Investment Report Module: 301LON- International

Investment Analysis

Tutor: Maggie Gao|

2012

Muhammad Tanvir Hossain

Student ID: 4325352

6/27/2012

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2 Contents Introduction: ........................................................................................................................ 3

1. The Company: .................................................................................................................. 4

2. Porter’s five forces: .......................................................................................................... 4

2.1 Bargaining power of buyers: ...................................................................................... 5

2.2 Bargaining power of suppliers: .................................................................................. 5

2.3 Competitive rivalry: ................................................................................................... 6

2.4 Threat of substitutes: ................................................................................................. 6

2.5 Threat of new entrants: ............................................................................................. 6

3. Competitive strategies: .................................................................................................... 6

4. Operating exposure: ........................................................................................................ 7

5. Management of operating exposure: ............................................................................... 8

Matching currency cash flows:......................................................................................... 8

Risk-sharing agreement: .................................................................................................. 8

Back-to-back or parallel loans: ........................................................................................ 8

Currency swaps: ............................................................................................................... 9

Conclusion:......................................................................................................................... 10

Recommendation: .............................................................................................................. 10

References: ......................................................................................................................... 11

Appendices 1: ..................................................................................................................... 13

Appendices 2: ..................................................................................................................... 14

Political factors: ............................................................................................................. 14

Economical factors: ........................................................................................................ 14

Social cultural factors: ................................................................................................... 15

Technological factors: ..................................................................................................... 16

Environmental factors: .................................................................................................. 16

Legal factors: .................................................................................................................. 16

Appendices 3: ..................................................................................................................... 16

Appendices 4: ..................................................................................................................... 17

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3 Introduction:

This is an investment report based on Tesco, which is a well-known U.K’s

supermarket chain. The Tesco Group is now considering expanding their business

internationally. I am their newly appointed international operations officer. In this

report the substance below will be analysed in order to manage the operational

currency risk exposure while the company is striving to maintain its position in the

global market.

The company (please see more in appendices)

Country analysis in this case is Brazil

Porter’s five forces framework

Competitive strategies

Operating exposure and how to manage different risks

Recommendation for Tesco to perform well in the international market

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4 1. The Company:

In 1919, Tesco was founded by Jack Cohen from a market stall in London’s East

End. (Tesco, 2012) The company trades internationally either through by its own

retail stores or partners. Tesco group has large number of stores based in the UK.

(Tesco, 2012)

Tesco Group’s profit margin in the market is great by its report that the profit they

earned from 2006 to 2011 was from £0.5bn to £1.0bn. (Tesco annual report, 2012)

For details, please see appendices 1.

The group has increased the profit double in the past 5 years of time. The amount

shows that Tesco Group has consummate an exceptional performance in the UK

market. This is the right time for the Group to expand their business into a new

emerging market, for example, Brazil. Details please see appendices 2.

2. Porter’s five forces:

Over the last two decades, government has lunched welfare schemes that halves

poverty rate in Brazil. Brazil was just like another emerging economy even in the late

1990s with extremes of assets and horrible poverty. But the emerging of middle

class empowered with good purchasing power has made Brazil’s name in the global

retail sector in the last decade. (Thomas White, global investing 2012)

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5

Source: Notes Desk, 2009

2.1 Bargaining power of buyers:

Buyer has the power to force the prices down. Buyers have moderate power in Brazil

as there are few company competitions within themselves, such as Pao de Acucar,

Carrefour S.A, Wal-Mart, Lojas Americanas, Lojas Renner and CIA Hering. If

bananas are too expensive in Tesco, buyers will move to other supermarkets. Good

news for Tesco, there is few large supermarkets retailers. That means Brazil have a

disciplined market where well organised price setting. Disciplined price setting stops

them putting unfair price tagging in a profit war.

