European Equity Research

UK – Food & Drugs Retailers
Madrid, October 6, 2010

TESCO
Better International Should Help Re-rating
RECOMMENDATION UPGRADED TO BUY FROM HOLD TARGET PRICE RAISED TO GBP490 FROM GBP450

BUY
CURRENT PRICE: GBP430 TARGET PRICE: GBP490

Jaime Vázquez
(+34) 91 289 5436 javazquez@gruposantander.com

Borja Olcese
(34) 91 289 1853 fdolcese@gruposantander.com

We upgrade Tesco from Hold to Buy and raise our Dec-11 TP from GBp450 to GBp490. The two key highlights from the 1H11 results are the better than expected international LFLs in 2Q and the increased confidence in the US. Management provided more detail than usual at the presentation, which we believe denotes confidence. International LFL: 4.1% in 2Q after 0% in 1Q. We believe LFL is the key driver of CROI and not scale via openings. With better LFLs, the ‘maturing effect’ looks more credible to us. In the four most mature countries, the CROI of the mature assets (>4 years) is 220bp higher than the CROI of all assets. US to break even in 2012E/13E: the improvement in LFLs and other underlying metrics show that the key components of a profitable model are coming together. The worsening of overall losses in 1H from US$132mn to US$143mn is explained by the adverse leverage from new space and the acquisition of two supplier factories (US$10-15mn loss). This is a highly operationally geared business and improving LFLs is therefore key. UK: we agree with management that LFLs (Tesco’s and the industry’s) will accelerate in 2H10 driven by rising food inflation and declining petrol inflation.

Relative Performance (12 Months)
160

140

STOXX Retail

120

100

Tesco
80

60 Oct-09

Jan-10

Apr-10

Jul-10

Source: FactSet.

Company Data, October 4, 2010 (Fiscal Year to Feb 28)
Reuters/Bloomberg code ADR code / ratio Market cap (GBP mn) Outst shares (mn) Website Free float (%) Avg daily vol (GBP mn) 12-month range (GBP) Performance (%) Absolute Relative to Stoxx Retail
Source: Reuters, Bloomberg.

TSCO.L/ TSCO LN TESO US 34,311.5 7,972.0 www.tesco.com 99.0 78.13 3.74-4.54 -1M -3M -12M 4.1 10.6 10.0 3.2 1.0 -13.5

(GBP mn) EBITDA % change Net income % change EPS (GBp) EV/EBITDA (x) P/E (x) GDY (%) FCF yield (%)

2008/09 4,279.0 19.3 2,161.0 25.3 25.70 10.2 16.8 2.77 -1.6

2009/10 2010/11E 2011/12E 2012/13E 4,795.9 5,199.6 5,679.5 6,099.3 12.1 8.4 9.2 7.4 2,327.2 2,756.4 3,154.2 3,573.9 7.7 18.4 14.4 13.3 27.34 32.43 36.80 40.45 9.1 8.1 7.3 6.5 15.8 13.3 11.7 10.7 3.03 3.53 4.01 4.41 3.6 3.3 4.4 6.3

Source: Company data and Santander Investment Bolsa estimates.

US investors’ enquiries should be directed to Santander Investment Securities Inc. (SIS) at (212) 692-2550. US recipients should note that this research was produced by a non-member affiliate of SIS and, in accordance with NASD Rule 2711, limited disclosures can be found on the back cover.

TESCO AT A GLANCE
SWOT ANALYSIS
Strengths
• Very strong position in the UK, where it is almost twice the size of the No 2. Ahead of domestic competition in multi-format skills, with Asda coming late to the small store game and Morrison until now not interested in hypermarkets or stores smaller than 10,000 sq ft. Multinational retailer with leading positions in most countries where it operates. Very good management track record, with continuity of in-house talent. One of the most predictable and consistent companies in the sector and indeed in the FTSE-100. Traditionally ahead of its competitors in retail competences, including property skills and the use of loyalty card data. Effective extension of its brand into services, such as financial and telecom services. Solid balance sheet and vast property portfolio valued by the company at GBP34.6bn.

Weaknesses
• Victim of its own success in the UK. With a 28% market share and the broadest appeal of all UK players, Tesco is finding it difficult to outperform competition in LFL terms as its competitors close the talent gap. It is possible that Tesco may have exceeded its natural market share in the UK in food. International operations have proved too capitalintensive. While margins are decent, capital turnover is relatively low and overall international returns (excluding the US) have been below the WACC. Improving LFL sales is therefore key. The US has made bigger than expected losses. The novelty of the format may require years of customer education and losses. However, we like the concept of a capital-light soft discounter.

• •

•

•

•

Opportunities
• The further development of financial services with the launch of mortgages by the end of the year and current accounts next year. The consolidation and densification of existing positions in international markets including China and India. The turnaround in the US with prospects to break even in 2012/13.

Threats
• The improvement in the management of its closest competitors in the UK. The narrowing of the sales density lead in recent years makes Tesco’s UK ROIC more vulnerable. In recent years, the UK ROIC has been maintained via expanding margins. Loss of talent following the departure of Terry Leahy. Tesco would not necessarily benefit from the possible return of high food inflation. Tesco proved vulnerable during periods of high food inflation (2008-1H09), when the discounters and Asda won market share.

