Tesco Plc (ISIN GB0008847096) – Potential value investment or turnaround gamble ?

For a very long time, Tesco, the UK supermarekt chain could do no wrong. They grew nicely year after year and margins, returns on capital etc. were in a league on its own compared to other supermarket chains.

In the 20 years leading up to 2007 for instance, the Tesco share price increased 15 fold, resulting in an annual gain of ~ 16,3% vs. ~7,0% for the FTSE 100.

In the last few years however, Tesco’s star faded. Profit warning was followed by profit warning. In 2013, after exiting the US business and the China venture, many thought that the worst was behind them. But now in 2014, the problems seem to have just begun with further sales declines in the UK markets and lately with an accounting scandal forcing the Chairman stepping down

Over the last few years I looked from time to time into Tesco. I usually don’t like retailers that much, but with Tesco the simple reason was always “Buffett is owning it”. I have to admit that for me the fact that Buffett is owning something creates an urgent need to look at those companies.

Anyway,
Warren Buffett admitted defeat and sold out a few weeks ago, after buying a large stake as late as in 2012, calling the whole episode as a “great mistake”.

Nevertheless, such a rapidly falling stock price of a “blue chip” company still lures many value investors. Among others, Vitaly Katsenelson came out with a “pro Tesco” article just a few days ago.

I would summarize his arguments as follows:

It is a good time to buy Tesco NOW because:
– the news is all negative
– there is an natural upper limit of discounter market share in the UK close to the level where it is today in the UK (~7%)
– Tesco is still twice as large as the nearest competitor and 10 times bigger as Aldi and Lidl
– US grocers have countered Walmart in the US succesfully, so will Tesco in the UK
– Tesco sits on a lot of prime real estate
– Tesco has a 50% market share in online groceries in UK
– the discovered accounting issue is not so bad, as part of if happened in past years
– there is a lot of hidden value in Tesco’s real estate
– Tesco has subsidiaries (loyalty cards, Asia) which are valuable, it could be a sum of parts play
– the 7,5 bn GBP debt load is not an issue because the company is “asset rich”
– at an assumed “fair”operating margin of 5%, Tesco would be a “steal” at 6x P/E

Overall, the pitch is well written and seems to be quite convincing.

However at a second look, the Tesco story seems less convincing. Regarding Katsenelson himself, I wonder why he didn’t explictly mention his article from 1 year ago, where he recommended to buy Tesco right back then, at a price of around 3,60 GBP with virtually the same arguments. Since then, the stock lost a -54% if you followed his advice.

But let’s look at some of his arguments:

There is an natural upper limit of discounter market share

Katsenelson claims that the current discounter market share of around 7% is a “natural limit”. He doesn’t link to any proof and only mentions the limited success some US chains to support this. However if you look at the “Motherland” of hard discounting, Germany, you can see that this argument is pure nonsense. Although German shoppers might be a little special, a market share of 44% for diacounters in 2014 clearly shows that there is a lot of room for discounters in the UK, even if the never get to German levels.

Tesco is still twice as large as the nearest competitor and 10 times bigger as Aldi and Lidl

Well, that’s true for the UK but not for the Europe. Lidl had total sales of 75 bn EUR in Europe, only slightly less than Tesco’s total sales. Aldi doesn’t issue consolidated sales figures but is only slightly smaller than Lidl. What Kastenelson however completely misses is the following: Aldi and Lidl offer only a very limited choice, usually several hundred products compared to 10.000 or more in a large supermarket. So you don’t have the choice of 10 different sorts of orange juice, there is only one and the same goes for other categories-

The result of this limited choice is a a massive scale effect. Even with less total sales, sales per single product at Aldi & Lidl might be already higher in the UK than at Tesco. And sales per single products are essential because this gives negotiation power with the suplier.

There is a lot of value in Tesco’s real estate

This is the same argument one hears all the time for struggling retail companies. They just need to sell their precious reals estate and everything will be OK. The problem with this kind of approach is that real estate for a retailer is not some kind of “extra asset” which comes on top, but real estate is an essential production factor. Selling real estate for a retailer normally means a “sale-and-lease” back and is nothing more than taking on more debt.

