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What Happened to Tesco?

March 11, 2014 | About:
Josh Zachariah

Josh Zachariah

36 followers

The British grocer Tesco (TSCDY) has certainly seen better days. The year 2013 seemed to be the nadir for the company until 2014 rolled around. Last year the company saw declines in its business globally. Its South Korean business was squeezed as the government enacted reduced operating hours for supermarkets. Thailand sales saw declines resulting from the extensive flooding. The company left the U.S. with a massive write-down, and the company’s mere presence in Eastern Europe — well, that needs no explanation. Add on top of that that its UK core which the company has been tending to is showing no improvement.

Today the company was showered with more bad news. The German grocer Aldi grew its market share to 4.3% from 3.3% in a year-on-year comparison for the past three months. Tesco nearly shed a full percentage point to 28.7% for the period. The UK supermarket industry which has traditionally had some of the highest margins in the Western world is seeing those good fortunes crumble.

Several years back the UK anti-trust authority came down on the large grocers for price collusion. The grocers had market power at the time and it showed in their financials. Now the rule isn’t collusion and market power, but ferocious price wars to preserve market share. Unfortunately these price wars mean lower prices and lower margins without any gain to sales and consequently lowered returns on equity, the benchmark for market power. This is surely why Warren Buffett (Trades, Portfolio) has curtailed his holding in Tesco from some 5% to 3.7% as of 2013.

An analyst had suggested Tesco should put the squeeze on the discounters by slashing prices dramatically. A move like that could be successful if the discounters were operating just above cost, but the margins of Aldi are only slightly below that of Tesco’s. Aldi reported a UK operating margin of 4.4% in 2012 and pre-tax margin of 4% on $3.9 billion in sales. It seems that these discounters have a cost structure that is very competitive with the likes of the major chains.

One bright side for Tesco is its online grocery segment which has been growing at double digits annually and one where they claim some 50% of the market. The problem is that it is still a small part of total sales and it will have to grow much faster to make up for losses in Tesco’s large format stores. Nevertheless if sales continue to migrate online Tesco will be much better positioned than most as it has the cash flow to fund expansion.

The million-dollar question readers of this website may ask is, is Buffett selling into this market? He trimmed some of his Tesco stake in the fourth quarter of 2013, but shares are worth 15% less today and just over 10x the expected earnings for 2014. Tesco has certainly lost its luster, but even mediocre businesses sell for more than 10x earnings.

A possible scenario of things to come may include a UK grocery environment with permanently lower profit margins. Stores like Tesco will retrench their assets to pump up inventory turnover and make up for margin erosion. Already Paul Singer (Trades, Portfolio) of Elliot Management is pushing Morrison’s to start liquidating its property into a conveniently hot UK real estate market. In the early '90s Tesco had profit margins less than 3% while its asset turnover was much higher. Granted, today's Tesco is much different, including global operations along with Tesco Bank, but its higher margins are at odds with its early motto, “Pile it high, sell it cheap.”

Another scenario may include Tesco taking a less aggressive stance on pricing. Management seems to believe an improvement in the economy is coming and when it does consumers will return to their branded goods including Heinz and Coca-Cola at Tesco as opposed to the private-label products that are found at Aldi. Tesco has announced price cuts on certain items such as milk and cucumbers, but they have yet to commit to a more aggressive pricing strategy against the discounters. Time will tell if this logic proves to be correct and fortunately the company has the positive cash flows and the time to steer the ship in the right direction should the low-margin environment prevail.

Long Tesco PLC

About the author:

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

Rating: 4.9/5 (8 votes)

Voters:

Comments

graemew
Graemew - 5 months ago
The last straw for me was when Tesco announced that they had bought the Giraffe restaurant chain and the Harris and Hoole coffee shop chain. Management just couldn't face up to the fact that they had reached a strategic dead end...so they trumpeted these small acquistions and went about some store redecorations rather than tackling head on their serious problems which in my opinion include quality issues and management complacency. For me Tesco seems stuck in quicksand ...the company needs new, highly experienced, financially savvy and creative management to salvage the sinking ship. However often when things look the worst is when it's the best time to buy....if only Carl Icahn (Trades, Portfolio) or Nelson Peltz could take a stake!

