CORPORATE FINANCE : Sainsbury VS Tesco
8/8/2008
A Financial Perspective |By:K0750207
Words: 2999
Index
. Summary......................................................................3
2. CAPM.........................................................................5
3. WACC........................................................................5
4. Sensitivity analysis...........................................................6
5. Capital Structure...............................................................7
6. Dividend policies..............................................................9
7. Ratio Analysis.................................................................11
8. Corporate Strategy............................................................14
9. References.....................................................................18
Summary
This Report features up to a five-year record of Tesco plc and Sainsbury plc financial performance, position and cash flows. The information is extracted from financial statements and relevant theories are used to evaluate the two firms as investment opportunities. The report contains key statistical data and ratios which would help managers understand the current and future position of the two companies.
.1Company overview
J Sainsbury plc
J Sainsbury plc is a United Kingdom-based company principally engaged in grocery and related retailing, and financial services. The Company's businesses are organized into two operating divisions: Retailing (supermarkets and convenience stores) and Financial Services (Sainsbury's Bank). J Sainsbury plc consists of Sainsbury's, a chain of 504 supermarkets and 319 convenience stores, and Sainsbury's Bank. (googlefinance.com)
Tesco plc
The UK's leading retailer Tesco was floated on the stock exchange in 1947 and in 1995 took over rival Sainsbury's position as the UK number one. The company launched a home shopping service in 2000, allowing customers to order their shopping online. Tesco is now expanding its convenience stores and overseas into areas such as Taiwan, Malaysia, Poland, the US and Ireland
2. Capital Assets pricing model to calculate cost of equity (Tesco plc)
The CAPM says that the expected return on any asset donated by E(Ri), depends upon the risk free rate, the security's beta and the market risk premium:
Risk free rate
The interest rate that is given on gilts is taken as the risk free rate because the British Government is reckoned to be one of the least likely entities in the world to default on a loan, this rate of interest is reckoned to be about as close to risk-free as you can get. In the UK this century, it has been about 5.6% per year. (www.fool.co.uk)
Beta
The Beta is taken as .93 from London Business School risk analysis
Market return premium
The market return is assumed at 8% depending upon the sector.
Therefore, Cost of Equity= 5.6+0.93(8-5.6)
= 7.83%
Capital assets pricing model to calculate cost of equity (Sainsbury plc)
Rf= 5.6% taken from returns on gilts.
Beta= 1.07 London Business School
Rm=8% assumed as market rate is higher than risk free rate
Equity=6,005 Million
Cost of Equity=5.6+1.07(8-5.6)
= 8.16%
2.1Calculating WACC using CAPM (Tesco plc 2008)
The weighted average cost of capital is the rate of return that the firm must expect on its average-risk investments in order to provide a fair expected rate of return to all its security holders. (Brealey,Myers,Marcus)
WACC= (D/V*(1-T) rdebt) + (E/V*requity)
Debt=5972M
Equity=31384M
Value = Equity + Debt= 37356M
Tax= 30%
Cost of debt=5.6
Cost of Equity=7.8%assumed
WACC= 5972/37356*(1-30) 5.6 + (31384/37356*7.8)
=7.1%
Calculating WACC using CAPM (Sainsbury 2008)
Debt= 2084M
Equity= 6005 M
0.98
Value= 8089 M
Tax=30%
Cost of debt=5.6%
Cost of equity=8.1%
WACC= 2084/8089*(1-30) 5.6+ (6005/8089*8.1) = 6.9%
2.2Sensitivity Analysis using asset beta
Sainsbury's
Equity beta=asset beta*1+D/E
.07=assest beta*1+2084/6005
=1.41
CAPM cost of equity=5.6+1.41(8-5.6)
=8.9%
WACC=2084/8089*(1-30) 5.6+ (6005/8089*8.9)
=7.65
Tesco plc
Equity beta= assest beta*1+D/E
.0.93=assest beta*1+5297/31384
=1.0
Cost of equity=5.6+1.0(8.56)
=8%
WACC= 5972/37356*(1-30) 5.6 + (31384/37356*8)
= 7.3%
3. Capital Structure of Tesco plc and Sainsbury plc
Capital structuring in particular locating the optimal capital structure have for a long time, been a focus of attention in many academic and financial institutions that probe into this area. The major breakthrough in capital structuring theory came with Modigliani and Miller's [M&M] propositions (Modigliani and Miller,1958). They had three approaches to how capital structure can affect the value of the firm. The theories are explained using ...