2.2 Bargaining power of suppliers:

Tesco have 3,500 suppliers and 90% of them reported that we are trustworthy. The

competition between suppliers is high and bargaining power low with Tesco. In Brazil

there are mainly 3 supermarket chains operates, Pao de Acucar, Carrefour S.A and

Wal-Mart Brazil. Suppliers have less option to supply other supermarkets hence their

bargaining power is low in Brazil as well. Tesco have a vast advantage over the

relatively small shopkeepers, such as off licenses shops. They can dictate the price

they pay to the suppliers. Suppliers must reduce price otherwise they will be left with

a much smaller market for their products, for example banana suppliers from

Ecuador or grapes suppliers from South Africa.

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6 2.3 Competitive rivalry:

In Brazil world’s two largest supermarket chain operates Wal-Mart and Carrefour

plus their local supermarket brand Pao de Acucar. Carrefour has an offer to merge

its Brazilian operations with Companhia Brasileira de Distrubuicao, a fancy Brazilian

chain. (The Economist, 2011) Tesco will face great competition from these

companies. Carrefour will be benefited from operating cash flows as they are

merging with local supermarkets.

2.4 Threat of substitutes:

Brazilian consumers are very trendy and give value to status as well as brand

names. Tesco is the 3rd largest supermarket chain in the world and well known brand

in many countries. Tesco’s ‘Value’ products are cheaper and great quality than other

substitutes product available in the market. Tesco will have less threat from its

substitute products.

2.5 Threat of new entrants:

Pao de Acucar, Carrefour, Wal-Mart and other supermarket put significant barriers to

entry. New supermarket chain such as Tesco will face compulsory barriers on them

from existing supermarkets implicitly and explicitly. For an example, Pao de Acucar

are good at bakery goods; Tesco will not able to find a cheap and reliable suppliers.

Importing raw materials will be costly for Tesco as they have to worry about

exchange rate and economic exposure.

3. Competitive strategies:

Brazil has many competitive national advantages which can be very use for Tesco

for their main 7 strategies. Tesco’s 2 main strategies are to grow in the UK market

and deliver an outstanding international service in retail stores and online. Tesco has

large number of profit from international business that present 30% of their group’s

profits. (Tesco PLC, 2012) Tesco also committed to the communities and the

environment. Tesco give more ‘Club Card’ points when consumers use reusable

bags. Tesco’s 6th strategy is to create a highly valued brand where providing

customers with the quality products at competitive prices. Brazil’s literacy rate is 90%

and Tesco’s final strategy is to build own team so that we can create more value.

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7 4. Operating exposure:

Operating exposure can be explained as a level to which the firm’s operating cash

flows would be affect by random changes in the exchange rate. (Eun, Resnick, 2012,

345) It is important for Tesco to manage operating exposure carefully to stabilise

cash flows in the face of fluctuating exchange rates. (See more on Appendices 3)

The four main important strategies which can assist Tesco Group to reduce the

operating exposure are listed below:

1. Market selection strategy

2. Production differentiation strategy

3. R&D strategy

4. Input sourcing/plant locating strategy (Eun, Resnick, 2012)

These strategies are suitable for marketing strategies and more appropriate in

marketing approaching. Attributes of operating exposure are transaction exposures

and anticipated transaction exposures. There are two types of cash flow, operating

cash flows and financing cash flows. Illustration of operating exposure:

The exchange rate between Brazil’s currency R$ and UK currency GBP is: £1 = R$

3.247. (Yahoo finance, 2012)

Let’s say Tesco manufactures in Brazil and half of its production sold in Brazil and

half outside of Brazil. All sales are invoiced in R$. Annual revenue equal to ¼ of

annual sales and the average collection period is 90 days. Inventory is equal to ¼ of

annual direct costs. (Lakehead University, 2012)

Depreciation (D) is R$40,000 per year and the corporate tax rate (t) is 20%.

Exchange rate: £3.247/R$

Sales volume (Q): 100,000 units

Sales price (p): R$8.0 per unit

Direct cost (c): R$6.0 per unit

Operation expenses (F): R$89,000

Tesco’s expected cash flows from operations (CFO) in 2012 is:

CFO = (1 - t)(pQ – cQ – F – D) + D

= (1 – t)((p – c) Q – F – D) + D

= (1 - .20)((8.0 – 6.0) * 100 – 89 – 40) + 40

= R$(.80)(200 – 89 - 40) + 40

= R$96.8

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8 = £314.31 (approximately) (see more in Appendices 4)

5. Management of operating exposure:

Operating exposure can partially manage by operating financial policies offsetting

anticipated currency exposures. Most common policies are:

Matching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

Matching currency cash flows: Tesco can hedge to equalize unexpected losses

that may occur in the future by matching its assets and liabilities. Tesco can use

financial tools such as insurance, forward contracts to hedge unforeseen losses.

