession.

Transport industry driven by the top line not the cost line