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.0.93=assest beta*1+5297/31384
=1.0
Cost of equity=5.6+1.0(8.56)
=8%
WACC= 5972/37356*(1-30) 5.6 + (31384/37356*8)
= 7.3%
3. Capital Structure of Tesco plc and Sainsbury plc
Capital structuring in particular locating the optimal capital structure have for a long time, been a focus of attention in many academic and financial institutions that probe into this area. The major breakthrough in capital structuring theory came with Modigliani and Miller's [M&M] propositions (Modigliani and Miller,1958). They had three approaches to how capital structure can affect the value of the firm. The theories are explained using the table beneath:
Sainsbury
2008
2007
2006
2005
2004
Market Price - Year End (£)
3.43
5.5
3.33
2.89
2.98
Market Capitalisation (£mil)
6005
9456
5670
4961
5073
Long Term Loans
2,084
2,039
2,126
,704
,879
Gearing (Debt/ Equity)
54.5
65.97
69.92
58.0
59.03
WACC
6.9%
Value of the Firm (£mil)
8,089
1,495
7,796
6,665
6,952
Tesco
Market Price - Year End (£)
4.01
4.32
3.38
3.05
2.58
Market Capitalisation (£mil)
31,384
34,192
26,703
23,588
8,831
Long Term Liabilities
5972
4146
3742
4511
4346
Gearing (Long term Debt/ Equity)
87.06
74.54
78.78
64.82
73.67
WACC
7.1%
Value of the Firm (£mil)
37356
38338
30451
28099
23177
Fig.2
The Traditional Approach to capital structure or financial gearing. This approach suggests that financial gearing can bring both benefits in terms the value of the firm and dangers because it can make the firm more risky. Taking the case of Tesco and Sainsbury above when Tesco had increased the gearing in 2006 from 64.8% to 78.8%, value of the firm increased. But, when in 2008 the company geared up to 87% the value of firm decreased because at lower levels of financial gearing the cost of equity is offset by cheaper cost of debt.
However after a certain level of optimal gearing, the financial risk by the shareholders increases and the cost of equity also rises. This has a negative effect on the firm's value as in 2008; the value went down compared to the previous year. Similarly, in the case of Sainsbury in 2006 the company had geared up to 169% increasing the financial risk to shareholders and therefore, increasing the cost of equity which would offset against the cheaper debt. The company de-geared in 2007 reducing the cost of equity and increasing value of the firm. But, when in 2008 it further reduced gearing, the value of the firm reduced as cheaper cost of debt could not be offset by higher equity costs at that level of gearing. (Spicer, Rugman 2004)
Another approach is Net Operating Income (NOI) approach to capital structure. This is in two parts - without and with taxes. In a real world increase gearing can reduce WACC and increase shareholder value. But, it is important to find the optimal gearing structure, which would maximise value of the firm. For, example in the case of Sainsbury the current position of the firm the gearing is 54% and value of the firm is 8,089. The optimal gearing would be at 65.9% which would increase the value of the firm to 11,495.
4 .Dividend policies
A dividend policy is a trade-off between the retaining earning on one and paying out cash and issuing shares on the other. According, to Miller and Modigliani in a perfect world, dividends are irrelevant. Paying dividends reduces the size of the company, thus decreasing the value per share in direct proportion to the dividends received. If the firms have a positive NPV project then shareholders would prefer the firms to invest. But, they ignored taxes and transactions costs and in a real world dividends can be important for both the company and shareholders.
