Sir John Templeton, father of international investing, coined the term “points of maximum pessimism” — you want to buy when the news flow is horrible, because the bad news is likely to be more than priced into the stock. This is where I feel Tesco is today, and this is why my firm recently added to our position in the U.K.-based retailer.
Although Tesco’s business is doing worse today than it was even six months ago, things are not as bad as you’d infer from the stock price or from reading the financial press. Almost every single piece of news coming from Tesco over the past few months could be put in one of two buckets: bad or horrible. Its same-store sales were down a few percentage points; it reduced its earnings guidance for 2014, fired its CEO and decreased its dividend. And to put a cherry on this sagging cake, Tesco found a £250 million ($400 million) accounting error in its earnings forecast. The cumulative effect of this news has sent the company’s shares to an 11-year low. Tesco went from being one of the most successful and respected retailers in the world — its previous CEO was knighted — to being a has-been in a matter of months, though it could be argued that this journey was long in the making.
I am writing all this not because I am masochistic but because I think this is how great investment opportunities are created. Every single article I’ve read about Tesco since the beginning of the year has been very negative, pointing out all the mistakes that Tesco has made.
Tesco’s problems stem from being too successful. It conquered the U.K. market and then started to look for new ones. Some of its international adventures were great successes: Tesco is the No. 1 or 2 market player in South Korea, Thailand and Malaysia. However, its trips to the U.S. and Japan were complete failures, and in China it had to merge its operations with a competitor to gain scale. Its Eastern European endeavor may still prove to be a winner, but it’s too early to tell. In 2013 the U.K. provided two thirds of Tesco profits; Asia (excluding China), about 20 percent; and Eastern Europe, about 10 percent.
With the benefit of hindsight, it is now apparent that these international conquests distracted management from Tesco’s U.K. market. The company’s share there peaked at 31 percent in 2006, and despite all the headlines describing Tesco’s demise, market share still stands at 29 percent.
In the U.K., Tesco has been attacked by discounters Aldi and Lidl, which combined have market share of around 7 percent. While Tesco’s same-store sales declined over the past few months, these discounters saw same-store sales growth skyrocket through the high teens. Though Tesco has been losing some customers to discounters, I don’t think it is warranted to continue to draw straight lines and assume that this will continue indefinitely.
Discounters have a place in every country — just as Dollar General, Family Dollar Stores and even Costco do in the U.S. — but their market share has an upper limit not that far from where it is today. Discounters are able to offer lower prices by having a lower cost structure, which comes at the expense of everything but price. They offer very limited selection, the ambiance is great if you are into the fruit-in-the-boxes-on-the floor kind of thing, customer service is limited, and you may be charged for a shopping cart if you don’t return it to where you found it.
This attack by discounters reminds us of what happened to grocery stores in the U.S. when Wal-Mart entered the space. In the early 2000s it looked like grocery stores might become a relic, especially since they were unionized but had to compete with the much larger, highly efficient, nonunionized behemoth Wal-Mart. The financial press was writing the obituary for the industry. Fast-forward a decade, and a few weak grocers have met their maker; but the rest — especially the big ones: Albertsons, Kroger and Safeway — are still around, and they are much more efficient than they were (thanks to Wal-Mart) and are thriving.
There is a very good reason why we are not all shopping at Wal-Mart today. Though price is an important factor for consumers (in both the U.S. and the U.K.), it is not the only factor that matters. To get low prices we have to give something up — it could be convenience, selection, ambiance, the aromas of deli food or just an overall pleasant shopping experience.
Tesco today is better positioned to fight discounters than the U.S. grocers were a decade ago. Its size gives it a tremendous scale advantage: Tesco’s revenues are almost double those of its nearest grocery competitor and almost ten times larger than Aldi’s or Lidl’s. Also, Tesco has prime real estate locked up in the U.K., which is a very important competitive advantage there. This will make the further growth of Aldi and Lidl challenging.
Finally, Tesco is where the growth will be: It has an almost 50 percent market share in the online grocery business, which is mushrooming and in the U.K. has much bigger penetration of the market, at 6 percent, than in the U.S. Tesco is using its significant footprint to its advantage with its “click and collect” strategy: You can order food online and pick it up on the way home at any one of 3,400 Tesco locations.
Analyzing Tesco management is extremely difficult, because investors get only a small glimpse at their big, strategic decisions and we don’t really know how good they are at doing the day-to-day stuff. I thought Philip Clarke, the now-fired Tesco CEO, made the right decision by refocusing Tesco on the U.K. instead of continuing the world-conquering strategy initiated by his predecessor. However, Tesco’s board decided Clarke was not an effective leader, and he was replaced by Dave Lewis at the end of July.