I have written about one case, Praktiker in Germany, where the sale-and-.lease-back finally killed the company, the same happened with Karstadt/Arcandor. Tesco by the way, seems to have been quite active in more or less intransparent sale-and-lease back transactions in the past, as this FT Alphaville article outlines. There is also a pretty good post at Motley Fool with regard to the assumed “real estate treasure” and the following quote nails it down:

The supermarkets’ race-for-space is over. Forget the news that Tesco is planning to build houses on some of its now unneeded landbank — that’s it’s a sideshow in the grand scheme of things.

The real story to focus on is those aircraft-hangar-like Extra stores that Tesco is currently padding out with Giraffe restaurants, gyms, children’s play areas and suchlike. This seems little more than a holding strategy, while the company decides what to do with the stores in the new consumer-is-the-destination world, where ‘destination stores’ already seem so last decade.

Analysts at Cazenove have painted a grim — but I think realistic — picture of the way Tesco’s UK property valuation is heading:

“The gap between the performance of large out-of-town stores and convenience stores continues to widen … This has direct and strong implications for the property valuation of the Extra stores (45% of the UK space). The company says that its UK real estate is worth £20bn based on the extrapolation of past sale and lease-back transactions to the entire estate. We believe it is likely worth less than half that value — the book value of UK land and buildings is £9.3bn and the alternative use value towards which several out of town stores are converging is a fraction of the book value”.

Whatever the final outcome will be, but buying a highly indebted retailer because of the assumed value of the real estate has never really worked. If Tesco doesn’t earn enough on the real estate they occupy, who else will do this ? From my experience, when a retailer’s main attraction is the value of its real estate, then you should better run.

US grocers have countered Walmart in the US succesfully, so will Tesco in the UK

Again, Katsenelson looks at the US and compares Aldi & Lidl to Walmart in the US. I think this is a big mistake. If we look again to Germany, one can see that traditional grocers and supermarkets NEVER recovered fully from the attack of the discounters. Just a few weeks ago, one of the German supermarket pioneers, Tengelmann, sold its remaining “classical” super markets to rival Edeka. Operating margins for normal supermarkets, even for the really big ones are more in the 2-3% area maybe half of that what UK supermarkets like Tesco still achieve. Aldi and Lidl are privately owned long term players who clearly are prepared to sacrifice profit for a long time in order to gain market share.

Summary:

It could easily be that we see a mighty rebound in Tesco, maybe even after I post this and I will look like an idiot. However in the medium and long term, I think many of the popular arguments for Tesco as a value investment (real estate etc.) are pretty useless and some of the arguments (i.e. “natural maximum market share” of discounters) are just plain wrong.

If you define a value investment as an investment where the probability of a loss is very small, than clearly Tesco with its highly leveraged balance sheet is not a value investment. On balance debt, off balance debt, a big pension deficit adds to Tesco’s pretty weak balance sheet. Just recently, Tesco was downgraded to BBB- from S&P. Below this level, refinancing will be difficult and much more expensive and subjct to capital market problems.

As an investor you will only make money with Tesco in the long run if they manage a real turn-around. How likely is that ? I have no idea and so I will better stay away from Tesco. In my opinion this is much more a turn-around gamble than a potential value investment.

17 comments

  • Hallo! Der letzte Jahresabschluss von tesco war wirklich beschissen. Eigentlich sollte man von tesco die finger lassen. Aber einen Supermarktbetreiber will ich schon im Portfolio haben. Ein bisschen globaler Walmart und evtl ein globaler tesco würden mein Portfolio abrunden. Jetzt zu meiner Frage – wie werden bei tesco die Immobilien gebucht. Die abschreibungen auf Immobilien waren ja schon gewaltig. Andererseits hat zb die hornbach holding laut dem geschäftsbericht einiges an stillen reserven. Auch Walmart hat denk ich mal stille reserven weil der buchwert im Verhältnis doch niedrig ist. Also dürfen die ag s Immobilien nicht zum verkehrswert buchen, oder??? Diese frage würde mich allgemein zu allen ag s interessieren.
    Danke im voraus und danke für den super blog.
    Meine gewinne bei drägergenüssen und hornbach holding sind auch aus diesem blog entstanden.

  • 4th profit warning of the year from Tesco. What a mess, but not really a surprise.

  • Thanks for the article and discussion of pro and contra arguments. This is what value investing vs. turnaround gambling is all about.