•

• •

INVESTMENT CASE
We view Tesco as a generally well-managed company with high earnings visibility. We believe that the UK food business is approaching maturity although space growth remains very robust. Domestic space growth and capex should be cut eventually and free cash flow would then rise. Internationally, Tesco has leading operations in a number of countries, but expansion has come at a high capital cost. Better LFLs are therefore welcome. Tesco’s future in the US has been unclear but the renewed management confidence and the improvement in underlying metrics have increased visibility. The bank’s prospects are interesting as new products are launched. Food inflation is on the way up in the UK. Mild inflation of c4% would be positive, but we believe that inflation in excess of 5% coupled with another VAT rise in January 2011 would adversely change consumers’ behaviour like it did in 2008.

VALUATION
Tesco’s P/E multiple has de-rated to levels where we see no downside. We consider that Tesco has higher earnings visibility than the average in the European food retail sector. Hence, we only see upside to the current share price. The stock trades at 11.7x 2011/12E P/E and 7.7x leaseadjusted EV/EBITDAR, below the recent historical averages of 13x and 8.5x, respectively. At our Dec11 TP of GBp490, the stock would trade at 13.4x P/E and 8.5x lease-adjusted EV/EBITDAR.

2

SUMMARY: MORE VISIBILITY ON INTERNATIONAL
International LFL and confidence on US, key highlights International LFL 4.1% in 2Q from 0% in 1Q

Tesco’s overall results were in line with market expectations. However, there were two key highlights: international LFLs and the confidence on the US. International LFL growth exceeded our expectations with 4.1% growth in 2Q. Tesco’s traditionally achieving mediocre international LFLs has been a long standing concern to us so an improvement here is welcome. We believe that LFLs, and not scale via store openings, should be the key driver of international ROIC going forward. We were also pleased with the increased confidence on the US including the expectation to break even during 2012/13. The company provided detail on a number of underlying metrics, all showing positive trends, such as the gross margin (+310bp), distribution costs per case, labour costs per store and sales per FTE, showing that the key components of a profitable model are coming together. The worsening of overall losses from US$132mn in 1H09/10 to US$143mn in 1H10/11 is explained by the adverse leverage from new space (33% contribution to sales growth) and the acquisition of two supplier factories (US$10-15mn loss) and comes despite 10% LFL. This is a highly operationally geared business (heavy upfront investment in sophisticated distribution and manufacturing, leasehold stores etc). With ongoing decent LFLs, losses are set to fall rapidly, we believe. We have always liked F&E as a concept (capital light, low cost, differentiated, positioned in the small store segment set to grow in the next 20 years). It is the first country where Tesco has gone with a fully clean slate, which we have always applauded. In the UK, LFLs in 2Q were about 1% below management’s own expectation as the industry remained subdued but they still expect to exit the year with LFL growth of c3% inc VAT, which implies a c2pp acceleration. We believe this is feasible as food inflation picks up and petrol inflation fades. Also the worst effect from currency on non-food purchasing terms is being cycled. This will hopefully offset the effect from the upcoming VAT rise on non-food. The Bank has been slower than expected in dealing with the IT platform migration and therefore with the launch of new products. However, it is performing well with underlying profits up 20% vs the 12% reported, once the release of fair value provisions and double running IT costs are excluded. Bad debts fell 19% to below 0.4% of customer balances. The Bank is now ready to launch new savings products and, from next year, mortgages in 1H and current accounts in 2H. The company is very confident it can drive group CROI from 12.1% to 12.8% this year and 14.6% in the medium term through global economic recovery, maturity of existing investments and the benefits of global scale and skills. They quantified the benefits of global scale in purchasing at over GBP300-400mn in 2-3 years from just ‘high tens of millions’ now. Global purchasing savings are a reality in non-food but are starting to be real in food as well. We are more confident about the CROI targets with more solid international LFL growth. We also believe that the reduction in work-in-progress capital in the UK (already paid for but yet to become productive) and the bigger proportion of new space in lower capital intensity formats will also contribute to achieving better returns. We are not moving estimates materially but we believe there is scope for the stock to re-rate from the currently, in our view, undemanding 11.8x next year P/E, as we stated in our recent initiation report. This view is now underpinned by the better international trading and the increased prospects for a profitable future in the US. In the UK, we believe that the rapid fall in YoY petrol inflation and the rising food inflation, as well as the cycling of adverse currency effects on non-food purchasing prices, bode well for a better 2H of the year that will likely offset the negative effect from another VAT increase due in January. We raise our recommendation from Hold to Buy and raise our Dec11 TP from GBp450 to GBp490.

Management willing to share underlying metrics in the US indicates confidence

Management expects 3% exit rate UK LFL

Solid performance by the Bank

CROI targets more credible with good LFL

Upgraded to Buy, scope for re-rating

3

INTERNATIONAL LFL
Maturing effect

For some time Tesco has been ‘selling’ to the market the idea that international ROIC will improve driven by scale and maturing assets. We believe, however, that the bulk of Tesco’s international invested capital is already relatively mature, and the historical LFL profile is indicative of that. Having said that, the company claims that in countries such as Ireland, Korea, Thailand and Hungary (the most mature of all), the CROI of the mature assets (older than 4 years) is 220bp higher, at 16.9%, than the CROI achieved in all the assets in those countries (14.7% including the mature assets).
Figure 1. Tesco – International CROI: Effect of Maturing Space

Source: Company data.

