Why Tesco is worth 330p

It's been a fortnight since Tesco flagged up a better than expected Christmas and new CEO Dave Lewis fleshed out his recovery plan for the supermarket chain. Now, Morgan Stanley has run through the numbers and thinks the shares could be worth significantly more.

"We argue that a more benign industry supply backdrop and scope to improve the efficiency of the UK operations will help Tesco restore EBIT margins to 3.5% in FY19 (4% assumed in the group's terminal margin of 4.5%)," says the broker. "With industry supply/demand in balance for the first time in a decade, and Tesco poised to reverse the trend that has seen SKUs (stock keeping unit) per store increase from ~55,000 to ~75,000, we expect the shares to start pricing in more of the recovery story in the UK business."

An obsession with margins in recent years not only lost Tesco market share but also complicated the business. This trend, however, is set to reverse, reckons Morgan Stanley. Branded goods manufacturers are more likely to share some of the pain, too, it says. Previously, Tesco has self-financed price cuts on big brands. The same tactic worked for French supermarkets in their battle against the discount stores.

Offloading the international operation could also unlock "substantial value" at the £18 billion company. Tesco has already said it wants rid of its data analysis unit Dunnhumby - it could be worth up to £2 billion, according to estimates - but the rest of the grocer's overseas empire could be worth at least another £15 billion - £1.7-£3 billion for Eastern Europe, £3.8-£5 billion for Korea and £5.4-£7.2 billion for Thailand and Malaysia.

Using a mixture of its three scenarios - bull, base and bear - Morgan believes Tesco shares deserve to trade on an enterprise value-to-cash profits (EV/EBITDA) ratio of 7. Broadly in line with the European food retail sector average. That values each share at 260p.

However, if the international business is jettisoned, Tesco shares could be worth 330p, according to Morgan’' number crunchers. But the retailer would still have to return UK retail margins to 3.5% by 2019 and 4% long-term. Tesco has pencilled in just 1.1% for 2015.

If Tesco sheds only £6-£8 billion of overseas assets, a multiple of 6-8.5 times EV/EBITDA would value its shares at 210-250p. Worst case, would be for the hard discounters to take 18% of the market, for UK margin to reach just 1% by 2019 and failure to increase store traffic. Downside here would be to 140p, suggest Morgan.

"Our price target implies 21% upside for the shares over the next 12 months, vs. only 3% upside for the rest of the sector, hence our Overweight rating on Tesco shares," writes Morgan. "While this limited level of upside means that Tesco shares are today more of a 'trade' than an investment, we could become even more constructive on the shares should we see hard discounters' market share gains slowing down further on the back of overtrading, industry consolidation, and leading national brand manufacturers focusing on market share gains."

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.