  • lidl is smashing the competition in finland also. they’ve taken a tenth of an ex-duopoly market in the 10(?) years they’ve been here. even the most hardcore nationalists have been turned by the prices and easy shopping. now we need to find a way to benefit from super-efficient german retailing spreading across the EU. there’s a lot of runway left. we’re probably not going to see an ipo from either of them 😀

  • Thank you for an excellent blog!

    In many lines of businesses it is possible to apply experiences from other countries directly to another country. I don’t think that it is possible to do in retail. What works in one county may fail horribly in another.

    Katsenelsons view may be applicable in the US but perhaps not in the UK and especially not in Germany as you show in your post.

    Another example is the Swedish market. Here we have one clear market leader, Ica, which has about 50 % market share. Then we have two companies with about 20 % each, one on its way up (Axfood) and one on its way down (Coop). Lidl and another hard discounter have about 5 % market share. International retailers are absent in Sweden! Why Ica is such a clear market leader is strange, at least to me. They are expensive and their stores are usually really, really crowded. I belive it is some kind of social status thing to go shopping at Ica instead of shopping at a better AND cheaper AND less crowded store from e.g. Axfood. I prefer Axfood but 50 % of Swedes apparently prefer Ica.

    Ica tried to enter Norway with about the same concept as in Sweden (large super markets, basically the same as Tesco’s largest stores, I believe) but failed horribly. In Norway they prefer smaller stores. If I am updated correctly, Ica has now left Norway.

    So, what works in the US does not work in the UK does not work in Germany does not work in Sweden does not work in Norway. Retailing is difficult and local social preferences are important. I would only invest in a retailer in my home country where I really “have a feeling” for the market. Therefore I stay away from Tesco.

  • In my view Tesco made a mistake and now their position in the middle is challanged from above and below. Well off families do not go to Tesco. They shop at waitrose. Not so well off families prefer cheap lidl and aldi. And in the middle Tesco is strugling. I do not think this likely to change. I would avoid Tesco. It has still a long way to come down to offset for the wrong positioning.

  • Halil Bahadirli

    Ich kenne keinen Fall (obwohl es die wohl geben mag), wo ein Einzelhaendler, der einmal in Schwierigkeiten kam, irgendwann danach die Kurve bekam. Nicht einen Einzigen!

    Nicht bei Neckermann, nicht bei Schlecker, nicht bei Karstadt, nicht bei Praktiker oder Max Bahr, nicht bei J. C. Penney und bei all den anderen, deren Namen mir jetzt entfallen sind. Ursache dessen dürfte sein, dass Konsumentenverhalten wie ein Supertanker ist, der einmal in Bewegung gesetzt, einfach nicht mehr zu stoppen ist. Kombiniert man dies mit dem fixkostenintensiven Geschaeft und den rasiermesserdünnen Margen, dürfte eine Umsatzerosion automatisch das ganze Boot in Schlingern bringen. Die regelmaessig vorhandenen Immobilienaktiva werden eh im Zuge des Überlebenskampfes peu a peu monetarisiert, da kein Management bei Zehntausenden von Beschaeftigten (mind.) die Reissleine früh genug zieht, und ein “gesundes” Unternehmen in Liquidation schickt.

    Selbst wenn ein Logiker wie Mr. Spock am Ruder waere, dürfte schon der politische Druck zu gross sein.

    • >> Ich kenne keinen Fall (obwohl es die wohl geben mag), wo ein Einzelhaendler, der einmal in
      >> Schwierigkeiten kam, irgendwann danach die Kurve bekam. Nicht einen Einzigen!

      Here is the exeption from the rule: Bijou Brigitte. In 1987 they enjoyed an EBT-Margin of 34,0 %, which gradually declined to 4,8 % in 1996. After 1996 the EBT-Margin once again gradually increased to 37,5 % in 2005. And since 2005 the EBT-Margin is again declining. The Future will show, whether the EBT-Margin will rebound once more.
      Here are the numbers in a nutshell:
      Year Revenue EBT EBT-Margin
      1987 17,2 Mio. € 5,9 Mio. € 34,0 %
      1996 43,7 Mio. € 2,1 Mio. € 4,8 %
      2005 301,6 Mio. € 113,2 Mio. € 37,5 %
      2013 356,3 Mio. € 42,8 Mio. € 12,3 %

      Best wishes JOE:)

    • C&A should be another example of a succesful turn around, as well Koninklijke Ahold, and Carrefour seems to be on a good track. But indeed, in other industries a turn around is more easy to achieve.