LFLs are key to drive CROI

The chart above is compelling but it is hard to believe in the upside without visible improvements in LFLs. We do not buy the idea that scale through store openings alone is a significant driver of ROIC. This is why we applaud the LFL improvement in 2Q to 4% from 0% in 1Q.
Figure 2. Tesco – International LFL

Source: Company data.

This improvement was driven by all regions, with 5.0% in Asia vs -1.8% in 1Q, 3.1% in the rest of Europe vs 1.3% in 1Q and 12.2% in the US vs 7.5% in 1Q.
4

Figure 3. Tesco – Asia (left) and Rest of Europe (right): LFL
6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% Q3 09/10 Q4 09/10 Q1 10/11 Q2 10/11 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% Q3 09/10 Q4 09/10 Q1 10/11 Q2 10/11

Source: Company data.

Countries showing a strong improvement in 2Q vs 1Q are China, Thailand, Czech Rep. and Slovakia.
Figure 4. Tesco – International LFL Growth by Country, 2003-1H11
(%) Ireland Hungary Poland Czech Rep Slovakia Turkey Thailand Korea Japan Malaysia China United States International 2003 7 8 -3 -5 -4 – -1 1 – 0 – – 1.6 2004 4 9 -3 -3 -5 – 1 -5 – 0 – – 0.6 2005 4 2 2 -7 -7 21 2 2 0 -3 – – 1.5 2006 5 0 2 2 5 5 0 4 -4 18 – – 2.8 2007 5 -2 3 2 6 4 2 0 0 17 – – 2.2 2008 6 1 3 3 6 4 3 -2 -4 8 – – 2.2 FY09 -4 0 2 -7 -3 -7 0 -2 -3 0 5 30 -1.6 1H10 -18 -4 0 -9 -15 -8 -5 -1 -5 -8 -6 10 -6.5 2H10 -6 -10 4 -5 -5 -1 -3 6 -9 -8 0 2 -1.9 FY10 -12 -7 2 -7 -10 -4 -4 3 -7 -8 -3 5 -4.0 1H11 6 -5 3 0 10 0 -1 3 -8 -2 6 10 2.0

Source: Company data and Santander Investment Bolsa estimates.

Smaller stores and new concepts set to help

For some years now we have been of the view that Tesco was wrong to choose the French hypermarket model for its international expansion while, in our view, it should have also looked more at Germany and the discounters which offer a lighter capital and more competitive model. Tesco has built generally successful businesses in Asia. We are less convinced about the future returns of its Eastern European operations, which are heavily exposed to the hard discount and category killer competition. This is a region where we welcome the increased focus on growth via smaller formats. In Poland, for example, the company claims its small stores are achieving double-digit LFLs like Biedronka. We also welcome the company’s fine tuning concepts. It has trialled its so-called ‘European Extra’ store in Bratislava with a 20% sales uplift. Figure 5 below shows Tesco’s cumulative net invested capital in the rest of Europe (including Ireland) and Asia, which together we estimate exceeds GBP10bn, and the pre-tax returns achieved.

5

Figure 5. Tesco – International Cumulative Invested Capital (GBPmn) (Left) and Pre-Tax ROIC (%) (Right), 1999-2010
12,000
20.0%

10,000
15.0%

8,000
10.0%

6,000

Asia Rest of Europe
5.0% Rest of Europe Asia

4,000

2,000

0.0% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
-5.0%

Source: Company data and Santander Investment Bolsa estimates.

Homever maturing

The fall in Asian ROIC in the last two years has been driven by the GBP1bn acquisition of Homever in Korea, which reduced capital turnover ratios in the region. We estimate, however, that the margin of Homever has gone up from c2% in 1H10 to c5% in 1H11 but still has c200bp further upside as it converges with the core business. International margins are actually pretty decent (5%-6%). The problem with the ROIC has been the low capital turnover, as Figure 6 below shows.

Figure 6. Tesco – International EBITA Margin (%) (Left) and Capital Turnover (x) (Right), 1999-2010
7.0% 6.0% 5.0%
2.5 3.5

3.0

4.0%
2.0

3.0% 2.0% 1.0% 0.0%
19 99 20 01 20 03

Rest of Europe

Rest of Europe Asia
1.5

Asia

1.0

0.5

-1.0% -2.0%

20 09

20 05

20 07

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Source: Company data and Santander Investment Bolsa estimates.

In short, Tesco has built valuable leading operations in Eastern Europe and Asia. So far the model has proved too capital-intensive, with overall international returns not yet covering the cost of capital. We have been of the view for some time that only through better LFL sales and not through overall scale, will Tesco drive international returns higher. In this context, we welcome the broad based improvement in international LFLs across all three regions and the increased focus on smaller, capital-light formats and new, better performing hypermarket concepts. For completion, we show below the evolution of the key sales and profit metrics of the international regions, and our expectation for the FY.

