Tesco

I thought I'd take a detailed look at Tesco.

Current price: 318p
EPS in 2008: 27p
EPS year-on-year growth: ~16%
Dividend in 2008: 10.9p
Dividend payout ratio: ~40%
ROCE: ~12%
ROE: ~16%

So 60% of earnings are reinvested at about 16% rate of return. That accounts for ~9% of growth. About 7% seems to come "free" - but are they just gearing up?

In 1999 they had debt of about £2bn, vs net assets of £4.3bn. In 2008 they had net assets of £12bn, but borrowings of £8bn. And £1.7bn in cash, so really only £6.3bn. So actually gearing has remained pretty static at 50%.

So this company has grown earnings per share at about 15% sustainably and is paying a 3.4% dividend. That's a total retun of 18.4%. Current P/E is under 12, whereas a safe company with such strong growth would normally command something like 15-20.

Even if we assume that organic growth moderates to 3% (i.e. only just keeping pace with inflation), you're still looking at dividend growth of 10% per year.

Refinancing debt may be more expensive in the future. Each 1% increase in finance costs equates to £80m off their pre-tax profits, which in the context of £2.8bn of pre-tax profits is not a problem.

This company has huge advantages:

• A stupendous growth record.
• Very strong cash flow.
• Low debt in the context of their massive earnings.
• A dominant position in their main market.
• Huge opportunities to export their business model abroad.

Concerns are:

• Growth will be difficult since it is so dominant in the UK.
• Economic conditions will hurt it, especially in the short run.

On the whole I'm struggling to find too many negatives. I'm convinced - I'll be looking to add some Tesco shares to my portfolio over the coming months.

Portfolio vs net worth

To cheer me up a bit, I thought I'd review the movement of my share portfolio over the last year, but also look at changes to my net worth in Norwegian kroner - since I plan to move to Norway in a few years.

Here is the disastrous performance of my shares, in order from best to worst:
MXM -5.34%
QDG -13.62%
NXT -20.62%
IAPD -28.06%
GNK -32.09%
IFFF -39.96%
IDVY -40.18%
LTAM -43.15%
IEER -58.82%
BDI -65.55%
ZRX -66.73%
RBS -75.33%
TW -90.16%

Movements in the dollar/pound exchange rate have almost exactly wiped out my share losses. The value of my house has also fallen over this period - I estimate this loss to be slightly greater than my loss on shares. Movements in the pound/kroner exchange rate have almost exactly wiped out this loss.

House prices, share prices and exchange rates have resulted in zero net movement in my net worth in the last year. It was a different story 6 months ago. Asset prices had not fallen so far, but I had made no profit on the dollar/pound rate, and had taken heavy losses on the kroner/pound rate. At that point my net worth in kroner had been hammered by approximately 25%.

So - my net worth is the same as last year, and I have an excellent opportunity to buy shares at reasonable prices. Reasons to be cheerful indeed.

What are RBS shares worth?

A bit premature, since I haven't seen the prospectus for the rights issue yet, but I thought I'd have a deep think about what RBS shares are really worth, and whether it's smart to continue holding. My gut says "hold at all costs", but am I just avoiding crystallising a big loss?

Net tangible assets
At the interims assets were £67bn, of which £5.8bn were minority interests, and £8.3bn were non-ordinary equity. £27bn were intangible assets. You could munge those in a variety of ways, but I reckon the ordinary shareholders have about £20.5bn of tangible assets.

At the moment there are 16bn shares, so 128p per share.

Post rights issue there will be about £35bn of ordinary shareholder equity, but 38bn shares. So about 92p per ordinary share.

Of course there are worries over further writedowns which might eat into these assets. On the other hand, this gives no value to RBS's brands: RBS, Natwest, Churchill, Direct Line, Citizens, Charter One, ABN Amro, Ulster Bank, Coutts, etc..

Earnings
This is the key question. Can RBS sustain anything like their previous levels of earnings? Obviously their funding costs will rise, but can they just pass this on to their customers? Securitisation and some other revenue sources will probably be blocked indefinitely. They still have the expertise to compete effectively, and many banks will be in the same boat, so surely they can earn an adequate return on their other business lines.

I'll have a stab at £5bn post-tax, as a hypothetical figure. That's 13.1p per share after dilution. At a P/E of 10 that would mean 131p fair value. But: is a P/E ratio of 10 reasonable? An ultra-safe (extremely well-capitalised) bank earning a RoE of 14% should trade on a premium due to its growth prospects. On the other hand, RBS is likely to have a curtailed appetite for growth for some time to come, so such a good RoE is largely wasted.

Shareholder return
Of course shareholder return is the only realistic way to value a company, but it's also the hardest. I think we can expect:

• Non-core disposals, such as insurance, etc.. helping to pay back preference shares ASAP. Let's assume a £5bn boost to capital attributable to ordinary shareholders, and the end of the 12% payout on the preference shares. But a hit to post-tax earnings of about £600m per year.
• Shrinkage of the balance sheet and risk-weighted assets in Global Banking and Markets. Perhaps a reduction in risk-weighted assets of £80bn over the medium-term, resulting in £8bn of surplus capital. A hit to post-tax earnings of £1.2bn.
• In the short-run, impairments running ahead of better margins, but longer term more attractive returns on residential mortgages.

