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1 February 2017 by Gordon Shannon

In the midst of all the tumultuous political headlines we have been seeing recently, it has been a pleasure to observe one leadership team who appear to have turned around a tough situation and continue to make sensible forward looking decisions.

Tesco’s announcement last week that it is to purchase Booker is not only a credit positive but also reminds us how far Tesco have come since the dark days of 2014 when following years of market share losses, a major accounting scandal dashed the City’s confidence in the retailer and a ratings downgrade to high yield status quickly followed.

Booker is the UK’s leading cash and carry business, serving wholesale customers like restaurants, pubs and independent shops. It is only around a 10th of the size of Tesco so the deal will not be transformational but still brings several positives to Tesco’s business profile.  With the UK food retail market mature and highly competitive, this deal allows Tesco an avenue of growth that does not involve another risky international expansion.  These have often come up short both for Tesco and other UK retailers.  The degree of intervention from the Competition and Markets Authority will be watched closely but thinking back to Sainsbury’s acquisition of Argos last year – we may be seeing the beginning of an M&A trend from UK supermarkets.  Bondholders can often find themselves the losers when deal-making activity picks up but we are spared any discomfort with this acquisition. There appeared to be something for everybody when the news hit, with a 10% rally in Tesco’s equity price as well as credit spread tightening.

Booker is a less capital intensive business than Tesco and converts a higher proportion of its profits into cash.  Its profit margins are almost twice as high as Tesco’s so a higher quality of revenue is being added.  Synergies of £200m per year are projected in 3 years’ time, but we would always advocate scepticism when assessing cross platform cost saving estimations.  Still there is plenty of logistical and procurement overlap, even if too much is being made of potential cost savings from dual use of delivery vans. We are hopeful that the addition of Booker’s CEO Charlie Wilson, who has been highly successful in adapting his organisation to changing customer demands, will add useful experience to Tesco’s management team. Ultimately, with the deal 80% financed through equity and adding a business that has a positive net cash position, better profitability and cash conversion means debt holders are seeing more cashflows supporting Tesco’s borrowing.  The net result is a reduction of around half a turn of leverage, circa 0.5x EBITDA.

How did Tesco recover from its 2014 nadir?  Firstly, management addressed Tesco’s balance sheet and cash flow issues early on; the dividend was scrapped to converse cash and Tesco dove into a series of asset disposals.  The overall result was an effective demonstration of its financial flexibility.  However, these decisions only bought Tesco time, and while we became comfortable with the balance sheet, poor profitability still gave us pause on Tesco’s longer term outlook.  In 2015 the discounters Aldi and Lidl were still eroding Tesco’s market share and simply cutting prices to match these low cost operators would mean eating into its (already slim) margins.

So what changed our minds? Waiting until we actually saw the full turn-around in profitability come through in the results would have likely meant sacrificing the opportunity to capture most of the associated credit spread tightening.  Instead, we tried to remain vigilant of slightly subtler clues. Firstly, we witnessed Sainsbury’s management successfully address their market share losses with a series of well targeted price cuts (and importantly corresponding price hikes) that left margins intact. All credit to the team there for being first, but as it became apparent this move had not sparked a wider price war, given the depth of management information and analysis available to Tesco it seemed likely they could replicate a similar “price rebalancing” strategy. Tesco also pushed its online offering and increased the number of convenience outlets to cater to changing demand.  Then the game became stalking the Kantar sales data for even the most tentative signs of a rebound.  As Tesco’s rate of market share losses began to plateau in early 2016 we had enough confidence to begin building a position.  With £14bn of public debt outstanding, we had a wide variety of bonds to choose from but fortunately already had a favourite prepared.  We like the extra security that comes with the bonds secured on Tesco property and the lower levels of duration associated with their amortising debt structures means these bonds generally experience less volatility than the longer dated unsecured debt.  Having spent time looking at which individual supermarkets and distribution centres back each bond, we settled on Tesco’s first ever secured bond – Delamare Finance – as the one we would buy if we ever turned bullish.  Helpfully as the first of its securitisations, Tesco assigned its best quality properties as the security for this bond – giving us an extra layer of comfort.  With the recovery in sight, capturing a 6% yield on this bond looked like an attractive proposition.

So far, the gradual recovery has continued to play out positively. In Q3 2016, Tesco achieved UK like-for-like sales growth of 1.7%, the sharpest increase in five years, gaining market share for the first time since 2011 while staying on track to deliver its operating profit target of £1.2bn for the full year.  The market has welcomed these results and Tesco bonds trade around 200 basis points tighter than a year ago.

The current analyst consensus is for Tesco to regain investment grade ratings in 3 years.  That would be a long time to wait if it was the only catalyst left for spread tightening and a lot can change in that time.  However this deal even combined with a plan to resume dividend payments next year should not slow down that timeline.  So while at some point before the upgrade we may well book our profits and leave more patient and risk-tolerant investors to eke out the last of the spread contraction, it is still refreshing to see management stay on track for bondholders at the same time as catering to equity investors’ need for growth and returns. In times of change, looking for companies where the interests of debt and equity look most closely aligned is often an effective way to dampen volatility.

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