6

Figure 7. Tesco – International Sales and Trading Profit by Region, 1H09/10-FY10/11E
(%) Rest of Europe LFL New space contribution Currency Total sales growth Sales (€ mn) Trading profit (€ mn) Trading profit margin Asia LFL New space contribution Currency Total sales growth Sales (€ mn) Trading profit (€ mn) Trading profit margin 1H09/10 -8.9 8.7 0.90 0.7 4,166 191 4.58 2H09/10 -4.1 0.2 0.19 -3.7 4,538 283 6.24 FY09/10 -6.5 4.6 0.24 -1.6 8,704 474 5.45 1H10/11 2.2 3.3 -0.01 5.5 4,395 212 4.82 2H10/11E 1.9 5.4 -6.87 0.4 4,555 297 6.53 FY10/11E 2.0 4.4 -3.60 2.8 8,950 509 5.69

-3.5 31.3 11.07 38.8 4,093 175 4.28

0.4 5.9 -0.83 5.5 4,346 265 6.09

-1.3 16.8 3.83 19.4 8,439 440 5.21

1.2 6.7 12.00 19.9 4,906 228 4.65

1.9 8.5 8.09 18.5 5,150 332 6.44

1.6 7.6 9.98 19.2 10,056 560 5.57

Source: Company data and Santander Investment Bolsa estimates.

7

MORE CONFIDENCE IN THE US
The idea that Tesco will leave the US is off the table

The second highlight from the results, in our view, is the increased confidence shown by management in the US, a region which got plenty of attention at the analysts presentation in London. Any idea of Tesco abandoning the project in the near or medium term is now gone. Sales were up 43% in dollars (10% LFL), 14 new stores were opened in 1H, 19 will open in 2H, and the plan is to reach break-even in 2012/13 (not in the FY). Thirteen stores will be mothballed due to urban de-population (6 in Arizona, 6 in Nevada, 1 in inland California). Losses worsened from US$132mn in 1H09/10 to US$143mn in 1H10/11 explained by the adverse leverage from new space (33% contribution to sales growth) and the acquisition of two supplier factories (US$10-15mn loss). However, this masks an underlying improvement. The company provided detail on a number of underlying metrics, all showing positive trends, indicating that the key components of a profitable model are coming together: The gross margin went up 310bp vs 1H10. The CEO explained that LFL could have been much better, perhaps 10% better, on a constant gross margin (i.e. if the 310bp had been reinvested into the offer). Marketing costs per store per trading week are down 10% vs 1H10 Distribution costs per case are down 6% vs 1H10 Sales per retail payroll hour are up 15%

Losses have peaked

The key components of a profitable model are coming together

Highly operationally leveraged

Management emphasised the high operational leverage nature of the US business and therefore the importance of the top line performance. The upfront investment is heavier than in emerging countries as the infrastructure built in distribution and manufacturing is highly sophisticated, and the stores are mostly leasehold. With decent ongoing LFLs, losses are set to fall rapidly, management explains. As a result, management has decided to accelerate the store opening programme next year.
Figure 8. Tesco – US LFL Sales Growth, 2Q09/10-2Q10/11

Source: Company data.

With better LFLs, long term project much more credible We like the F&E concept

With high operational leverage, decent ongoing LFLs and rapidly falling losses, the long term project becomes a lot more credible. We have always liked F&E as a concept (capital light, low cost, differentiated, positioned in the small store segment set to grow in the next 20 years). Of all the metrics shown in Figure 9 below, only in ‘one-stop shop’ does F&E score worse, as would be expected from a format with a more limited range.

8

Figure 9. Tesco – F&E Customer Satisfaction Metrics vs Competition

Source: Company data.

9

UK RESULTS AND MARKET UPDATE
Not a highlight

The UK is not a highlight in today’s results as overall sales and earnings were in line with expectations. The company delivered another decent margin increase of 8bp despite the dilution from higher petrol sales and the subdued trading environment.
1H09/10 18,963 3.7 2.8 6.5 -2.3 4.2 1,155 6.09% 18 410 115 2H09/10 19,595 2.7 3.0 5.7 0.2 5.9 1,258 6.42% -6 450 135 FY09/10 38,558 3.2 2.9 6.1 -1.1 5.1 2,413 6.26% 12 860 250 1H10/11 19,739 0.2 3.0 3.2 2.6 5.8 1,218 6.17% 8 474 129 2H10/11E 20,940 0.3 3.1 3.4 2.4 5.8 1,377 6.57% 15 511 156 FY10/11 40,679 0.2 3.0 3.2 2.6 5.8 2,595 6.38% 12 985 285

Figure 10. Tesco – UK Sales and Trading Profit, 1H09/10-FY10/11E
(GBP mn) UK retail sales LFL ex-petrol ex VAT (%) New space (%) Core sales growth (%) Petrol UK retail sales growth UK trading profit UK TP margin bp movement TPF sales TPF trading profit

Source: Company data and Santander Investment Bolsa estimates.