Josh Zachariah
Josh Zachariah - 5 months ago

I agree entirely. Getting into the restaurant business is just plain rediculous. Wal-Mart leases out space to Mcdonalds and Subway in its American stores. I was also a little vexed about Tesco's and its competitors drive to get into the tablet market. I see how they want to have a multi-channel approach and be able to interact with the customer, but why not just focus on building a great app for tablets as opposed to creating a tablet?

As frustrated as I am with Tesco, I can't sell at these prices. They're not going away, though I think margins will be permanently impaired. In Morrison's statement today the company acknowledged the growth in discounter chains is not cyclical but structural, which is at odd's with Tesco's logic. Regardless, today's selloff was excessive as even Morrison's revenue dip was only 2%. The earnings hit was one-off items that brough earnings down

DocMoney
DocMoney - 5 months ago

Tesco has a quality and a customer service problem. Check their facebook page. Rotten vegetables, foreign objects in food, products not as advertised... Until this is fixed, success will elude them.

batbeer2
Batbeer2 premium member - 5 months ago

>> I think margins will be permanently impaired.

Are you saying this time is different?

- If no, then we wil one day see stronger margins.

- If yes, then the only real change is online. Tesco is much better at that than anyone else.

Just some thoughts, thanks for an interesting read!

parklanefamilyoffice
Parklanefamilyoffice premium member - 5 months ago

Buffett cut his holdings thru the sale of a derivatives position (voting rights equity swap) a long time ago. This is reported as news now, which is weird.So "Surely" is not the word I would use. If he was truly bearish, he would probably have sold more already.

Regarding margins, Tesco could have EBIT margins sliced all the way to 4% flat forever and still be worth 10% more than today. In that scenario though,their market share would probably grow markedly at the expense of Sainsburys, Morrisons and others who have lower EBIT margins.

A prolonged price war is not in anyones interest. If it happens, tesco will win. But they will try to avoid it at all costs. Market share is unimportant to some extent, Tesco is huge and will stay huge. They are not at risk of losing the position as the largest retailer in the UK.

Market share has gone from 30.3% in 2007 to 28.7% in 2014. This is not that dramatic. Asda has about 17% while Morrisons has about 10%. I mean, let's keep things in perspective. Tesco doesn't care if their amrket share falls to 25% as long as the prfitability is good. ROIC is the name of the game now for that industry. They will will stay away from price wars as long as possible. Hence the tentative 200m GBP price cuts recently.

In a scenario where Tescos EBIT margins dip from say 5% this year to 4.5% in fiscal 2015 and stay there until 2019 and then recover to 5%, the stock should be worth about 4.5 GBP.I think that's much more realistic. I am basing this on an average top line growth rate of 4.6% (very reasonable assumption, IMO)., an 8% WACC and a 2.5% terminal FCF growth rate.

I'm confident Tesco is a solid buy here. Remeber Wal-Mart at P/E 11? Didn't last long, did it.


parklanefamilyoffice
Parklanefamilyoffice premium member - 5 months ago

I would also add that I disagree that Giraffe, H&H etc are bad ideas. Economically, the results are promising (ref company presentations and transcripts) and they help make Tescos larger stores more attractive as shopping destinations. As for quality issues, customer satisfaction is on the rise, and management are clearly making this a priority. I think (very few agree with me) that management is handling this diffcult period well.

Turning around a giant after it lost its way in the late innings of Leahy's tenure will take time. Investors have no patience for long term fixes.Personally, I love it when something is perceived as dead money.

parklanefamilyoffice
Parklanefamilyoffice premium member - 5 months ago

Finally on the subject of Buffett's holdings of Tesco, one should note that on an updated shareholder's list of Tesco, Berkshire is listed with approxximately 3.7% of the stock. But Geico is also listed with 90m shares or about 1.1%. The Geico position is not part of the Berkshire listed position as it is part of a Berkshire subsidiary pension fund. So the Buffett sphere really owns 4.8%.

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