In the case, of Tesco hasn't given any dividends but Sainsbury increased dividend to 12p compared to previous year. There could a reason where both the companies feel that they are in the growth part of the life cycle and therefore, cash is needed for developments and investment in growing market share.
Current developments and investments opportunities
J Sainsbury plc and British Land Company plc announced that they have agreed to create a £1.2 billion joint venture property partnership incorporating 39 superstores across the United Kingdom. The superstores, currently owned by British Land and leased to Sainsbury for 20 years, form the basis of the new 50:50 joint venture partnership.(Reuters.com)
Tesco expansions
Tesco has become an international retailer and has expanded in to new markets; the Tesco expansion plan is a part of increasing market share and diversifying to reduce risk through entering markets and utilizing cash.
Tesco Corporation announced the acquisition of two tubular services businesses. The Company completed the acquisition of Lightning Casing, Inc. of Parachute, Colorado for a purchase price of $12.0 million on July 31, 2007. In addition, the Company completed the acquisition of Hill's Casing Service Ltd. of Grande Prairie, Alberta for a purchase price of $5.7 million on August 2, 2007. Lightning provides conventional casing running and tubular services in the Rockies and the Hill's Casing Service provides conventional casing running and tubular services in the northwest Alberta and northeast British Columbia regions.(www.reuters.com)
Principal agency theory problem
The agency explanation suggests that the role of dividends is to ensure that managers 'disgorge' free cash flow (defined as cash flow in excess of that required for all positive NPV projects) rather than waste it on unprofitable investment and managerial slack,. (Archbold, Smith 2004).
In a real world scenario taking both the companies the agency theory does not help to define whether a consistent dividend structure can lead to agency problems. In the case of Tesco and Sainsbury both believe in expansion and gaining market share to increase the value of the firm and thus, increase shareholder value.
Fig.3
Source: corporateinformation.com
Signalling effect
Share buybacks scheme by Tesco sending strong signal to the market and investors as Group sales rose 10.9% to £46.6bn with its 1,500 UK stores bringing in sales of £35.6bn. The firm's international expansion continued, with 8.2m square feet of new store space being created abroad and total international sales up 18%
Tesco originally said that the programme would allow it to return at least £1.5bn to shareholders through share buybacks, but it has now said it expects to return at least £3bn. (news.bbc.co.uk).
In the case, of Sainsbury's signal has been week as the company decided to increase dividend in year 2006 after increase in earning and after that have not paid dividends. Therefore, inconsistency may have a negative effect on the share price.
5. Ratio Analysis
TESCO PLC
FINANCIAL RATIOS
2/29/2008
2/28/2007
2/28/2006
2/28/2005
2/29/2004
Dividend Yield (5yrav.)