Management still expects 3% LFL growth by year end

LFLs in 2Q were about 1% below management’s expectation as the industry remained subdued but they still expect to exit the year with LFL growth of c3% inc VAT, which implies a c2pp acceleration from 1H levels. We believe this is feasible as food inflation picks up and petrol inflation fades. Also, the worst effect from currency on non-food purchasing terms is being cycled. This will hopefully offset the effect from the upcoming VAT rise on non-food. The first half has been subdued for all players, not just Tesco. Volumes have slowed, despite the fact that inflation in the half was not high, yet, as Figure 11 below shows.
Figure 11. UK Food Retail Sale Volumes (Left) and Food Inflation (Right, Inverted), 1999-10
5.0% 4.0% 3.0% 2.0% 1.0% 0.0% -1.0% -2.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0%

-3.0% 14.0% Aug-99 Aug-00 Aug-01 Aug-02 Aug-03 Aug-04 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10 UK food retail sales - Volume (% yoy, 3mma) UK food RPI (% yoy, inverted, rhs)

Source: ONS.

Volumes falling

As Figure 11 above shows, volumes in the UK have traditionally responded positively to the fall in food inflation. However, since the beginning of this year, volume growth (including mix) has slowed down sharply (from 3% to -1%) despite moderate inflation. We believe this has to do with VAT increasing back up to 17.5% in January (from 15%) and the hike in petrol prices, affecting consumers’ budgets and behaviour. We understand that there are new ‘end of month’ trends which were not visible two years ago, whereby sales pick up right after payday.

10

With rising food inflation and declining petrol inflation, 2H prospects are better

But the worse is behind the company and as food inflation picks up and the petrol price hikes of last year are cycled (Figure 11 above), value sales are slowly improving.
Figure 12. UK Average National Petrol Price (Indexed Price per Litre)

Source: Company data.

Industry growth is on the way up already from the lows in the spring.
Figure 13. UK Food Retail Industry Growth (Total Grocery 12-Week Rolling), 2007-10
9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
Se p07 No v07 Ja n08 M ar -0 8 M ay -0 8 Ju l-0 8 Se p08 No v08 Ja n09 M ar -0 9 M ay -0 9 Ju l-0 9 Se p09 No v09 Ja n10 M ar -1 0 M ay -1 0 Ju l-1 0 Se p10

Total grocers growth

Total grocers growth ex VAT effect

Source: Kantar.

Industry space growth impact minimal

Management also stated in the presentation that the impact from new capacity remains minimal in the industry as a lot of the space goes to non-food, convenience or is recycled. We agree with this, as we explained in our recent initiation report. Tesco provided an interesting chart in the analyst presentation (shown below) indicating that both the impact from its own cannibalisation and the attrition from competitors is down in 1H versus last year and remains relatively stable over the years.

11

Figure 14. Tesco – Attrition from New Capacity

Source: Company data.

3.2% food space growth

We expect the top ten food retailers, which account for c90% of the sector’s sales, to increase overall space by nearly 5% in 2010E. This excludes the 1.5mn sq ft that Asda has acquired through Netto. Although the Netto space already exists, it is likely that sales densities in the 193 stores acquired will improve considerably in the hands of Asda or other retailers to whom Asda might sell some of the stores due to OFT requirements. This follows a 4% industry space increase in 2009. About a third of the space being opened in 2010 in the UK industry is devoted to non-food goods. This space growth puts pressure on non-food retailers rather than on the grocers. We estimate that food space growth is more modest at 3.2%.

37% of total space comes from Tesco

If space growth is not an issue for the industry it is even less of a one for Tesco, which accounts for 37% of the sector’s space growth.

Figure 15. UK Retail Industry – New Space Growth, 2010
(‘000 sq ft) Tesco Sainsbury Asda Morrison Co-op M&S food Waitrose Iceland Aldi Lidl Total % increase Net Space Additions 2,100 1,370 620 400 -50 100 220 150 375 375 5,660 Increase (%) 6.4 7.7 3.5 3.4 -0.4 2.0 4.6 4.0 8.0 5.5 4.8 Non-Food (%) 60 50 50 10 5 0 5 0 10 10 Non-Food Space 1,260 685 310 40 -3 – 11 – 38 38 2,379 13.4 Food Space 840 685 310 360 48 100 209 150 338 338 3,281 3.2

Source: Company data and Santander Investment Bolsa estimates.

With positive food inflation, current space growth is not a problem

As the UK has one of the lowest levels of saturation in Western Europe (measured as sqm/pop.), we are not concerned about space growth of 3%. In fact, the industry’s sales growth only fell below 3% for a short period of time during 2Q10, according to Kantar. With food inflation returning, we do not see space growth as a problem, unless industry volumes fall further.

12

A rational market

The UK is therefore likely to remain a ‘rational’ market. We believe that competitive intensity should not be measured by promotional participation in total spend, which has reached record high levels of 37%, according to Kantar. These promotions are mainly supplier-funded and have not had an impact on grocers’ gross margin. We would rather look at the trend in the food RPI (CPI) vs the food PPI in the UK as an indicative measure of gross margin trends. Figure 15 below (note the slightly different scales) shows that the environment has been relatively benign or rational as the industry players like to define it, with food CPI normally exceeding PPI.
Figure 15. UK Food RPI vs Food PPI, 2003-10
14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% Aug-03 Aug-04 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 14.0% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% Aug-10

UK Food RPI (% yoy)
Source: ONS.

UK Food PPI Output prices (% yoy, rhs)

This chart contrasts strongly with the situation in the US, for example.
Figure 16. US Food RPI vs Food PPI, 2003-10
8.0% 6.0% 4.0% 2.0% 0.0% -2.0% 10.0% 8.0% 6.0% 4.0% 2.0% 0.0% -2.0% -4.0% -6.0%

03

04

05

06

07

08

09

Au g-

Au g-

US Food CPI (% YoY)
Source: Bureau of National Statistics.