Tesco can be benefited by using Brazilian currency for export its goods and that will

give the company the competitive advantages over competitions.

Risk-sharing agreement: Contractual agreement between buyer and seller to

‘share’ currency risk on payments. (Connolly, 2007) This will minimise the risk that

may occur in foreign currency exchange rate. For example:

Tesco has to pay Gillette $100,000.

Tesco purchases from Gillette in US Dollar at current spot if spot £ is

b/n $.80 & $.85.

If spot rate falls outside range, such as $.90 or $.75, Tesco & Gillette

share the differences.

If spot rate is $.75, Gillette gets payment of $100,000 / ($.80 – ($.05/2))

= $77,500

If spot $.75/£, risk sharing favours Tesco but if spot $.90/£, then risk-sharing favours

Gillette.

Back-to-back or parallel loans: Two firm borrowing from different countries each

other’s currency for a specific period of time. Two loans should be equal value at

current spot.

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9

For example: Tesco buy petroleum from Holland and export it in Brazil. Tesco’s

major expenses will be in Pounds (£) while earning will be in Real (R$).

If the exchange rate is R$ 3.247/£, Tesco Brazil receives petroleum worth £1000, it

will pay R$3247 to Tesco’s account in Brazil.

Currency swaps: Dealer & firms are agreed to exchange certain amount of two

different currencies for a specific period of time. It has advantages of wide range of

maturities and fee to compensate for interest rate differential.

It does not appear in Tesco’s balance sheet. Via swap both translation and operating

exposure can be avoided.

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Conclusion:

Tesco has great opportunities doing business in Brazil as it is world 7th strongest

economy also 190 million of people and over 80% of people are educated. The

strategies Tesco group have not all of them might work in Brazil. Brazil has low

income tax and federal tax and this is a big opportunity for Tesco. Tesco not only

face competition from international supermarket in Brazil also they will face

competition from local supermarkets too.

Recommendation:

To hedge the risk doing business in international market Tesco Group can apply all

the financial tools I have mention in this report as well as, Reinvoicing Centres,.

For managing operating exposure Tesco can apply marketing strategies and product

management. For example: Market selection, pricing and promotional strategy, input

mix, plant location & shifting production and raising productivity.

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11 References:

Eun, Resnick, Sabherwal (2012) International Finance. 6th EDN. New York:

McGraw-­‐ Hill Company.

Connolly, 2007 ‘Hedging Foreign Exchange Currency, School of Business

Administration, University of Miami.

Background note: Brazil, U.S. Department of State. [Online] available from

<http://www.state.gov/r/pa/ei/bgn/35640.htm>[30th November 2011]

Brazil VAT and Other Taxes, worldwide-tax. [Online] available from

<http://www.worldwide-tax.com/Brazil/brazil-vat-taxes.asp> [26th of June 2012]

Brazil - tariff rate, index mundi. [Online] available from

<http://www.indexmundi.com/facts/brazil/tariff-rate> [June, 2012]

Brazil's trade policy, The Economist. [Online] available from

<http://www.economist.com/node/21542780> [14th Jan, 2012]

BRIC Spotlight, Thomas White, Global Investing. [Online] available from

<http://www.thomaswhite.com/explore-the-world/bric-spotlight/brazil-retail.aspx>

[March 2012]

Currencies Centre, Yahoo Finance. [Online] available from

<http://uk.finance.yahoo.com/currencies/converter/#from=BRL;to=GBP;amt=1> [26th

Jun, 2012]

Internet World stats. [Online] available from

<http://www.internetworldstats.com/stats15.htm> [1st March 2012]