  • The link to the claim Buffett sold out is broken, so I couldn’t check what your source is. As far as I know the news what that he went under the regulatory disclosure barrier, so he sold some, but could still hold 2.99% for all we know. Do you have more details?

  • Really enjoyed the post. I too have been musing about the company. Post the profit debacle(s) that ousted Mr Clarke the ex CEO I posted and bought at 225p. Not the greatest decision given the accounting debacle that followed. You are always learning with investments…

    So I hold on not because I won’t take a loss (sometimes you just have to) but because I do see value. Here are my basic key angles –

    I acknowledge all the property stuff but I am more with you on the limited worth of such appraisals given the difficulty of finding dual/alternative uses. Tesco have been fairly active in sale/leaseback so if there was a mega opportunity here I am sure they would have tried it out.

    Tesco’s big retained opportunity in the UK is centred on range (they can appeal to all consumers), outlet distribution (the leader in convenience, online as well as bigger stores) and loyalty (Clubcard is still a data machine). What they need to rediscover is their soul or – more precisely – what excites customers about the company. A near 30% of the UK food retail market means it is a behemoth but it also gives opportunities in terms of range, sourcing etc. It is not impossible (the Financial Times the other day observed that the new CEO – part of a team that undertook something similar at Unilever) was quoted saying something very akin to comments made by the legendary Tesco CEO Terry Leahy.

    Of course the market is ultra-dynamic at the moment but range, distribution and loyalty are the ways to fight back beyond prices and ‘experience’.

    The value angle may come from the non UK food retailing businesses. Various press articles have recently highlighted some potential bid interest in the Asia business or even Tesco Bank both of which performed ok in the recent interim numbers. As a value angle I think such a sum-of-the-parts approach may indicate some worth. On the latest numbers I did post (say) a sale of the Asian business the UK business was valued at best currently at zero growth. Now this could happen but I think it is unlikely.

    Across institutional and private investors alike I can barely find anyone who has a good word to say about the company…which naturally gets my contrarian interests going! Clearly it is not a slam-dunk ‘easy’ investment but, for what it is worth, from here I think I will show an ok total return over the next year or two. So at the moment I am holding onto what I have got but I don’t rule out buying more in the future.

    Always enjoy your postings, keep up the good work.

    Chris

    • Chris, thanks for your comment. Maybe just one observation: As a “contrarian” ´, you should make sure that you do have a clear understanding, why your view is better than the market. Personally, I have made the experience that contrarian investing works better if a whole country or even continent is out of favour compared to single companies.

  • Nice post! I also wonder about the uniqueness of the German consumer vs other markets, they really are value focused. There doesn’t seem to be any supermarket brands in Deutschland catering to the higher end, like Waitrose in the UK – I’ve never been inside a nice German supermarket. Perhaps they’re around and I just missed them? But the market seems quite unique, different even from nearby Austria and Switzerland. Perhaps high-end food is an opportunity for someone to develop. Or perhaps bio stores like Denn’s are the ones filling that role.
    BTW, talking about top-end retail, I went into the KaDeWe building in Berlin last week for the first time, quite impressive. I’m not sure how much that’s changed since Benko bought it, but it’s an interesting concept getting all the expensive labels in there. I wonder how the leases are structured.

    • hi GB,
      yes, I think the German market might be indeed not the benchamrk but if you look at the success of Aldi and Lidl in Europe, there is still a lot of room left for them. In Austria by the way, Aldi is called Hofer and is also quite succesful.

      Interestingly, the high end grocery market in Germany is mostly captured by the “Bio” or organic markets. You see them popping up everywhere, especially in rich cities like Munich. Germans seem to be prepared to pay extra for organic food. Also Rewe and Edeka at least try to move more upmarket.

      mmi

  • Fukin’ awesome post. Nailed it. It reminds me of Sears to a degree or WEB buying that department store business.

    Keep up the good work (even got the two TTs in Buffett – I think I owe you a donation to your fave charity as I mentioned a year back). What charity is your pick?

    Thanks too for Pharmstandard – bought it for $6, due a stock dividend (the OTC business) worth around say $5, balance of the stock trades for $13. You want to be late not early in Russia.

    Keep up the good work.

    Best,

    JB

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