Au g-

Au g-

For the market to remain rational Tesco must not lose much market share. In fact, Tesco is no longer underperforming the other big 4 players as it did in 2008-09.

Au g-

US Food PPI (% YoY, rhs)

Au g-

Au g-

Au g-

10

13

Figure 17. Tesco – Total Sales Growth Less Growth at the Other Members of the ‘Big Four’ (Till Roll 4-Week), 2008-10

2.0% 1.0% 0.0% -1.0% -2.0% -3.0% -4.0% -5.0%

Ja n08

Ja n09

Ja n10

8

9

8

8

9

0

8

No v-0 8

9

No v-0 9

9

Se p0

Se p0

0

0

Ma

Ma

Source: Kantar.

14

Ma

Se p1

Ju l -0

y-0

Ma r-0

Ma r-0

Ma r-1

Ju l -1

Ju l -0

y-0

y-1

0

VALUATION
Tesco’s valuation has rarely been so cheap, at least when measured on straight one-year forward P/E multiples. With improved relative trading in the UK, better absolute LFLs internationally and the prospects of a profitable future in the US, we believe there is only upside to the multiple.
Figure 18. Tesco– Historic Ten-Year Forward P/E Multiple, Jan00-Jan10
30 25 20 15 10 Aug-00 Aug-01 Aug-02 Aug-03 Aug-04 Aug-05 Aug-06 Aug-07 Aug-08 Aug-09 Aug-10

Source: Bloomberg.

On 2011/12E lease-adjusted EV/EBITDAR, Tesco trades at a 12% discount to Sainsbury and a 12% premium to Morrison. We believe that Tesco’s broader set of skills and long-term international growth opportunities justify a small premium to Morrison on hopes that future investments will prove more capital-efficient.
Figure 19. UK Food Retailers – Summary of Valuation Multiples (5/10/2010)
(x) 2010/11E P/E 2011/12E P/E 2010/11E EV/EBITDA 2011/12E EV/EBITDA 2010/11E LA EV/EBITDAR 2011/12E LA EV/EBITDAR Morrison 13.0 12.1 7.2 6.8 7.3 6.9 Tesco 13.4 11.8 8.2 7.3 8.5 7.7 Sainsbury 15.9 14.5 7.9 7.6 9.1 8.8

Source: Company data and Santander Investment Bolsa estimates.

Valuation backed by property

Tesco’s valuation is well supported by its property portfolio. According to the company, its group properties are worth GBP34.6bn, covering 83% of the company’s EV. This is well in excess of the book value (GBP20.7bn net in February 2010 plus investment properties with net book value of GBP1.7bn valued at GBP3.2bn in the annual report). The company continues to release value created through the development of its property portfolio. Last year Tesco completed deals with total proceeds of GBP1.8bn and it expects to divest a similar amount this year. The ‘strong demand for these assets and the good yields achieved (initial yields between 5.0% and 5.2% for stores) demonstrate the strong underlying value of our property and the strength of the Tesco covenant’, according to the company. Profits from property in the year totalled GBP377mn. Tesco’s property mix remains strong –over 70% of its UK property is freehold– supported by new capital investment in freehold assets each year. Internationally, the company also owns the majority of its space and a lot of shopping malls around its stores, classified in Tesco’s accounts as investment properties, providing group rental income of GBP351mn. The annual report conservatively values these investment properties at GBP2.8bn, but the real value is higher (we believe GBP4.3bn using an 8% rental yield). Considering the relatively high earnings visibility and the solidity of its balance sheet with significant property backing, we set our target price at GBp490, 13% above the current price.

15

At this price, the stock would trade at 13.4x 2011/12 P/E and 8.5x LA EV/EBITDAR, still a discount to Sainsbury today. The chart below shows the performance of The Three listed UK food retailers year-to-date, with Tesco underperforming Sainsbury by 20% and Morrison by 7%
Figure 20. Tesco, Morrison and Sainsbury YTD Share Price Performance
125 120 115 110 105 100 95 90 85