I like Lewis’s pedigree — he was in charge of consumer products at Unilever and has accomplished a lot. I also think the perspective of an outsider should benefit Tesco. And this was all I was going to say about Lewis, besides that I thought that the CEO change, net-net, would likely be a long-term positive. But then this morning I watched him and new CFO Alan Stewart present their turnaround plan.
I can see why the board picked these guys to run Tesco. To begin, the board did not just replace the CEO and CFO; Tesco got a brand-new management team. Lewis has a deep respect for the retailer’s history, but at the same time he understands that since Tesco-the-global-conqueror is in the past, he needs to rebuild Tesco to work as a homogeneous unit in order to meet the challenges of today’s grocery market, which is experiencing deflation in the U.K.
Here’s a simple example of Lewis’s leadership from the turnaround plan presentation: He explained that signage in Tesco stores today is very confusing because each department creates its own signs. That’s an efficient way of doing things if you are opening hundreds of stores a year in a dozen countries. But different signage doesn’t communicate a consistent message. Tesco’s troubles today are not just high prices and low service. Even if those were fixed, Tesco would still face a perception problem — something Lewis is good at fixing. I also like that Lewis got rid of Tesco’s fleet of corporate jets and that he makes everyone from headquarters spend 10 percent of their time working at stores.
Tesco’s accounting irregularity ended up being less significant: Despite a £264 million charge, the impact on 2014 earnings was only £118 million — the remaining £145 million had been misstated in previous years. Further good news was that the misstatement was isolated to one country, the U.K., and to one issue, rebates. On another level, however, the accounting problem indicates that Tesco has cultural issues that still need to be dealt with. This is another reason why I welcome the new management team. The chairman’s resignation today is admirable from the point of view of accountability, but I’m not really sure it matters.
Even investors were thrown a bone: Lewis promised to make Tesco’s financial reporting clearer and more transparent. This is good news in the long run because at some point, when Tesco’s problems are fixed, this transparency will result in a higher valuation.
There was another factor that gave my firm confidence to add to our position: Tesco’s enormous real estate holdings. Tesco owns a lot of its stores, the strip malls surrounding them and undeveloped land. The market value of this real estate is about £34 billion; if you take out £7.5 billion of net debt, the real estate value is still almost double Tesco’s £14 billion market cap today.
Over the past few years, Tesco has signaled that it will pay much closer attention to return on capital and slow down store openings in the U.K. The combination of these two announcements leads us to believe that there is value left to be unlocked through the sale or, more likely, the development of excess Tesco real estate. We have already seen news that Tesco will use some of the dormant land to build 5,000 homes.
But there is more. Tesco has many other assets it can monetize: It owns the Dunnhumby loyalty card service company, which has been valued north of £2 billion. Its Asian operations, with sales of £10 billion and operating earnings of £700 million, are very valuable and could be worth around £8 billion to £10 billion. As an investor, there are multiple ways to win here. Lewis said that nothing is off the table, but it is too early for him to make any permanent decisions on dispositions.
Tesco has about £7.5 billion of net debt, which is not an alarming amount in the context of its asset-rich balance sheet and its very stable cash generation. Despite its profit warnings this year, Tesco will still generate £1.5 billion in earnings.
Of course, headlines like “Tesco reports 92 percent drop in profits” will scare the bejesus out of anyone. But the reality is that first-half profits got kitchen-sinked with a lot of one-time, two-time and many-time items. First-half accounting profits have very little to do even with short-term Tesco real profits. Also, what these headlines don’t say is that Tesco performance in October actually improved in the “less bad” kind of way: Sales were down only 2 percent, an improvement for Tesco and less of a decline than its competitors suffered.
Tesco stock today is a classic short-run-pain, long-term-gain trade-off. Its U.K. operating profit margins have taken a dive from 6.2 percent in 2011 to under 3 percent today. Its earnings are down 30 percent. Our model does not project a return to 6.2 percent margins, but if they come back to 5 percent, then we are paying less than 6 times earnings for a stock that should be trading at 15 times earnings — a significant upside.
When Sir Templeton referred to investing in “points of maximum pessimism,” the word “points” was plural for a reason. The true maximum point is only apparent in hindsight — a luxury afforded to academics but never to practitioners. What appears maximally pessimistic today may get stretched to a new level by new news, and thus the stock price may decline even further. In the short run I have no idea where Tesco’s price is going to end up; in the long I am extremely excited about its prospects.