International Monetary Fund, World economic outlook Database. [Online] available

from

<http://www.imf.org/external/pubs/ft/weo/2012/01/weodata/weoselser.aspx?c=223&t

=1> [April 2012]

Operating exposure, Lakehead University. [Online] available from

<flash.lakeheadu.ca/~pgreg/assignments/4079chapter9n.pdf> [2012]

Operating Exposure. [Online] available from <pages.stern.nyu.edu/~llitov/teaching/>

Porter's five forces model, Notes Desk. [Online] available from

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12 <http://notesdesk.com/wp-content/uploads/2009/04/porters-five-forces-model.jpg>

[4th April, 2012]

Supermarkets in Brazil, The Economist. [Online] available from

<http://www.economist.com/node/18897881> [30th June, 2011]

Tesco Financial Review. [Online] available from

<http://www.tesco.com/investorInformation/report96/page22a.html> [2012]

Tesco Financial Highlights. [Online] available from

<http://www.tesco.com/investorInformation/report97/review/pagea.html> [2012]

Tesco History. [Online] available from

<http://www.tescoplc.com/index.asp?pageid=11> [2012]

Tesco operations. [Online] available from

<http://www.tescoplc.com/index.asp?pageid=8> [2012]

The World Bank, Brazil. [Online] available from

<http://data.worldbank.org/country/brazil> [2012]

Tesco online profits, Computing. [Online] available from

<http://www.computing.co.uk/ctg/news/1818618/tesco-online-profits-26-cent> [20th

April 2010]

Tesco strategy, Tesco PLC. [Online] available from

<http://www.tescoplc.com/index.asp?pageid=97 > [26th June, 2012]

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13 Appendices 1: Tesco company information:

Financial Highlights:

£72.0bn Group sales

+7.4% Group sales growth

£3.8bn Group profit before tax

+5.3% Group profit before tax growth

+2.1% earnings per share

Operating Highlights:

Receive prestigious award in 2011 ‘Green Supply Chain’ in China.

Vision: Our vision is for Tesco to be most highly valued by the customers we serve, the communities in which we operate, our loyal and committed staff and our shareholders; to be a growth company; a modern and innovative company and winning locally, applying our skills globally. In May 2011, we launched our four-part vision for the future of the business. We would like Tesco to be seen as the most highly valued business in the world. Valued not only by our customers, but also by the communities we serve our staff and our shareholders. We are, and we will remain a growth company. We will continue to pursue growth in all parts of the business – in the UK, internationally, in services and across general merchandise, clothing and electrical. We will be a modern and innovative company. We’ll stay ahead of the curve, anticipating changes and adapting for the sake of our customers and staff. We will win locally by applying our skills globally. The key word here is ‘locally’ – all retailing is local. But increasingly we are utilizing the skill and scale of the Group to benefit the performance and competitiveness of each of our businesses around the world. Tesco’s Value: Tesco’s Value:

No one tries harder for customers:

Understand customers.

Be first to meet their needs.

Act responsibly for our communities.

Treat people how we like to be treated:

Work as a team.

Trust and respect each other.

Listen, support and say thank you.

Share knowledge and experience.

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14 Appendices 2:

Country Analysis:

As Tesco Group decided to go international market, Brazil is one of the emerging

markets where Tesco has great chance to do well.

Political factors:

Brazil has very stable and peaceful democratic political system, without any external

enemies. Brazil has higher tariff rate then UK. (Brazil’s tariff rate, 2012) Brazil has

protective trade policy for her own industries. The aim is to influence more foreign

direct investment than import goods and services. (Brazil’s trade policy, 2012)

Exhibit 2.1: Unemployment rate, source: IMF.

The table above shows Brazil will have more unemployed people coming year than

2012. This is a risk for Tesco because will spend less money.

Economical factors:

During the global recession, it has less impact on Brazil. Brazil is the 7th largest

economy in the world. Exhibit 2.2 shows Brazil’s GDP will grow from 2012 to 2014 by

$2,450 to $2,691bn. Tesco has great chance to do well in Brazil’s market as their

economy getting stronger.

