U.K. retailer Tesco PLCÂ (LSE:TSCO, Financial) used to be the jewel in the country’s retail empire. The company was in almost every single town, village and city within the U.K. and a huge overseas presence. At its peak, the company accounted for more than a third of the U.K.’s total market and was the world’s third-largest supermarket group with stores in 12 countries. One British pound ($1.26) of every seven pounds spent in the U.K. went into Tesco’s tills at its peak.
In 2013, however, the company started to unravel. Its market share began to fall, customers started going elsewhere and a number of the company’s overseas ventures were shut down. An accounting scandal followed, the dividend was cut, non-core businesses were sold and speculation of a rights issue to shore up the balance sheet swirled. By 2015, the company was on its knees and even Warren Buffett (Trades, Portfolio), who had bought into the business at its peak, decided to sell, calling one of his few mistakes.
An important lesson
Tesco’s rise and subsequent fall is a great lesson for retail investors across the board. The company's success was driven by its rapid expansion. The group expanded out of food retail into businesses such as fast-casual dining, clothing and even tried to turn some of its largest stores into shopping malls. Tesco also embarked on a space war, acquiring thousands of acres of land for its retail stores across the U.K. in an attempt to price competitors out of the market and give itself a vast property portfolio.
But while Tesco was expanding (between 1998 and 2011 the company’s earnings grew from 7 pounds to 34 pounds), return on capital employed (ROCE) collapsed, a huge red flag for investors. Between 1998 and 2011, ROCE fell from 20% to 13%. What’s more, according to the Financial Times, Tesco changed its definition of return on capital employed eight times.
In his 1979 letter to shareholders, Buffett wrote, “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.”
Unfortunately, it seems he did not take his advice on Tesco. But it is not too late for current retail investors to heed the same warning as the sector faces increasing pressure from the likes of Amazon (AMZN, Financial) after several years of aggressive expansion.
Second time lucky?
Macy’s Inc. (M, Financial) is a prime example. Over the past five years, the company’s capital base has remained almost constant, with total liabilities and shareholder equity falling from just under $21 billion to just under $20 billion at year-end 2017. Over the same period, return on capital employed has collapsed from 15.2% at the end of 2012 to 9.3% for 2017. Return on assets has more than halved from 6.2% in 2013 to 3.1% for 2017.
Wal-Mart Stores Inc. (WMT, Financial) is suffering attrition. In fact, the retailer's deterioration is even more pronounced because the company has invested around $8 billion in its operations since 2012, taking book value from $71 billion to $78 billion by year-end 2017. Despite this investment, return on invested capital has declined from 20.2% to 17.3%. Return on assets decreased from 8.5% to 6.8% and return on equity has dropped from 23% to 17.2%.
What’s interesting about these figures is that while Walmart’s earnings and efficiency have been deteriorating, the company has continued to attract a premium valuation. Indeed, back in 2013, shares traded in a price-earnings (P/E) range of 17.1 to 12.6. Today, the shares trade in a range of 18.4 to 14.9. Even though net profit has fallen by around $2 billion per annum and the company has invested $7 billion with little to show for it, it seems the market does not care. In addition, investors do not appear to have learned anything from Tesco’s debacle.
Disclosure: The author owns no stock mentioned.
