Tesco Plc: Buffett's Folly?
C. is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Tesco (NASDAQOTH: TSCDY.PK) has been attracting a lot of attention from investors recently. In January, the company issued its first-ever profit warning, last week it announced its plans to turnaround the business (as well preliminary annual results), and Buffett's stake now stands at just over 3.5% of the company. Unfortunately, this latter point has, perhaps, led to a herd of investors moving in whilst some well-known local funds, such as Odey, have moved out. Some investors argue that this is a "no-brainer", that Tesco is the Walmart of the UK, or other platitudes. Hopefully, this post will shed some light on the issues at the heart of this debate.
The starting point of this analysis is looking at valuation in comparison to historical performance. The current market cap is £25.8bn ($41bn), the LFY earnings multiple of 9.7x, and the LFY book multiple of 1.56x. Return on Net Operating Assets is a good measure of core operating performance and as shown below, Tesco seems to have been slipping over the past ten years.
(RNOA = return on core operations, OPM = operating profit margin, and ATO = asset turnover. This analysis uses operating profit, which is net tax but not interest expense, and net operating assets, which means debt and cash are taken out. Particularly important here is the inclusion of operating leases within operating assets and the removal of the interest expense portion of rental expenses from operating profit.)
RNOA measures the return on core operations, the table above highlights that whilst margins have been fairly steady asset turns have fallen rather dramatically. The fall in asset turns explains the fall in returns on core operations. Asset turns essentially measures the sales per unit of assets (in this case, net operating assets) and whilst sales have increased by £18bn over the past five years, total assets have increased £22.4bn. 67% of this increase in total assets has been in long-term assets and the majority of this is PPE. The increase in current assets is obviously less concerning as it is met by an increase in current liabilities. Either way, whilst the company has achieved impressive top-line growth, this has required more and more assets leading to lower and lower returns.
However, with Tesco it is never that simple. First, the book value of PPE clearly understates the actual market value of the assets. The Director's Report in the last annual report recognizes this stating that book value is substantially less than market value. The company has been booking significant gains on the sale of property (some £400m in the LFY), and the recent IPO of Thai property, the Tesco Lotus Property Fund, all support this point.
Second, my operating profit calculation uses Depreciation & Amortization, but whilst D&A costs have averaged 2.2% of revenue over the past five years, actual capex has been 6.48%. In other words, operating profit appears to overstate profit by a fairly significant amount. Given the fact that Tesco appears to be selling a lot of property each year as well net capex might be more appropriate but there is clearly some uncertainty here. There are also broader questions about the cash flow statement given that Tesco is now a bank as well.
Another big problem is that being a retailer, a significant amount of operating assets don't appear on the balance sheet. So a better way to look at this problem might be to look store numbers and sq footage.
First, we need to find out how important the UK operations are? The answer this, as with everything about Tesco, isn't straightforward. UK operations are in one sense tremendously important making up 66% of total group sales and 74% of the total retail group (not including Tesco Bank) "trading profit", as defined by Tesco in the footnotes to its annual report. However, the UK counts for only 50% of total stores and 35% of total square footage. What this clearly highlights is that whilst Tesco has made significant investments in new stores and square footage in Asia, Europe, and, to a lesser extent, the US this hasn't translated into better sales.
To understand the scale of this gap between the UK and everywhere else, we can imagine what total sales would be like if all the non-UK stores and square footage was running at UK levels. If the non-UK stores caught up to the UK sales per store, total group sales (inc. the original UK sales) would be £80bn (they are currently around £60bn) and the two parts would be roughly equal in terms of sales. If the non-UK stores caught up to the UK sales per sq foot tota,l group sales would be £115bn. To understand Tesco we have to realize that the UK and non-UK operations are running at massively different levels of efficiency.
Getting back to the issue of asset turns, we see the same trend at the store and sq footage level. Group sales increased at a CAGR of 7.3% over the past five years, but total stores increased at 10.52% and total sq footage at 8.73%. Was this driven by investment in the UK or non-UK business? Non-UK stores increased at 15.89% and UK stores increased at 6.43%. Non-UK square footage increased at 10.61% and UK square footage increased at 5.74%. Non-UK sales increased at 15.26% against 4.20% for the UK business. The main data is reproduced below as well as some comparisons with SBRY and MRW, the main publicly-traded UK competitors (Asda, owned by Walmart (NYSE: WMT) is the other one).