That would suggest £8bn of excess capital to return to shareholders. Earnings around £5bn in the medium term. The potential for higher dividend payments in the absence of growth. So perhaps 21p per diluted share in capital return, combined with 131p per share value based on earnings. So around 150p as a reasonable value for the diluted shares.

Quality

The recent market turmoil is seeing some quality companies punished with the rest. This looks like a good opportunity to pick up some top quality shares on the cheap. Over the next couple of months I will have plenty of cash available to invest. At the moment I'm drawing up a shortlist of shares to consider.

In general I'm looking for Buffett-type shares that I can hold for the extreme long term. What I want is:
- Plenty of free cash flow
- Strong potential for organic earnings growth (i.e. not requiring investment)
- A wide moat protecting them from competition
- Large profit margin
- Stable, growing revenue
- Limited debt
- Not excessive P/E ratio
- A reasonable dividend yield

So far I'm looking at:
- Diageo at around 800p
- Tesco at around 300p
- GlaxoSmithKline at around 1000p

Market plummeting

I suppose I should say something about the plunging stockmarket. How about "hooray!". Cheap shares - fantastic. For someone who is going to be a net buyer for many years to come, the cheaper the better.

I hope the market doesn't recover too quickly.

Of course, some of the companies I own shares in have also seen their "real" value affected.

Royal Bank of Scotland, worth perhaps £7 per share if the credit crunch had fizzled out and gone nowhere, and maybe £4 if the US had rescued Lehman and avoided further panic, will now be worth maybe £2.

It remains to be seen how Taylor Wimpey resolve their funding issues, but I'm now far more pessimistic about the direction of house (and particularly land) prices. I think the value of their shares has probably fallen from £2.50 to maybe £1 at best.

Zirax are clearly having short-term problems, but I remain fairly confident in the long run.

On the whole I think pretty much all the shares in my portfolio are undervalued. So I clearly won't be selling. And in fact, I just put in an order to buy more IAPD, IDVY and GNK next week.

Government bank bailout

Well, with hindsight I did get a good price on Monday (about 160p I think) but I spurned it. Shame - RBS are now at 70p. Which I think is crazily low, especially given the government bailout plans. I suppose there's a chance RBS will have to suck up some big losses on Lehman CDSs - I would be seriously unimpressed if they have much exposure though. The other big worry is that shareholders will be massively diluted.

Analysts have been saying that RBS will raise about £10bn. I think they're probably not far wrong. The government said that banks would raise about £25bn between them. To take them up to a 10% tier 1 ratio, I reckon they need:
Barclays about £5bn
RBS about £10bn
HBoS about £5bn
Lloyds about £3bn
HSBC about £1bn
That adds up to £24bn.

RBS's market cap is currently about £11bn. Some newspapers are suggesting that they will try to raise £10bn via a rights issue underwritten by the government. Surely not? That would be hugely dilutive at the current share price.

I think they would be far better off giving the government preference shares. Alastair Darling strongly pushed the benefits of preference shares in his Commons speech, so it seems that's what the government has in mind.

If RBS give the govt £10bn of perpetual, non-cumulative, non-convertible preference shares paying a dividend of 10%, what would that mean? Maybe we can assume some sort of normality in a few years - let's say £7bn of profit after tax. The govt would take £1bn of that. With a total dividend payout of 45% that would leave 13.4p per share for ordinary shareholders. And crucially, the remaining 55% will be reinvested to benefit ordinary shareholders - preference shareholders will just continue to get their 10% per year. So that's £3.85bn reinvested - even with a lower return on equity (say 10%) that means 5.5% growth of total profits, but 6.4% growth in profit attributable to ordinary shareholders. A yield of 5%, growing at 6.4% a year would be perfectly acceptable. That would suggest shares will be worth about 270p. A P/E ratio of 7, which you could also imagine rising to around 10 in a future bull market.

On the other hand, things do not look so rosy if governments receive convertible shares, or ordinary equity. The lower RBS's share price goes, the worse this option looks. Preference shares convertible at 62p, or a rights issue at the same price, would mean 50% dilution. Using the same profit calculations you end up with earnings per share of about 22p and a 10p dividend. So a share value of perhaps 200p.

It will be interesting to see how this turns out. I'll hold onto my shares, since I since there's little point bailing out at this low price, but my highest hopes at the moment are to break even in a few years.

RBS uncertainty

I've been reading some worrying things about RBS over the weekend, and if I can get a reasonable price on Monday morning I may well sell off some of my shares. I'm already nervous about quite how large my stake is as a percentage of my total portfolio.

Paul Mason's blog suggests that he knows "for a fact" that the government is considering taking an equity stake in major UK banks and financial institutions.
http://www.bbc.co.uk/blogs/newsnight/paulmason/2008/10/pretty_big_steps_does_the_real.html

Alastair Darling says he is looking at a "range of proposals".
http://news.bbc.co.uk/1/hi/uk_politics/7653194.stm

European leaders say they are prepared to lift borrowing restrictions.
http://news.bbc.co.uk/1/hi/world/europe/7648249.stm

What I find scary is that on the one hand government talks about providing all the liquidity that the banks need, whereas on the other it wipes out shareholders in Northern Rock and Bradford and Bingley - when as far as I can tell their main problem was one of liquidity. They seem to be a bit more willing to bend the rules for the big banks, but I don't really like the inconsistency.

Government also seems determined not to tell the market anything - Robert Peston blogs about pretty much everything of substance before the government announces anything.