Analyzing a company is like putting together a jigsaw puzzle
that you bought at a garage sale some pieces will always
be missing. No matter how hard you try, youll never have
a complete picture. But the beauty of investing is that to
succeed you dont need all the pieces, just enough to see
what the picture is trying to tell you.
Ive been solving the puzzle of Tesco since
Warren Buffett bought a stake in the grocer a few years back.
The pieces I gathered piqued my interest enough to actively
follow the company every quarter but not enough to buy its
shares. Finally, over the past few months, Tescos puzzle
came together for us and we purchased its stock.
Tesco used to be the U.K.s darling retailer its
Wal-Mart or Target. It is still one of the largest global
retailers, with sales topping £74 billion ($120 billion).
Two-thirds of its sales come from the U.K. and Ireland; the
rest are divided more or less equally between Asia and Eastern
Tesco was well managed from the early 90s through the
mid-2000s and grew earnings like a clock. Its stock went up
eightfold during that period. It had an impeccable reputation
and a conservative balance sheet. As the largest retailer in
the U.K., Tesco had competitive advantages that are usually
hard to come by in retail: huge buying power and enormous real
estate holdings. The latter is a key asset in the U.K.
Ive been told (facetiously, though theres a lot of
truth to it) that it is easier to get a permit to build a
nuclear power plant in the U.S. than it is to get one for a new
grocery store in the U.K.
During the global financial crisis, Tesco management thought
we were facing a depression, not a recession. They overreacted,
and instead of putting on a long-term hat, they put on a
flimsy, short-term one. They went into preservation mode,
stopped reinvesting in their stores and cut costs. Though Tesco
squeaked through the crisis in one piece, these decisions came
back to bite the company stores looked tired, customer
service declined, and merchandise selection became stale.
Predictably, Tesco started ceding 30 percent of its market
share to rivals. Mistakes are human, any management will make
them, but it is how a company goes about admitting and fixing
them that matters. Tescos management owned up to their
mistakes and started fixing them fast. They cut prices, hired
thousands of associates and reinvested in the business. The
stores appearance, selection and customer service
improved dramatically my scuttlebutt research confirms
this, and the data supports it too and same-store
grocery sales turned positive.
There were two other pieces of the puzzle I could not solve
in the U.K. market: First was the attack from discount
retailers like Aldi that offer limited selection but at lower
prices than traditional grocers. However, after observing the
U.S. market, I realized that while discount retailers will
always have a place in the grocery business, their market share
will always be limited. Wal-Mart, Target and Costco have taken
market share in groceries for a long time, and they have
probably curbed a few points of growth from other grocery
retailers, but grocery shopping is in large part driven by
convenience and a stores proximity to our daily commute
route. A grocery store that offers a good shopping experience
and diverse, high-quality selection (not necessarily at
rock-bottom prices) is one to which consumers will default for
most of their shopping. That is why Kroger and Safeway are
still very much alive and kicking, their stocks making
multiyear highs despite being disadvantaged by their unionized
workforces and intense competition from discounters.
The importance of convenience is even more pronounced in
Europe, where people drive less than SUV-loving Americans, burn
calories by taking public transportation and live in houses the
size of our two-car garages. Europeans have smaller
refrigerators and shop more frequently. Discounters have an
even lower impact in Europe.
My second concern in the U.K. was Tescos capital
allocation new stores were coming in with lower
incremental returns. That concern was put to rest in April when
management announced a reduction in new-store openings. But
even more important, Morrisons and Sainsburys,
Tescos two largest competitors, followed its lead and
announced their own reductions in store openings. This will be
likely to stick.
Tescos earnings power in the U.K. will probably expand
significantly over the next few years. The U.K. economy, which
in addition to being sucker punched by European recession was
bitch slapped by government austerity, shows some early green
shoots of recovery. Unless these turn brown, Tescos sales
growth will accelerate and currently depressed margins will
expand. Also, the company will benefit from a declining
corporate tax rate yes, you read that right: The U.K.
government lowered corporate taxes. (Our government could learn
a thing or two from theirs.)
The two other pieces that fell into place over the past few
months were the U.S. and China. Tescos business in the
U.S. was struggling. It is hard to know why exporting
your retail model is always difficult (just ask Wal-Mart).
Maybe Tesco hoped to metaphorically switch Americans from
burgers and fries to fish and chips. In September the retailer
announced it would stop throwing good money after bad and sell
its Fresh & Easy store in the U.S. to an affiliate of
Yucaipa Cos. It had learned a $1.8 billion lesson (Americans
dont like fish and chips) and got out of the U.S.
China was another concern. Even though it is an attractive
and growing market, Tesco got off on the wrong foot there
it opened stores on both coasts. Thus its strategy
lacked much-needed scale and density. China started to look
like a giant black hole for future capital expenditures,
uncertain returns and continued losses. Worry no more. In
September, Tesco came up with a brilliant solution to this
problem it will merge its 200 stores in China with the
largest Chinese grocery retailer, and in exchange it will
receive 20 percent ownership of a much larger entity that is
more likely to succeed and, most important, be able to
self-finance going forward.
Tesco is doing well in the rest of Asia. For instance, it is
the second-largest retailer in South Korea (also known as the
place where Wal-Mart failed), a country with an only slightly
smaller population than the U.K. and with a huge GDP-per-capita
Tescos Eastern European business is struggling, but it
is profitable and not structurally challenged (as in the U.S.
or China). Although margins have been impacted by the depressed
economy, the good news is that profitability is unlikely to get
any worse and will probably significantly improve as Europe
emerges from its economic ice age.
A year made a huge difference in the Tesco puzzle the
company patched its international black holes and is now a much
more focused retailer. Its U.K. business will become a great
source of cash that will lessen risk and enhance profitable
growth of its Asian and Eastern European markets, as well as
contribute to the companys dividend. Finally, you can
have this great retailer at a 30 percent discount to Wal-Mart
and at only 11 times depressed (or 9 times normalized
postrecession) earnings. Oh, and Tesco comes with a 4 percent,
and likely rising, dividend.
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