0
PE Ratio
35.1
Current Ratio
0.61
0.56
0.52
0.57
0.56
Liquidity Ratio
0.38
0.32
0.33
0.35
0.35
Shareholders Liquidity Ratio
.46
.71
.66
.69
.59
Solvency Ratio (%)
39.17
42.35
41.57
44.13
42.80
Asset Cover
5.05
5.98
6.03
4.52
4.27
Gearing (%)
87.06
74.54
78.78
64.82
73.67
TESCO PLC
PROFITABILITY RATIOS
2/29/2008
2/28/2007
2/28/2006
2/28/2005
2/29/2004
Profit Margin (%)
5.93
6.22
5.66
5.78
5.19
Return on Capital Employed (%)
4.08
5.93
4.86
3.68
2.36
Interest Cover
2.21
3.28
0.27
9.35
7.20
Stock Turnover
9.46
22.08
26.95
25.95
25.70
J SAINSBURY PLC
FINANCIAL RATIOS
3/31/2008
3/31/2007
3/31/2006
3/31/2005
3/31/2004
Dividend Yield(5yr av)
3.02
P/E Ratio
18.65
Current Ratio
0.66
0.71
0.80
0.85
0.83
Liquidity Ratio
0.40
0.50
0.68
0.74
0.67
Shareholders Liquidity Ratio
.92
.74
0.96
2.04
.98
Solvency Ratio (%)
48.79
45.42
30.49
37.65
40.53
Asset Cover
4.85
4.58
5.85
6.82
5.81
Gearing (%)
54.57
65.97
69.92
58.00
59.03
J SAINSBURY PLC
PROFITABILITY RATIOS
3/31/2008
3/31/2007
3/31/2006
3/31/2005
3/31/2004
Profit Margin (%)
2.69
2.78
0.65
0.10
3.56
Return on Capital Employed (%)
6.38
6.96
.31
0.23
7.94
Interest Cover
4.63
5.46
.67
.12
8.18
Stock Turnover
26.19
29.07
27.88
27.57
22.7
Fig.4
Source: (fame.bvdep.com)
Trend Analysis of Tesco plc and Sainsbury plc for the last five years taking in to account few important ratios:
Return on capital employed- Tesco has seen a strong growth in year on year return on capital employed. From 12% in 2004 to 14% in 2008, this shows that the company is using its assets well compare to Sainsbury which has seen a low return on its capital, in 2005 it went to as low as 0.23 from 7% in 2004. The ROCE for Tesco suggest that the company is getting value for its current borrowing and Sainsbury's return has increased to 6% in 2008, but it has not been consistent over the few years.
Profit Margin- It is important to compare the profit margins of the two companies because they are in the same sector and share same customer base. Tesco year on year growth has been very marginal but, it has been consistent, profits margins have been consistently over 5% for past years. Sainsbury plc has seen a slow growth especially in 2005 and 2006; the growth was down to 0.10%. It shows uncertainty in the company to generate good revenues.
Stock Turnover- This ratio is important as both the companies are in a food retail business. Therefore, faster the turnover time, the less wastage of inventory and the companies can depend just in time delivery. But, both the companies are shows consistent and fast turnover time. Tesco is slightly better.
Interest cover- The interest cover for both companies fell in 2008 from previous year. Interest cover ratio shows whether the companies are earning enough profits before interest and tax to pay its interest costs comfortably. Tesco's interest cover is high because its highly geared compared to Sainsbury, but the fall in interest cover needs to be looked at carefully.
Gearing Ratio- The higher a company's degree of leverage, the more the company is considered risky. As for most ratios, an acceptable level is determined by its comparison to ratios of companies in the same industry. A company with high gearing (high leverage) is more vulnerable to downturns in the business cycle because the company must continue to service its debt regardless of how bad sales are. A greater proportion of equity provides a cushion and is seen as a measure of financial strength. Tesco has geared up highly over the years to 87% in 2008, but has also increased it EPS due to consistent rise in sales and share buy backs. In comparison to Sainsbury which has a gearing of 54 %, Tesco could face risks if its sales fall.
P/E Ratio- A strong P/E represents strong investor confidence in the company and its future. Tesco has a much higher P/E ratio compared to Sainsbury for the year 2008. The current share is also factored has factored in investor expectations of growth in profits and EPS in the future.
Dividend yield- It is the dividend return a shareholder currently expects on the shares of a company. Tesco did not pay dividends for the past few years and therefore, its zero. But, this can be related to the Tesco corporate strategy of expansion in positively NPV projects. Sainsbury's dividend yield has been 3.02 but it has not been consistent. This is due to changes in annual dividend.
6. Corporate Strategy: Tesco and Sainsbury
Tesco
Tesco has a long term strategy for growth, based on four key parts: growth in the Core UK, to expand by growing internationally, to be as strong in non-food as in food and to follow customers into new retailing services.
