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Tesco And Its Lofty Profit Margins

June 06, 2012 | About:
Josh Zachariah

Josh Zachariah

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Tesco (TSCDY) has been a favorite stock of this website for several reasons. The main one being that Warren Buffett owns 5% of the company, but some columnists have focused on the company’s balance sheet, specifically its valuable real estate portfolio. I tend to see value in the cash flow and income statements.

As the graph below shows, Tesco has the highest margins of the major grocers in the UK. Now this can be good thing and it can be bad thing. It is good in that it provides an ample cushion of profit should costs creep up. At the same time it tends to be inversely related to asset turnover. In 1995 Tesco had an asset turnover of 1.84 and profit margin of 3.4%. We see as the profit margin has crept up, sales per dollar of assets has gone down.

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Despite its high margins, Tesco remains the largest grocer in the UK with around a 30% market share. It is also one of the lower priced of the large grocers along with Asda. Tesco churns out high free cash flows and is moving more towards a sale-leaseback strategy for its real estate in order to minimize capital outlays.

Why Tesco Will Thrive

Last fall Tesco initiated a strategy called the “Big Price Drop” to stimulate demand for its goods through lower prices. Early results have shown declines in comparable sales, but it is still too early to pass any judgement. Sales could very well have been much worse without this strategy. The strategy, however, is the right track for the company.

In "The Great A&P and the Struggle for Small Business in America" the author delves into the collapse of one of the great supermarket chains in the U.S. A&P is credited (or chastised) for homogenizing the goods we see on grocery shelves as well as pushing the use of preservatives. In doing so the company was able to bring its costs down. The chain also used its clout, much like Tesco has, to force price concessions from suppliers. This came to an end with the Robinson-Patman act, but it only slowed down A&P.

The demise of A&P, the author concludes, was brought on by its own doing. He wrote that the company’s failure to reinvest in the company as well as its inching prices higher to lock in juicier profit margins ultimately pushed customers to other stores.

Tesco seems to be heeding A&P’s failure by doing just the opposite. It is plowing £1 billion into its UK operations by means of store aesthetics, more staff and investment into its online business. Coupled with lowered pricing this looks to be the recipe for long-term success. Tesco acknowledges return on capital employed will be flat this year because of the capital investments, but they expect it to grow above 14% by 2014.

Walmart (WMT) also seemed to be following the same path as both A&P and Tesco. In 1998 Wal-Mart was pushing $2.59 of sales per dollar of assets on a profit margin of 2.9%. The most recent year shows $2.31 of sales per dollar of assets on a 3.5% profit margin. In plain English, Walmart is forcing higher profit margins at the expense of asset turnover.

This should not come as a surprise. Walmart’s price advantage over Target and other competitors has waned over the years and it has gone from the cheapest retailer to just a cheap retailer. The company had gotten away from the “Everyday Low Price” scheme its founder championed. There was good reason to push such a strategy. If consumers believed you were the cheapest retailer then you could reduce spending on advertising.

Walmart has since realized its follies and did make a push to lower prices, and Tesco is doing the same. Like Tesco, Walmart had been in a slump for some time with same store sales declining. The company is finally seeing improvement, albeit modestly, but investors have taken notice and have pushed its stock from the mid-$50s to mid-$60s in just a year's time. Hopefully Tesco's experience will be just the same.

Disclosure: Long Tesco (TSCDY)

Josh Zachariah

About the author:

Josh Zachariah
I credit my father and Warren Buffett for molding me into the investor I am today.

Rating: 4.4/5 (20 votes)

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