+20.3%

+6.9%

+0.5%

01 /0 8/ 10

01 /0 5/ 10

01 /0 1/ 10

01 /0 6/ 10

01 /0 9/ 10

01 /0 3/ 10

01 /0 4/ 10

01 /0 2/ 10

TESCO

MORRISON

01 /0 7/ 10

SAINSBURY

16

01 /1 0/ 10

NOTES

17

Important Disclosures
ANALYST CERTIFICATION: We, Jaime Vázquezand Borja Olcese, hereby certify that the views expressed in this research report accurately reflect our personal views about the subject company and its securities. We also certify that we have not been promised compensation either directly or indirectly for expressing the recommendation in this report.
This report has been prepared by Santander Investment Bolsa, Sociedad de Valores, S.A. (“Santander Investment Bolsa”) and is provided for information purposes only. This document must not be considered as an offer to sell or a solicitation of an offer to buy. Any decision by the recipient to buy should be based on publicly available information on the related security and, where appropriate, should take into account the content of the related prospectus filed with the CNMV (Spanish National Securities Market Commission) and available from the CNMV, the company governing the related market (Sociedad Rectora de la Bolsa) and the company issuing the security. This report is issued in the United States by Santander Investment Securities, Inc. (“SIS”), in Spain by Santander Investment Bolsa and in the United Kingdom by Banco Santander, S.A., London Branch (“Santander London”). Santander London is authorised by the Bank of Spain. SIS, Santander Investment Bolsa and Santander London are members of Grupo Santander. This report is not being issued to private customers. The information contained herein has been compiled from sources believed to be reliable, but while all reasonable care has been taken to ensure that the information contained herein is not untrue or misleading at the time of publication, we make no representation that it is accurate or complete and it should not be relied upon as such. All opinions and estimates included herein constitute our judgement as at the date of this report and are subject to change without notice. Santander Investment Bolsa may change the recommendation it has on a stock at any given time. It may also cease to cover a stock or initiate coverage of new stocks. There is no specific calendar for any such actions. From time to time, Grupo Santander and/or any of its officers or directors may have a position, or otherwise be interested in, transactions in securities which are directly or indirectly the subject of this report. Santander Investment Bolsa has internal rules of conduct that contain, among other things, procedures to prevent conflicts of interest with respect to recommendations, including: the consideration of its Research Department as a separate area, Chinese Walls, and the possibility of establishing specific restrictions on research activity where appropriate. Santander Investment Bolsa’s research reports contain a certification stating that they reflect the authors’ own opinions. Grupo Santander may from time to time perform services for or solicit business from any company mentioned in this report. Neither Grupo Santander nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. This report may not be reproduced, distributed or published by any recipient for any purpose. Santander Investment Bolsa is under the supervision of the CNMV. Any US recipient of this report (other than a registered broker-dealer or a bank acting in a broker-dealer capacity) that would like to effect any transaction in any security discussed herein should contact and place orders in the United States with the company distributing the research, SIS at (212) 692-2550, which, without in any way limiting the foregoing, accepts responsibility (solely for purposes of and within the meaning of Rule 15a-6 under the US Securities Exchange Act of 1934) under this report and its dissemination in the United States. US recipients of this report should be advised that this research has been produced by a non-member affiliate of SIS and, therefore, by rule, not all disclosures required under NASD Rule 2711 apply. © Santander Investment Bolsa, Sociedad de Valores, S.A., 2010. All Rights Reserved.

KEY TO INVESTMENT CODES*
Rating Buy Hold Underweight Under Review Definition Upside of more than 15%. Upside of 10%-15%. Upside of less than 10%. Covered with This Rating 53.03 25.00 21.21 0.76 % of Companies Provided with Investment Banking Services in Past 12M 61.11 16.67 19.44 2.78

NOTE: Given the recent volatility seen in the financial markets, the recommendation definitions are only indicative until further notice. (*) Target prices set from January to June are for December 31 of the current year. Target prices set from July to December are for December 31 of the following year.

LOCAL OFFICES
Madrid Tel: 34-91-257-2309 Fax: 34-91-257-1811 Bogotá Tel: 571-644-8006 Fax: 571-592-0638 Mexico City Tel: 5255-5629-5040 Fax: 5255-5629-5846 Lisbon Tel: 351-21-381-6580 Fax: 351-21-389-3680 Buenos Aires Tel: 54114-341-1052 Fax: 54114-341-1226 Santiago Tel: 562-336-3300 Fax: 562-697-3869 London Tel: 44-207-756-6605 Fax: 44-207-756-5033 Caracas Tel: 582-401-4306 Fax: 582-401-4219 São Paulo Tel: 5511-5538-8226 Fax: 5511-5538-8407 New York Tel: 212-692-2550 Fax: 212-407-4540 Lima Tel: 511-215-8100 Fax: 511-215-8185 Tokyo Tel: 813-3211-0356 Fax: 813-3211-0362

3Y STOCK PERFORMANCE VS RATING
140 120

100

Tesco

80

60

40

20

Buy Hold U/W U/R No Coverage

STOXX Retail

0 Oct-07

Jan-08 Apr-08

Jul-08

Oct-08

Jan-09 Apr-09

Jul-09

Oct-09

Jan-10 Apr-10

Jul-10

Oct-10

Source: FactSet and Santander Investment Bolsa.

18

TESCO sales. The most important

CURRENT PRICE: GBP430 TARGET PRICE: GBP490

Buy which accounts for 8.5% of sales.

Tesco is a global food retailer operating in 14 countries in Europe, Asia and the US. It has a very strong market position in the UK, where it is almost twice the size of the No. 2. The UK accounts for 68% of this year’s expected international operation is Korea,

