FTSE 100: TESCO vs. RECKITT, What the Markets see?

Both are FTSE 100 companies that are where the similarities end. In this post, we examine why Reckitt Benckiser performed better than Tesco in the last six years.

Before we go into the nitty-gritty details.

Let’s us look at the share price performance for both Tesco and Reckitt.

TESCO AND RECKITT SHARE PRICE

A typical £10,000 investment would turn out differently.

Reckitt would have caused your investment rise to £25,800, excluding dividends.

Meanwhile, Tesco would turn ten grand into £4,200.

Reckitt clearly won the “share price” appreciation contest!

 

Now, we must ask why Tesco has underperformed versus Reckitt?

What are the fundamental catalysts to look for?

To do this, we need to look at the following: –

  1. Asset Turnover (minus the cash);
  2. Operating and Net Margins;
  3. Pension Surpass/(deficits);
  4. Total Debt;
  5. Capital Turnover;
  6. Net Operating Cash Flow;
  7. Free Cash Flow.

 

 

 

 

The Battle between Two Mammoths Tesco and Reckitt Benckiser

As mentioned in the introduction we will go through these eight factors below.

 

 

 A. Operating profit

 Operating profit margins

The margins between Tesco and Reckitt is “Night and Day”!

Even in Tesco’s good years in 2010 and 2011, it barely makes 5% margin, whereas Reckitt delivers no lower than 20%.

Why the huge Gap?

Tesco doesn’t make, patent or design it products. It is a distributor of goods for businesses like Reckitt, Unilever and thousands of other businesses. So, a supermarket has no differentiation, apart from customer service and making sure stock is available.

Reckitt successfully creates and brand its goods in the marketplace. People trust its brands and are willing to pay a premium.

(N.B.: It owns Durex, Lemsip, Air Wick and Calgon to name a few.)

 

B. Asset Turnover (minus the cash)

Thought Reckitt would beat Tesco, given it has the greater operating margins!

There is a great explanation WHY.

When the firm makes great margins like Reckitt (close to 25% vs. Tesco’s 2%), it is not focusing on generating greater revenue, but on margins improvement.

Illustration

Reckitt generates £9.9bn in sales and produces £2.4bn in operating profits.

Tesco generates £56bn in sales and produces £1bn in operating profits.  

This comparison would concentrate your mind and tell you to focus more on the bottom line than the top line (after expenses, not before expenses).   

Also, when a business impairs their assets they reduce the “denominator”, and this artificially create a higher asset turnover, without seeing improvement in its operations.

C. Capital Turnover

See Asset Turnover section above for explanation.

 

D. Total Debt

Tesco is a highly-leveraged business. And that is true when it comes to comparing it to the company’s cash earnings.

In 2016, Tesco debt to net cash earnings ratio is close to 8 times! Reckitt is one time.

But, are supermarkets generally heavily in debt?

Well, using the debt to cash earnings ratio, Morrison is 3.5 times and Sainsbury is 6 times. So, Tesco is the worse of the bunch!

Is Tesco’s debt levels always this high?

Tesco’s debt grew as the business got bigger, but operating cash earnings failed to keep pace. If one looks back to its 2004’s results, Tesco made a net cash profit of £3bn, when the gross debt was £5bn!

 

E. Pension Surpass/(deficits)

Both companies run a pension deficit. The difference is Reckitt’s pension are manageable, while Tesco has grown considerably larger.

A growing and unsustainable deficit put more pressure on a firm to make bigger contributions to plug the gap. And since the announcement of their results, which resulted in the doubling in its pension deficit, the shares have fallen by 10%.

 

F. Net Operating Cash Flow

 

Consistent net cash generation from Reckitt helps built trust in the market and gives it momentum to send the shares higher. On the other hand, Tesco saw its earnings dropped by 60%. It lost shareholders trust and the shares fell.  

It is likely those Tesco’s shareholders could have gone to Reckitt, Unilever and elsewhere.    

 

G. Free Cash Flow

As most FTSE 100 companies are mature businesses growing at the same pace as the economy. They also generate positive free cash flow because they don’t need to invest to expand, those days are over.

Again, Reckitt is the consistent performer. In the past eight years, it manages to report £13.7bn. vs. Tesco’s£2.9bn.

 

Other Noteworthy Mentions

Dividends getting the chop, or funded via borrowings and disposals aren’t sustainable.

Falling shareholders’ equity.

-More frequent impairment charges.

Higher trade receivables, as % of Total Sales.

Exploding Trade Payables, another form of borrowing in disguise.

 

What Did We Learn?

First, Asset and capital turnover is no indication of a strong business because asset values get chopped up to make sales look good.

 

So, for these mammoths, you need to assess net cash earnings.

In the case of Tesco, there were signs of deteriorating cash profits in 2013. That is the first signal, all is not well. The next most important indicator was the free cash flow generation. Tesco was up and down with no consistency.

By the time, we get the firm cutting its dividends or announcing huge asset write-downs, the valuation is already priced in the market!

 

Call to Action

Are there any metrics missing in this article that would warn you something not right about the business?

Please, share below.

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