Charles Stanley picks holes in Morgan Stanley's Tesco 'buy' note
Analyst Garry White at UK broker Charles Stanley has picked a few holes in the arguments behind Morgan Stanley's promotion of Tesco onto its best ideas list.
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White agrees that the main problem in determining Tesco’s valuation is the fact that we do not know where its margins will ultimately settle, but thinks that the US investment bank's assumptions are rather "heroic", or stretched.
In a note from Morgan Stanley issued earlier on Monday, analysts calculate Tesco has scope to materially improve its UK operations and return to 3.5% operating margin by 2019 and 4% over the long term as it is confident that the opportunity to improve the efficiency of its UK operations is greater than the market expects.
The US analyst team believes Tesco's commitment to slim down its store ranges will free up significant capital, while combining with leading branded goods companies to fight back against hard discounters could have a "very powerful impact", pointing to a French discounters’ market share that went from 14.3% in 2008 to 11.7% in 2014 after a similar pincer move by grocery groups there.
With the end of the store space race bringing UK grocery supply into line with demand, White agrees that the argument so far seems pretty rational.
"However, when [Morgan Stanley] looks at asset disposals its assumptions appear to get a little more heroic. The broker has calculated that having theoretically disposed of all its international assets, Tesco's stub could still worth up to 330p, some 48% above the current share price. This can only be described as punchy," White said.
Overall, Morgan Stanley values Tesco's international operations and data analysis unit Dunnhumby between £12.1bn and £17.1bn, compared with the current Tesco market capitalisation of £17.8bn.
There are risks, which Morgan Stanley accepts, that this investment case could prove too optimistic in the event of a full-blown price war, or from a lack of potential buyers for Tesco's international assets.
"Both of these things are possible," cautions White, who notes the City consensus is against Morgan Stanley, with 17 out of 22 City analysts having Tesco as a 'hold', 'sell' or 'strong sell'.
"Morgan Stanley’s bullish view is therefore not shared by the rest of the market. Only time will tell if they are correct. However, the assumptions on its valuation once the international part of its business are sold may be a little on the bullish side," he said.