Clearly, this should all be taken cautiously. For example, a comparison between Non-UK Tesco and Sainsbury's doesn't make sense. In addition, the store comparison between Sainsbury's and Tesco may not make sense if they have different store sizes. Either way, the point is that the non-UK side of the business is running at a totally different level of efficiency. The company has been growing stores and square footage faster in the non-UK side but this hasn't led to growth at the sales per store level and growth at the sales per sq foot has been a lot slower than the increase in sq footage. The UK situation isn't much better, although it isn't worse, with mid-single digit annual growth over the past five years leading to declining per store and per sq foot figures.
The question then is: are these investments outside of the UK going to pay off? Clearly, the US operations are troubled but the Europe and Asia operations aren't so bad. Most of the countries that Tesco is operating in are growing and presumably the per store and per sq foot figures will develop with the broader economies. For example, in South Korea, a fairly well- developed economy, the sales per store figures are at the same level as the UK operations. This part of the business will surely develop and has promising growth potential.
It certainly appears that current discontent amongst analysts has largely focused on the UK operations. Media attention has focused on the "end of hypermarkets" and the rise of click-and-collect, necessitating far smaller stores. To some extent, this criticism is accurate and the recent trouble (and bankruptcies) amongst retailers of electrical goods in the UK clearly highlights how difficult non-food retailing is. On the other hand, Tesco has been extremely effective in these areas. For example, in retail apparel Tesco captured a decent market share in only a few years of operations and is causing consternation among incumbent apparel retailers. Non-food retailing has become more difficult and the company has to do something about its large stores however, investors shouldn't ignore the success that Tesco has had in some of these areas.
The more serious problems relate to the massive underinvestment in staff, poor systems, and a failure to keep up with massive improvements in store layout/marketing made my competitors like Morrisons.
On the first point, Tesco appears to have become ensnared by its own commitment to labour saving, there simply aren't enough staff to control wastage or the warehouse and morale at stores appears to be terrible. The company has recognized this and has pledged to boost hiring, the question is whether this is enough? What is more, Tesco managers have less freedom than competitors to make promotions and boost sales.
These restrictions are intertwined with the systems problems. Companies like Morrisons and Sainsburys have short lead times in ordering and stores can respond quickly to changes in demand. At Morrisons, managers have the freedom to manually order certain products whilst a lot of Tesco ordering is automated or at HQ-level. Inditex, the Spanish apparel retailer, highlight the importance of short lead times and built their competitive advantage on staying responsive to customer demand. The result is that Tesco stores have availability problems, a problem exacerbated by a lack of staff to restock stores. In addition, these problems mean there is no way that Tesco can compete on fresh food, an area that is becoming more important in the industry and which is the driver behind the success of Morrisons.
Finally, whilst Tesco has been lagging, the competition has really stepped up their offerings. Morrisons have moved into established themselves in fresh food/counters, Sainsburys have established a high-quality image, and Asda has managed to move away from its reputation of low-quality, cheap food. All of this has bit into Tesco's market share. In retrospect, it looks like Tesco has been moving in exactly the wrong direction. Whilst Tesco built out larger and larger stores, Morrisons has been making it's stores more efficient and working on areas like fresh and counters where differentiation can be obtained.
These problems are probably surmountable. What is most worrying though is that the response of management has been poor. Through the past few years, the Tesco's strategy to the loss in market share has been to cut prices and decimate margins. This hasn't worked. The latest "big price drop" cost £600m, but sales actually fell through the period it was implemented. The recent £1bn allocated for a turnaround seems to be woefully inadequate against recent expenditure made by Morrisons to revamp their stores. Equally, the increase in staff and investment in systems may prove to be inadequate. The danger for investors is that the state of the UK business gets worse and worse whilst management continues to low-ball the cost of turning it around. The international business, property, and Tesco Bank all provide some protection against these problems, but investors may have to wait a while for the UK business to pick up again.
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