A recap of Tesco's problems

Tesco is in a mess. It has spent far too much money opening up lots of new supermarkets in the UK and across other parts of the world. Unfortunately, these supermarkets have not made enough money to make them good investments. Quite the reverse in fact.

Tesco is also under intense competitive pressure from its rivals. This has left it with lots of problems to fix.

For a long time, the company's spending binge looked to be paying off as profits continued to rise for much of the last decade. That said, the warning signs that all was not well were there to see for anyone who took the time to crunch a few numbers.

The huge amounts of money spent on its supermarkets steadily made less money as return on capital (ROCE) fell gradually before falling off a cliff.

Then there was the question of how much money Tesco was really making. This only really became an issue when the company was forced to admit that it had overstated its profits in 2014. However, the company's spending spree meant that it hadn't fully converted its profits into free cash flow for years (see chart below). It had become virtually impossible for any outside investor to work out what its true profits were (this is arguably true for most supermarkets).

Tesco's poor cash flow performance combined with an increasing pension fund shortfall has seen its debt levels increase..

This trend has been made worse by Tesco selling lots of its supermarkets and renting them back from property companies in order to raise money to invest in more supermarkets (much of which has been wasted). What this also did was to create a huge pile of hidden debt (over £10bn according to my estimates) which has left Tesco with a growing rent cost (see below). Not only that, it has tied it into a lot of large out of town supermarkets which customers have deserted in droves. This has increased Tesco's fixed costs and made the company's profits even more sensitive to a fall in sales - known as operational gearing.

To fix Tesco and make it a good company again it has to do the following:

• Halt the fall in sales and profits and start growing them again.
• Turn more of its profits into free cash flow.
• Pay down its debts.

Let's see how it is getting on.

The rise of Aldi

I've had a look at the financial performance of Aldi in the UK between 2009 and 2014. The key takeaways are shown in the tables below.

Aldi Stores (£m)	2009	2010	2011	2012	2013	2014
Sales	2055.7	2144.1	2768	3890.9	5275.3	6893.3
EBIT	-5.9	27.7	108.3	177.6	274.8	260.3
EBIT margin	-0.30%	1.30%	3.90%	4.60%	5.20%	3.80%
Capital Employed	1347	1640	1517	1426.4	1595.4	1744
Rental expense	63.9	52.8	48.4	54	54.6	54.6
Rents x7	447.3	369.6	338.8	378	382.2	382.2
Lease-Adjusted Capital Employed	1794.3	2009.6	1855.8	1804.4	1977.6	2126.2
Lease-adjusted EBIT @ 6%	20.9	49.9	128.6	200.3	297.7	283.3
Lease-adjusted ROCE	1.20%	2.50%	6.90%	11.10%	15.10%	13.30%

As you can see, Aldi's growth has been stunning. Sales have grown from just over £2bn to just under £7bn in five years. What's even more impressive is that Aldi has been able to do this with an increase in investment (lease-adjusted capital employed) of just £332m. Unlike lots of retailers that grow, it would seem from its accounts that Aldi is not doing this by renting lots of new stores (but I don't know this for certain).

Having said this, Aldi's profits, profit margins and ROCE all fell in 2014 which suggests that it hasn't been able to escape totally unscathed from the supermarket price wars. Its lease-adjusted ROCE of 13.3% is comfortably more than Tesco, Sainsbury's and Morrisons.

The success of Aldi's business model is based on its lean structure and focused approach to retailing (read more limited product ranges and smaller stores compared with the big 4 supermarkets). The effectiveness of this strategy is shown in its impressive cash flow performance.

Aldi Stores (£m)	2009	2010	2011	2012	2013	2014	Cumulative
Operating cash flow	40.6	60.8	297.3	399.8	517.9	509.1	1825.5
Tax paid	-13.6	-1.2	-4.8	-30.1	-55.5	-60.7	-165.9
Capex	-221.4	-127.8	-116.8	-165.5	-274.3	-438.1	-1343.9
Free cash flow for Firm (FCFF)	-194.3	-68.2	175.7	204.2	188.1	10.3	315.8
Interest received	1.8	1.5	1.9	2.9	2	1.5	11.6
Interest paid	-10.1	-20.1	-25	-17.5	-16.6	-14.5	-103.8
Free cash flow for Equity	-202.7	-86.8	152.7	189.6	173.4	-2.7	223.6
Depreciation & amortisation	64.8	69.8	75.4	78.9	85.7	110.3	484.9
Capex to depreciation	3.4	1.8	1.5	2.1	3.2	4	2.8
Capex to Sales	10.80%	6.00%	4.20%	4.30%	5.20%	6.40%
FCF as % of operating cash flow	-498.70%	-142.80%	51.40%	47.40%	33.50%	-0.50%	12.35%
Net funds	-16.9	-300.4	-115.6	192.2	238.2	221

Despite very high rates of investment, Aldi has been able to generate a cumulative free cash flow of £223m since 2009 and has cash in the bank. It seems that Aldi can finance its growth from its own cash flow and doesn't have to borrow money. It is therefore no surprise that Aldi feels confident that it can still expand massively in the UK over the next few years. This should worry the big supermarkets and could be very bad news for Tesco.