Financial Data: P&L, Balance Sheet and CF Statement, 2008-13E
P&L Account (GBP mn) Total revenues YoY change (%) 2008/09 54,327.0 26.8 40,779.0 13,548.0 24.9 -5,802.0 -3,467.0 4,279.0 19.3 7.9 3,090.0 25.4 5.7 -362.0 324.0 2,954.0 21.6 -788.0 26.7 -5.0 2,161.0 25.3 2,020.0 2009/10 2010/11e 2011/12e 2012/13e 56,910.0 61,188.3 65,250.2 69,503.2 4.8 7.5 6.6 6.5 42,504.0 45,699.3 48,733.0 51,909.4 14,406.0 15,489.0 16,517.2 17,593.8 25.3 25.3 25.3 25.3 -6,195.0 -6,660.7 -7,102.9 -7,565.8 -3,415.1 -3,628.6 -3,734.8 -3,928.7 4,795.9 5,199.6 5,679.5 6,099.3 12.1 8.4 9.2 7.4 8.4 8.5 8.7 8.8 3,411.9 3,783.7 4,176.8 4,502.5 10.4 10.9 10.4 7.8 6.0 6.2 6.4 6.5 -314.0 -295.0 -206.3 -100.0 226.0 350.0 350.0 350.0 3,175.9 3,714.7 4,250.5 4,815.6 7.5 17.0 14.4 13.3 -840.0 -947.3 -1,083.9 -1,228.0 26.4 25.5 25.5 25.5 -8.7 -11.1 -12.4 -13.7 2,327.2 2,756.4 3,154.2 3,573.9 7.7 18.4 14.4 13.3 2,169.2 2,572.4 2,919.2 3,208.9 CAGR (%) 2010-13E 6.9 – – – – – – 9.7 – – 9.7 – – – – 14.9 – – – – 15.4 – – CAGR (%) 2010-13E – – – – – – – – – – CAGR (%) 2010-13E – – – – –

Per Share Data, 2010-13E
(GBp) 2009/10 2010/11e EPS 27.34 32.43 % chg 6.4 18.6 Adj EPS 27.34 32.43 % chg 6.4 18.6 DPS 13.05 15.23 % chg 9.1 16.7 CFPS 0.57 0.58 % chg 7.3 2.9 FCFPS 0.15 0.14 % chg -321.5 -9.0 Div payout 47.7 47.0 % chg 2.6 -1.6 2011/12e 2012/13e 36.80 40.45 13.5 9.9 36.80 40.45 13.5 9.9 17.29 19.00 13.5 9.9 0.67 0.75 15.6 10.6 0.19 0.27 35.5 43.3 47.0 47.0 0.0 0.0

COGS Gross profit As % of revenues Personnel expenses Other op expenses EBITDA YoY change (%) As % of revenues EBIT YoY change (%) As % of revenues Net interest expenses Extraordinary items Pre-tax profits YoY change (%) Taxes Tax rate (%) Minority interests Net profit YoY change (%) Adj. Net profit Balance Sheet (GBP mn) 2008/09 2009/10 2010/11e 2011/12e 2012/13e Fixed assets 30,538.0 32,414.0 33,248.1 34,789.7 35,929.7 Goodwill 0 0 0 0 0 Inventories 2,669.0 2,729.0 2,934.2 3,128.9 3,332.9 Trade receivables 1,798.0 6,144.0 6,285.9 6,420.7 6,561.8 Cash & equivalents 3,509.0 2,819.0 2,819.0 2,819.0 2,819.0 Total assets 40,536.0 46,023.0 47,204.2 49,075.3 50,560.4 Shareholders' equity 12,938.0 14,596.0 16,317.1 18,263.0 20,465.5 LT financial debt 6,294.0 11,744.0 10,375.4 9,378.6 7,683.8 ST financial debt 4,584.0 1,529.0 1,529.0 1,529.0 1,529.0 Trade payables 13,456.0 15,262.0 16,079.6 16,989.3 17,952.9 CF Statement 2008/09 2009/10 2010/11e 2011/12e 2012/13e (GBP mn) Op cash flow 4,184.2 4,524.9 4,656.0 5,380.4 5,949.7 Chg in working capital -86.0 -186.0 -35.1 -166.8 -185.8 Capex -4,650.2 -3,107.0 -3,500.0 -3,694.4 -3,586.8 Dividends -886.0 -968.0 -1,035.3 -1,208.4 -1,371.3 Free cash flow -552.0 1,231.9 1,120.9 1,519.2 2,177.1 Source: Company data and Santander Investment Bolsa estimates.

Source: Company data and Santander Inv B estimates.

Market Ratios, 2010-13E
(x) 2009/10 2010/11e 2011/12e P/E 15.8 13.3 11.7 EV/sales 0.7 0.7 0.6 EV/EBITDA 8.8 7.8 7.0 EV/EBIT 12.4 10.8 9.5 P/CF 7.6 7.4 6.4 P/BV 2.1 1.9 1.7 FCF yield 3.6 3.3 4.4 GDY 3.03 3.53 4.01 2012/13e 10.7 0.5 6.3 8.5 5.8 1.5 6.3 4.41

Source: Company data and Santander Inv B estimates.

Financial Ratios, 2010-13E
(%) ROE ROCE D/E D/EBITDA (x) Int cover 2010 16.9 14.4 0.5 1.7 15.3 2011E 17.8 14.6 0.4 1.2 17.6 2012E 18.2 15.8 0.3 0.9 27.5 2013E 18.5 16.5 0.2 0.6 61.0

Source: Company data and Santander Inv B estimates.

2009-10: Sales by Region
Asia 15% Europe 15% United States 1%

EBIT by Region
Asia 12% TPF 7%

Shareholder Structure
Free Float 100%

Rest of Europe 13%
TPF 2% UK 67%

UK ex-TPF 68%

Source: Company data and Santander Investment Bolsa estimates.