June 11, 2012 - 2:52pm EST by
2012 2013
Price: 3.03 EPS $0.35 $0.39
Shares Out. (in M): 8,045 P/E 8.7x 7.8x
Market Cap (in $M): 24,360 P/FCF 9.6x 8.7x
Net Debt (in $M): 8,244 EBIT 3,592 4,009
TEV ($): 32,604 TEV/EBIT 9.1x 8.1x

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  • Retail
  • Food and beverage
  • United Kingdom
  • Turnaround


Note: all figures above are in GBP, not US$.

Tesco has appeared twice on VIC - once in Jun 2006 and again in Apr 2011 so perhaps the third time is a charm. I suggest reading both of those write-ups as they provide some good discussion on Tesco's history and why this is a good franchise with a strong long-term history of growth and returns. Thus, I won't retread the ground on company background/history but rather spend the bulk of the discussion on what went wrong recently and why this can be resolved.
In Jan of this year, Tesco announced their first profit warning in 20 years. After ceding market share to competitors, the management team decided they needed to reinvest in the UK business, which will result in a re-set of UK profit margins. Given the company's long history of steady profitability, the market did not take this well, sending the stock down 20% in a few days. Since the initial shock, the shares have drifted ~5% lower and in my opinion represent a very compelling risk/reward at these levels.
What happened to cause the profit warning?
Starting in 1997, Tesco started pushing hard to grow into new areas outside of its core UK grocery business. This primarily meant expansion in emerging markets (E Europe and Asia) but also included a few ventures in developed markets (US Fresh & Easy concept, UK banking). While there have been justifiable questions regarding some of these forays (especially in the US), it's hard to argue that the overall growth push has been successful. In the last 10 years, businesses outside the core UK retail business have grown operating profit at a 27% CAGR and their contribution to the group total has increased from 9% to 34%. The non-UK retail businesses have thus been a significant contributor to Tesco's 12% EPS CAGR over the last 10 years. However, the primary negative side effect has been that Tesco took it's eye off the ball in its core UK market. I believe that since Tesco was so focused on their growth initiatives, some of the best management talent and resources has been foucused outside the UK (more on this later).
Prior to the profit warning, Tesco was able to report stable UK profit margins (6.2-6.1% in FY08-FY11) despite the weak retail environment in the UK. This was viewed as a testament to the strength of the franchise. When the UK consumer recession hit, part of Tesco was actually hit harder than its competitors, namely the non-food sales (~20% of total UK sales). Adding to this hit was the fact that Tesco had made a big push into consumer electronics and physical media which suffered structural hits in addition to the cyclical hits. Since Tesco management thought the UK recession would be relatively short lived, they chose to offset the declines in non-food profits by taking short-term measures to boost food retailing profitability. These measures included a) increased promotions (e.g. double loyalty points) and b) cutting costs in the stores. In short, Tesco's management chose to milk profits in its UK food retail business in order to mask deterioration in other areas.
Meanwhile, the quality of the competiton in UK food retail continued to improve. This caused Tesco to lose relative positioning in the eyes of the consumer, leading to market share losses. Tesco's UK share hit a high of 31% in late 06/early 07 but has recently retreated to just under 30%. Thus, even though the UK business looked reasonably steady on the surface, there were building underlying problems in the franchise due to the short-term profit boosting initiatives the company had undertaken. When the new CEO took over in March 2011, I believe he saw the need make some hard changes in the UK business which would hurt profits but get Tesco's competitive positioning back to its former level.
Why do I think these changes will work?
As mentioned earlier, many of Tesco's best managers had been working outside the UK. This includes the new CEO, Philip Clarke, who had previously ran the international operations for the group. He has brought in new UK team, most of whom he's hand-picked from the international operations. I believe this has brought new perspectives and talent back to the UK.
I don't think Tesco has big structural problems relative to its peers. In fact, in a number of key areas such as real estate, internet presence and pricing they actually look better than most of their key competitors. If you look at the EBITDAR margins implied by the new, lower level of margins, they are in-line with peers (same as Sainsbury, lower then Morrisons) despite the fact that Tesco should have some scale advantages (80% larger than Sainsbury, 140% larger than Morrisons).
Importantly, I think the management team seems to be pretty open in discussing and addressing the problems it faces in the UK. They have admitted that they milked the profitability of the UK business too much, which led to deterioration in the customer experience. Thus, they are making the hard decision to reduce current earnings to fix these issues. The turnaround plan they are proposing is not a huge overhaul of the business model, but rather, seems to be retail blocking and tackling comprised of: a) cutting back on new store growth, b) refurbishing half of square footage over next two years, c) increasing staffing levels to improve customer service, d) relaunching private label products with new recipes and better ingredients.
The consensus view seems quite negative on the prospects of the turnaround. There is a perception that there will be more profit warnings to come and that this turnaround will be very hard to do. I do acknowledge that retail companies of this size don't turnaround on a dime and I don't pretend to have any edge on exactly when these changes will actually show up in the numbers. However, I think the current valuation reflects a lot of skepticism and thus it's worth the risk of being a little bit early on this one.
What is the upside/downside?
Downside seems reasonably limited to me. The stock has a 5% dividend and dividend looks secure (40% payout of net income). Even if the UK margins go to 4% (instead of the low 5% range management "blessed"), Tesco will still earn 27p of EPS and the dividend payout would go up to ~55%. As mentioned in previous write-ups, Tesco owns >70% of the real estate underlying its stores. According to management this property is worth GBP38bn, which is more that the current enterprise value of GBP33bn. I do not expect a huge value unlocking real estate transaction, but at very least this property value should help provide a psychological floor on the downside. It's often hard to put downside figures on things when they go wrong, but I would say 10-15% looks reasonable (excluding 5% dividend).
On the upside, if UK EBIT margins can stabilize around 5.2% and they can make some progress reducing the EBIT losses in the US business I think EPS of 39p is achieveable for next year (FY ending Feb 2014). Putting 11x PE on this gets to 42% upside (excluding dividend).


Company makes progress on the UK turnaround effort (LFLs start to rebound, there is more clarity on UK EBIT margins stabilizing in the low 5% range)
Money losing US business (negative 4% drag on group EBIT) makes progress towards breaking even.
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