Tesco Plc’s decade of international expansion has pushed debt ratios at the UK’s largest retailer to record levels, endangering the company’s credit rating and sparking a backlash from fund managers and bondholders.
Bradley Mitchell, who helps oversee about $62 billion at Royal London Asset Management, said he stopped holding Tesco shares for the first time in 20 years in October as the stock didn’t adequately reflect the risks faced by the supermarket operator. Cheshunt, England-based Tesco has net debt of £9.6 billion ($15.6 billion) and this week sold £431 million of mortgage-backed bonds secured on commercial property.
“Tesco never get to the point where they generate cash,” said Mitchell. “At the end of every year, they have more debt than they did at the start because there’s always new markets to invest in. I used to be a big fan, but there is a lot to be concerned about.”
Tesco has increased leverage to pay for expansion in markets from the US to China as UK sales growth slips behind competitors. Borrowings in the fiscal year ended February 28 were equal to 3.96 times earnings before interest, tax, depreciation and amortization, the highest since at least 1988. Moody’s Investors Service last month cut the retailer’s credit outlook to “negative,” endangering its A3 rating.
“Tesco’s tolerance for financial risk has steadily increased in recent years,” said Georg Grodzki, head of credit research at Legal & General Group Plc, whose £280 billion of funds include Tesco bonds.
“You can’t help wondering if on their way to becoming a truly global player they are prepared to leave some of their traditional debt investors behind.”
According to data compiled by Bloomberg, Tesco’s Ebitda declined to £6.60 for every pound of interest paid in the last fiscal year, the lowest since 1993.
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The increase in borrowing ratios follows a year in which Chief Executive Officer Terry Leahy spearheaded £6.6 billion of spending on expansion, including the £958 million takeover of South Korea’s Homever supermarket chain.
Moody’s cut Tesco’s credit outlook from “stable” on May 28, saying the company is likely to take on more cash-draining leases in pursuit of its expansion strategy. The current A3 rating is the seventh of 10 steps on the investment-grade scale.
“Tesco’s credit metrics are not in line with the A3/A- credit ratings and there is good probability of downgrade to Baa1 at some point over the next 12 months,” said Sonia Van Dorp, a credit strategist at Societe Generale SA in Paris.
Tesco’s stock valuation has declined relative to smaller competitor J Sainsbury Plc over the past year. The ratio of share price to earnings for Tesco has shrunk 7.5 per cent to about 13 times, while the same measure for Sainsbury has risen 12 per cent to about 19 times, Bloomberg data shows.
Tesco still gets about 75 per cent of earnings from Britain, where competition from Sainsbury and Wal-Mart Stores Inc’s Asda, and discounters Aldi Group and Lidl has eroded its market share. Tesco plans to open 320 stores in Europe and Asia this year, increasing its selling space in the regions by almost 10 per cent, and will also add 60 more outlets in the US.
The international expansion hasn’t been without difficulty. Operations in China and Japan are not profitable, while earnings in eastern Europe are being sapped by slowing economies and the weakness of the Polish zloty and the Hungarian forint against the pound. Tesco’s first full year of business in the US produced a so-called trading loss of £142 million, more than the company’s own £100 million forecast.
“In the near term, it is not paying back returns,” Ching Mei Chia, associate director of Fitch Ratings Ltd’s European retail and consumer team, said of the supermarket company’s international unit. “Tesco’s debt is high for its rating, and we are expecting it to come down this year. It if doesn’t, then of course we would review our rating.”
Fitch cut its long-term rating one level to A- in February.
Tesco credit-default swaps have almost tripled in the past year, indicating a deterioration in the perception of credit quality, while swaps for Sainsbury have declined 4.5 per cent.
Tesco will cut net borrowings by £1 billion this year and next, Finance Director Laurie McIlwee said on June 17.
“Even though debt is high, it’s still a very healthy balance sheet,” McIlwee said in an interview. “I’m hoping we hold onto our A rating, it’s important to us, but of course we’ll do the right thing for the business.”
To be sure, not all investors question Tesco’s strategy. Guy Walker, who helps manage £9 billion at Schroders Plc including Tesco shares, said the company must continue to expand internationally to deliver returns for shareholders.
“Looking at what this company has achieved and the potential for future international growth, it’s a good long-term investment that won’t disappoint you,” Walker said. “This isn’t a company in distress — it has incurred debt to buy assets from distressed companies at good prices.”
The retailer is slowing its expansion in the US, where it has opened 115 stores since entering the market in 2007.
“The US business is still two-to-three years from break- even,” said Tom Gadsby, an analyst at Societe Generale in London with a “sell” rating on the shares.
Tesco this week said sales at UK stores open at least a year rose 4.3 per cent in the first quarter, excluding gasoline and value-added tax. Sainsbury reported a 7.8 per cent gain for the period and said it will add 15 per cent to its UK store space in two years, a faster rate of expansion than Tesco plans.
Tesco’s share of the £120 billion UK grocery market was 30.8 per cent as of May 17, according to Taylor Nelson Sofres Plc, down from a peak of 31.8 per cent in October 2007.
“At some stage they are going to disappoint,” said Paul Mumford, who helps oversee £600 million including Tesco shares at Cavendish Asset Management in London. Mumford said he doesn’t plan to increase his shareholding.
This week’s sale of asset-backed bonds, which are secured by store and warehouse leases, added to concern that the rating on the company’s unsecured debt may be cut in the near future.
Tesco will find it “difficult” to reduce its debt by £1 billion this year “given commitments in terms of capital expenditure and dividends,” Societe Generale’s Van Dorp said. “This is bad news for existing bondholders.”