Let's look at Tesco on the same basis over the same time period. You can easily do this by creating a custom results table in SharePad and exporting it to a spreadsheet to do a few more calculations.

Tesco Plc (£m)	2010	2011	2012	2013	2014	2015	Cumulative
Net cash operations	5435	4881	4939	3294	3681	1097	23327
Dividends received	35	62	40	51	62	88	338
Capex	3018	3551	3708	2987	2881	2318	18463
Free cash flow to the firm	2452	1392	1271	358	862	-1133	5202
Interest received (CF)	81	128	103	85	121	104	622
interest paid	-690	-614	-531	-457	-496	-613	-3401
Free cash flow to Equity	1841	904	840	-14	487	-1642	2416
Depreciation & amortisation	1384	1420	1445	2254	1532	1552	9587
Capex to depreciation	2.2	2.5	2.6	1.3	1.9	1.5	1.9
Capex to sales	5.30%	5.90%	5.80%	4.70%	4.50%	3.70%
FCF as % of operating cash flow	33.90%	18.50%	17.00%	-0.40%	13.20%	-149.70%	10.40%
Net borrowing	10454	8647	9444	8322	8707	10494

Tesco has also been able to finance its investment from cash flow over the same period but its free cash flow has turned sharply negative recently. Despite having a big one-off boost to free cash flow in 2010 it has turned less of its operating cash flow into free cash flow than Aldi - 10.4% versus 12.4% over the same time period.

Aldi's performance is even more impressive given its average capex to depreciation rate was higher at 2.8 times compared with Tesco's 1.9 times. It has invested more but still generated more cash. Unlike Tesco it is also not burdened with a pension shortfall and lots of hidden debts.

Slashing Investment

There's no doubt that Tesco spent too much money in the past. Now it is slashing its investment spending or capex as it is known.

Capex was just over £500m in the first six months of this year compared with over £1.1bn for the same period in 2014. Tesco says that full year capex for 2015/16 will be around £1bn.

This might seem a good thing to do. But could Tesco go from a position of spending too much on its stores to spending too little?

This £1bn needs to be compared with a TTM depreciation and amortisation expense of £1.5bn. I've written a lot about the topic of maintenance or stay in business capex in recent weeks and have argued that for most companies this is likely to be more than the depreciation expense in the accounts.

The chart below compares Tesco's depreciation expense with its ten year average capex spend over the last ten years. For most companies - but not all - this ten year average could be seen as a reasonable proxy for what they need to spend most years to keep its assets in good shape and maintain their ability to produce the same amount of sales. This is not straightforward with Tesco due to its spending splurge but, if anything, there could be grounds for arguing that Tesco's stay in business capex is higher - maybe a lot higher - than its depreciation charge.

So what is spending less than depreciation on new assets going to do for the look of Tesco's stores and its ability to woo more customers?

One of the most cited criticisms of Tesco's UK supermarkets is that they are a bit scruffy and could do with a bit of money spent on them. This doesn't look like it is on the cards.

So where does this all leave Tesco in its quest to generate free cash flow?

Let's say that capex can be slashed to £1bn and kept there (I think this is unlikely). Given its interest bill and money coming in from joint ventures, growth in free cash flow just to get to a breakeven position is going to have to come from trading cash flow. It might not be able to squeeze its suppliers so this growth is probably going to have to come from extra operating profits.

Tesco path to breakeven FCF	TTM/Adjusted (£m)
Net cash from operations	626
Dividends from JV's	76
Interest received	57
Interest paid	-517
Capex	-1000
Free cash flow	-758
Extra operating profit needed	758

The profit increase needed to generate a meaningful free cash inflow so that Tesco can start paying a dividend again is even bigger.

What level of sustainable profits is baked into the share price?

You can spend a lot of time trying to work out how much money Tesco might be able to make in the future. Alternatively, you can try and work out what the current share price is implying. You can do this using the earnings power value (EPV) tool in SharePad.

EPV gives you the value of a company based on it making a certain level of profit (EBIT) at a given tax rate and discount rate (the investor's required return needed to own the shares). To read more about this valuation method click here.

You can also use it to invert share prices to get a level of sustainable profits implied by the current share price. Simply choose a long-term tax rate and discount rate and then keep putting profit numbers into the tool until you get the current share price. Using a discount rate of 8% and a long-term tax rate of 20%, SharePad is telling me that Tesco needs to have sustainable EBIT of nearly £3bn to justify its current share price.

With a trailing 12 month normalised EBIT of £800m, Tesco's road to recovery and a higher share price looks tough.