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