The bears are in town. Investors are betting on a decline in Tescos (LSE: TSCO) stock price as optimism around chief executive officer Dave Lewiss revival plan has waned,Bloombergstated on Friday.
Tesco short sellers are coming back in droves, the news agency wrote, adding that the number of bets taken out against the companys share price has risen sevenfold since Tescos annual results in April.
In a short selling,investors borrow shares from a broker in order to sell them to someone else at the current price, betting that their value will fall fairly quickly. If that happens, they can buy the borrowed shares for lower than the price they sold them for, in order to fulfil the trade, thereby banking a profit.
This sort of trading carries big risks if the price goes upyouve got to buy the borrowed shares for more than youve been paid and is likely to backfire with Tesco, in my view.
Two Problems
The first problem is to determine whether the UKs largest grocer will be able to hit a 2016 underlying trading profit higher than 1.3bn1.4bn, hoping that Tesco will meet estimates of 1.6bn and 1.8bn in 2017and 2018, respectively.
Investors also have tomake sure that based on the value of its assets Tesco is a reasonable value play.
Trading Profit
Say that Tescos sales decline 2% to 61bn in the current year (fiscal 2016) a drop in line with that of fiscal 2015.Both its quarterly performance at constant rates, excluding fuel and VAT and market share data suggest that such a performance is pretty likely.Id not expect Tesco to surprise investors on this front.
Its 2015 trading profit was down 58% to 1.39bn year-on-year, with the UK the biggest revenue contributor at 43bn, excluding VAT generating some 467m.Previously a cash cow, the UK operations have become a money pit.
Its domestic tradingmargin came in at 1.07% in 2015, a reduction of almost four percentage points year-on-year: the impact of like-for-like sales decline was clearly felt, but thecombinationof prior initiatives and net cost base inflation had a bigger impact on Tesco poor performance, which read -79% over the previous year in terms of trading profit.
Prior initiatives, inparticular, were a drag on performance, and a much bigger issue than much-publicised investment in lower retail prices.
Quite simply, onceprior initiatives in the UK are deducted and theres reason to believe they will go down over time the New Tesco led by Mr Lewis may be able to record a trading profit margin of between 2.5% and 3%, yielding a trading profit of between 1.5bn and 1.8bn -. There are risks associated withthese estimates, but Tesco could indeed hit its medium-term goals sooner than expected.
You should also consider that its Asian operations reported 9.8bn of sales and a trading profit of 565m (down 18%, trading margin at 5.7%), while Europes 8.5bn of revenues contributed 164m (down 31%, trading margin at 1.93%) to the groupsunderlying trading performance.
Management is playing down expectations, of course, but a target of at least 1.5bn for a 2016 trading income is doable, Id argue.
Assets
Some 5bn of undrawn credit lines cover for the majority of its net debt position, while the duration of its debt profile offers some reassurance, although net leverage is high.
So, lets move on tothe value of its current and long-term assets.
Taking into account the book value of:
- inventories, 2.9bn(as at 28 February)
- trade and receivables, 2.1bn
- loans and advances to customers, 3.8bn
- Cash and equivalents, 2.1bn
- other current assets, 650m
youd be buying Tescos equity at 213p a share against 11.5bn of cash-like items, whose value is 141p a share.
Yet there are still some 30bn of long-term assets that must be taken into account.
If we apply to these non-current assets a massive discount of about 80%, thus betting on huge write-downs over time, wed still have to add6bn (about 74p a share) to a valuation of 141p a share for Tescos current assets.
Then, Tescos equity would be valued at 17.5bn, which is bang in line with its current market cap, butdoes not includethe difference betweenthe book value of its total long-term assets and the aggregate value of net debt, discounted operating lease commitments and pension deficit.
Thats about 37p a share, or 3bn in terms of additional market cap.
That said, several risks still surround Tesco, and you may also needmore evidence to invest your savings in shares at present time.
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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK owns shares of Tesco. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.