5.4 5.6 5.8

6 6.2 6.4 6.6 6.8

7

Brazil Unemployment rate:

Brazil Unemployment

rate Percent of total

labor force Source:

National Statistical

Office Latest actual

data: 2011 Primary

domestic currency:

Brazilian reais Data

last updated: 03/2012

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15

Source: International Monetary Fund, 2012

Social cultural factors:

Brazil’s population, currently 190 million and annual growth rate 1.17%. (Background

note: Brazil 2011) Among this large number of population, Brazilians are stylish and

fashion- oriented and they like to spend money with very high literacy rate of total

adult population 90%. (The World Bank, 2012)

Exhibit 2.3: Household expenditure

Source: EIU (Economist Intelligence Unit), July 2006

0

500

1000

1500

2000

2500

3000

1 2 3 4

Country Subject

Descriptor Units Scale

Country/Series-specific

Notes

Brazil Gross domestic

product, current prices

U.S. dollars Billions

See notes for: Gross

domestic product,

current prices

(National currency).

2005

Food, beverages & tobacco

Clothing & footware

Housing & household fuels

Household goods & services

Health

Transportation &

communications

Leisure and education

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16 Tesco Group has big opportunity to capture food, beverages & tobacco markets as

well as household fuels as those are its main business.

Technological factors:

Brazil is the fifth largest internet user in the world and top in the South American

region with amount of users are 81.8 million. Tesco’s online revenue growth of 14%

and 26% increase in profit. (Computing, 2010)

Environmental factors:

Brazil is the partner of Free Trade Area of the Americas (FTAA) and Brazil has

industrial structure for cleaner air. Brazilian government are strict on mandatory

norms on environmental legislation. It is also Tesco’s corporate ethics to recycle and

be environment friendly.

Legal factors:

Tesco can be benefited from Brazil’s federal V.A.T and tax system. Brazil’s federal

V.A.T rate is 20%, where average V.A.T rate is 17%. In Sao Paulo the standard rate

is 18%, whereas in Rio de Janeiro the rate is 19%. Brazil has very low tax rate for

acquiring property and annual tax is as low as 0.2%. (Brazil V.A.T and Other Taxes,

2012) Tesco will be also benefited from Brazilian government as they are giving tax

concessions to foreign investors. Also there are very few compulsory law required for

national security.

Appendices 3:

In common, there are four types of risks that a company would face when they are

planning to invest in a new market.

The risks are following below:

1. Currency risk

2. Country risk

3. Cross-culture risk

4. Commercial risk

In this report I am going to focus on operating exposure which is part of currency risk

and how to manage that exposure by using several financial tools. Currency risk also

includes foreign exchange rate, interest rate, inflation and currency inconvertibility.

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17 Before even I start doing into details, foreign exchange rate is the exchange rate

between two countries’ currencies. Tesco operating internationally and the exchange

between home country and foreign country have major affects to the Groups. There

are three exposure that would affect Tesco’s finance and operating directly,

economic exposure, transaction exposure and translation exposure.

Tesco owes its overseas supplier, R$1million, which is due for payment in two

months. The current spot rate is R$3.0/£ and the UK interest rate is 6%. It is forecast

that the starling will depreciate to R$2.5/£ over the next two months.

Under what circumstances should Tesco Group lead the payment?

Solution:

Sterling is forecast to depreciate to R$2.5

- Do nothing

Payment=R$10, 00,000/R$2.5=£400,000

- Leading payment

Borrow sterling to buy at spot rate and make payment

Borrow=R$10,00,000/R$3.0=£333,333.33

Repay borrowing in two months=£333,333.33*(1.01) = £336,666.67

Effective exchange rate=£2.90

Therefore, by using leading technique helps Tesco to avoid suffer from the

depreciation of GBP, which effectively hedged the currency risk.

Appendices 4:

If there is no change then Tesco’s level of NWC is not expected to change and it will

remain same in next 3 years as £502.896(3 years tax 20%)

If the value of the Brazilian Real falls from R$3.247 to R$2.95 in year 2013 January,

the present value of the firm’s cash flows will fall to £332.422 for a decrease of

£170.74.