Tesco PLC (TSCDY) is a United Kingdom based company that, together with its subsidiaries, operates as a grocery retailer. In addition to selling groceries, the company also provides retail banking, financial, and insurance services.
Tesco is also engaged in data analysis, distribution, sourcing, telecommunications, online entertainment, and property operations.
Big Footprint
The company serves its customers through approximately 7,300 stores in United Kingdom, China, India, Malaysia, South Korea, Thailand, the Czech Republic, Hungary, the Republic of Ireland, Poland, Slovakia, and Turkey, as well as through the Internet.
Tesco has recently run into a myriad of problems.
Sales have failed to meet expectations as discounters Aldi and Lidl have taken market share from the “big four” United Kingdom (U.K.) grocers, of which Tesco is the largest.
Tesco’s market share of the U.K. grocery market has fallen from 31.8% to 28.7%, its lowest percentage of market share in a decade. Tesco’s share price decline recently accelerated after announcing that its 2015 profit forecast was overstated by$409 million, due to an accounting error.
Warren Buffett recently told CNBC, “With Tesco, we definitely made a mistake. I made a mistake on that one more than anybody else made a mistake … That was a huge mistake by me.”
Earlier this year he sold down his shareholding in Tesco, reducing his ownership from 5.2% to 3.7% of the company. If Warren Buffett, the Oracle of Omaha, is selling and has already admitted that an investment was a mistake, why would anyone be purchasing Tesco?
Scale
During this recent collapse in Tesco, I have enthusiastically been purchasing shares for the Concentrated Risk portfolio.
Lost in market share decline and accounting scandal headlines is the fact that Tesco still has by far the largest market share of the U.K. grocery market as shown in the Kantar Worldpanel chart in this BBC article.
A quick look at Tesco financial results shows that its fortunes are tied to the U.K., with 61% of Tesco’s revenues comes from that market. With 28.7% of the market, Tesco has an economy of scale its competitors cannot match.
In theory, with its size Tesco can purchase more efficiently from suppliers. Not only does it have an advantage when bargaining with suppliers, but in theory, the large quantity of stores allows for more inexpensive distribution.
With Tesco’s size and customer base, a large amount of consumer information is created, which itself has value. Recently private equity firm TPG has offered $3.2 billion (2 billion pounds) for Tesco’s clubcard subsidiary.
Tesco has many options when it comes to turning around its core business. It can cut prices, and reduce selection to compete with the discounters using its economy of scale. It can sell off some of its many non-core businesses for capital to execute a change in retail strategy.
Cleaning House
While the market has priced Tesco for market share collapse, the reality is the new CEO, Dave Lewis, has many options to turn things around.
He has already begun facing the reality of the situation by cutting the interim dividend by 75% to preserve cash and suspended eight executives as part of Tesco’s internal investigation of accounting issues.
If the new CEO can stabilize revenues and get operating profit margins to 4% (which were at 6.5% just a short while ago in 2012) Tesco could be a great value. A rough estimate of the P/E ratio in this scenario is around 7.5 assuming the following:
· Sales stay flat at £70.9 billion
· Operating profit margin of 4% (5 year average of 5.3%)
· £62.6 million profit from joint ventures and associates (5 year average)
· £342.2 million finance charges (5 year average)
· 25% Tax rate (ranged from 15%-26% over the last 5 years)
· No write offs for discontinued operations now that they completed their exit from the US market and China.
As an investor it’s often necessary to purchase when the future seems most uncertain. Any turnaround will most certainly cause a jump in share prices, preventing the investor who buys in later from getting the vast majority of gains to be had from an improvement in the company’s outlook.
The recent news surrounding Tesco has been anything but rosy, but I have a strong conviction that things will stabilize, and have a large position in the Concentrated Risk portfolio to take advantage when this does occur.
DISCLAIMER: The investments discussed are held in client accounts as of September 31, 2014. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable. Past performance is no guarantee of future results.
