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Time to Buy Former Retailing Darling Tesco

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, you’ll never have a complete picture. But the beauty of investing is that to succeed you don’t need all the pieces, just enough to see what the picture is trying to tell you.

I’ve 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, Tesco’s 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 Europe.

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. I’ve been told (facetiously, though there’s 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. Tesco’s 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 store’s 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 Tesco’s 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 Sainsbury’s, Tesco’s two largest competitors, followed its lead and announced their own reductions in store openings. This will be likely to stick.

Tesco’s 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, Tesco’s 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. Tesco’s 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 don’t 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 growth runway.

Tesco’s 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 company’s 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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