Growth in the UK business comes from new space, extensions to existing stores and a multi-format approach. Sales of non food, which are growing significantly faster than the rate of food, also contribute to the overall growth picture.
Tesco International is based upon acquisitions and mergers with local companies. But, it is important to see whether their international expansion has increased shareholder value and the impact of such strategies on the performance of the firm. Geographic expansion in to the new may increase shareholder wealth if there is little or no competition in the new market. Looking at two relevant out of the four hypotheses on M&A motives:
. The market for corporate control- The corporate control refers to the monitoring, supervision and direction of a corporation or other business organization. (Megginson, Smart, Lucey). Tesco launched its Asian business through the acquisition of the Lotus chain in Thailand in 1998. Today over eight million customers every week shop in 636 stores across Asia: in China, Japan, Malaysia, South Korea and Thailand.
2. Synergy Hypothesis-This refers creating synergy of the target firms resources to improve performance and market share through economies of scale. For example Tesco is developing a very good market position in Malaysia, with plans to add a further 22% of space in 2006. The eight Makko stores that Tesco acquired in January will double the space when converted.(tescocorporate.com).
Impact of these strategies on financial performance (Asia expansion)
Fig.5
Source:tescocorporate.com
The expansion has had a positive impact on the overall sales and markets share of Tesco. But, whether it is helped in increases the share value is still not clear.
Impact on share price
Fig.6
Source: yahoofinance.com
Sainsbury
Sainsbury corporate strategy is totally different from Tesco. They want to recover from loses in 2005 and grow within the home market. According to Sainsbury's website the company plans to accelerate the growth of complementary non-food ranges: To continue to develop and accelerate the development of non-food ranges following the same principles of quality, value and innovation and to provide a broader shopping experience for customers, reaching more customers through additional channels and to extend the reach of Sainsbury's brand by opening new convenience stores, developing the online home delivery operation and growing Sainsbury's Bank.
Fig.7 (12manage.com)
Sainsbury's strategy can be defined by the 3c's model where Sainsbury is planning to improve its services for the customers by adding new channels. They should have done this much ahead of competition as Tesco introduced inline retailing much before Sainsbury. Therefore, this model implies that Sainsbury is in the growth stage of the life cycle mainly domestic growth.
Effect on the financial performance
Share price
Fig.8
Source: yahoofinance.com
The share price of the company seems to have been steady in 2007, meaning their MSRG strategy is working and investors are gaining confidence in the company, organic growth for the company is important.
7 Recommendations
After evaluating both the companies it is recommended that bank's fund managers should invest in Tesco plc if they are looking for growth in their stocks. The company's size and market capitalization is much greater than Sainsbury. According to the financial performance Tesco has increased its international market share as home market is saturated.
Tesco has expanded its operations to Asia and Europe whereas Sainsbury is still recovering from heavy loses of 2005 to grow in the home market. Tesco expansion plans are based on utilizing the surplus funds in investment of positive NPV projects to increase the value of the firm. The company did not pay dividends over the last year, but, has made consistent share buybacks over the last 2 years, sending a strong signal to the market and showing confidence in the management.
References:
Bender. R and Ward. K, (1993). Corporate Financial Strategy. Oxford.
Brealy.et al, (2004). Fundamentals of Corporate Finance. McGraw-Hill.
Cole. B, (2002). Managing Financial Resources, Kingston University.
Ellis. J and Williams. D, (1993). Corporate Strategy and Financial analysis, London.
Ogier. et al, (2004). The Real Cost of Capital. Prentice Hall, London.
Weston. F and Copeland. Thomas. (1979). Managerial Finance. CBS College, New York.
www.tescocorporate.com "Tesco corporate strategy" online accessed on 06-08-2008
www.fame.bvep.com "ratio analysis" online accessed on 05-08-2008
www.yahoofinance.com "Share Price model" online accessed on 05-08-2008
www.reuters.com "Financial statements" online accessed on 02-08-2008
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