Tesco TSCO
October 30, 2013 - 1:25pm EST by
2013 2014
Price: 368.90 EPS $32.50 $35.50
Shares Out. (in M): 81 P/E 11.4x 10.4x
Market Cap (in $M): 29,737 P/FCF 0.0x 0.0x
Net Debt (in $M): 7,455 EBIT 0 0
TEV ($): 37,192 TEV/EBIT 0.0x 0.0x

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  • Retail
  • Management Change
  • Divestitures
  • Turnaround


Tesco PLC has been written up a few times before so I will attempt to make this short and sweet. I recommend reading the prior write-ups for more in-depth information. The numbers above are in £.
Investment Thesis: Good business at a cheap valuation and an inexpensive way to gain exposure to emerging markets adopting western behavior for grocery purchases. New management is ~2.5 years into turning around the company—within the next few years its results should reflect its operational changes and investments.
The prior management team was mainly focused on growth and not on returns. As a result, it underspent on the UK business given its dominant position to help fund its expansion into the U.S., China and other Asian/Central European markets. What happened was that the UK business began to suffer while it invested a lot of money into certain international markets that never had a realistic chance of making it.
This led to the management change where current CEO Phil Clarke is doing the right things for the long-term health of the business. He brought in new management throughout the company and changed both the operational strategy as well as capital deployment. The first thing management did in order to get the UK business back to sustainable growth was to improve its pricing position and marketing message (Price Promise) to reflect that. Then it realized it needed to better staff its stores with more, well trained people. Lastly, it needed to remodel a number of stores, which it has begun to do. The life-for-like sales improvements on the base of stores that have been remodeled is an encouraging sign.
The other key thing management has done is exit markets where it does not have a realistic chance of being competitive and profitable in order to earn a good ROIC. First, Tesco exited Japan. Then it decided to sell Fresh & Easy in the U.S. followed by contributing a loss making Chinese operation into a JV with CRE (China Resources Limited's Vanguard subsidiary, CRV). CRV has 2,986 stores making it the leading retailer in 7 of the 8 most populous and highest GDP provinces in China. 

Thus one has the ability to buy a world class retailer at a similar priced paid (but at a 40% lower valuation at 10-11x EPS) to where Berkshire Hathaway accumulated its ~3% ownership position back in 2006, paying a then 17x EPS.

Business Description: Tesco operates the largest grocery retailer (~30% market share) in the UK (~2/3 of Tesco’s operating profit) and 3rd largest in the world.

  • Has among the highest sales per sq. ft. in the industry thanks to its Club Card (powered by its Dunnhumby division) rewards program launched in 1995 (that 1 out of every 4 British carry) and a very strong private label offering across a broad spectrum of merchandise categories that has resulted in greater than 50% penetration.
  • Has among the highest EBITDAR margins in the industry (including Europe and North America) due to its leading sales per sq. ft. and its 50%+ private label penetration.
  • Tesco operates in 12 foreign countries within Asia and Europe, which makes up ~1/3 of its operating profit. It has top 5 share in 9 of these 12 markets and has been in most of them for over a decade.
    • Its ROCE has always been below its WACC within Central Europe and Asia due to its lack of scale and skill, which it believes will increase over time leading to higher margins and returns.


Valuation: Backing out amortization of intangibles as well as the China losses (restructured its business into a profitable JV) and U.S. losses from Fresh & Easy (which was recently divested), Tesco trades at 10-11x 2014E EPS and sports a 4% dividend yield. Also, Tesco owns ~70% of its real estate. Based on management’s estimate of its properties’ worth, the stock currently trades at approximately that value.


Future Capital Allocation (of free cash flow after property sales):

  • ~40% dividends
  • ~60% development property (sales of properties underlying mature stores help fund about 40% of the real estate investment on which to build new stores)


Upside/Downside: Tesco should be a compounder given the nature of its business and strong competitive position. Assuming its P/E multiple is at least maintained, if Tesco can grow EPS at its targeted goal of 12%+ per year for the next few years then one would expect a 15%+ return per annum including dividends—or a 50% total return over a 3-year period. Given the low multiple Tesco trades at coupled with a 4% annual dividend, downside over the long-term should be low unless the earnings power of its business declines materially from an already depressed base.


Management: Phillip Clarke (CEO) joined Tesco as a graduate trainee in 1981 (having already worked there on a part-time basis for seven years). He has been on the board since 1998 and was responsible for all of the group’s operations outside the UK, Ireland and the U.S. prior to becoming CEO. He did a very good job establishing new foreign markets as well as growing them to their current sizes today. Clarke has replaced most of the high level executives at the company with his own team who are dedicated to making the proper investments for sustainable long-term growth and maximizing return on capital.

  • Clarke, 4/26/11: “We’ve been investing substantially around the world…it’s about time we delivered higher returns. We’ve been saying that we’re going to do that for a while. We’ve gone through a recession but we invested during it so it’s not surprising that returns didn’t advance. When I talked to investors they said to me ‘please tell us how much you’re going to reach and when you’re going to reach it’, so we did what Tesco doesn’t like to do. We set a date and we set a target—14.6% return on capital employed in the 2014/15 financial year.”
  • Clarke established clear ROCE hurdles and EPS growth goals for the top 5,000 executives to meet in order to attain maximum compensation. The prior management team did not compensate these executives based on ROCE and underinvested in the UK business.
Management Comments (from most recent earnings call)

Long-term Competitive Outlook/Strategy/Capital Allocation

Our 3 priorities [are]: Firstly, continuing to invest in a strong U.K. business; secondly, establishing multi-channel leadership in all of our markets; and thirdly, the pursuit of disciplined international growth. And as I said in my introduction, despite some very challenging conditions in some of the countries we operate in, the strategy is very much on track. We made progress against all 3 of these priorities

We've stopped opening as many new large stores. We switched more of our investments into digital growth, and we've accelerated the transformation of our general merchandise business at home and in Europe.



It's also been important for us to do more to ensure customers are aware of and confident in the quality and the providence of the food that we sell. Food First is at the heart of our strategy, and the start of our Love Every Mouthful campaign has played an important part in improving and reinforcing our food credentials. Love Every Mouthful is not just a series of new adverts. It's an enduring conversation we'll be having with our customers and with our colleagues, and one which highlights the renewed passion for fresh foods. The initial response has been everything that we hoped for and more. We always expected that the first adverts would grab the attention of customers, it's come through strongly in our analysis. And most pleasingly, and as you'll see here, the campaign has prompted nearly 2/3 of those who've seen it to think more positively about the Tesco brand. And they've got in their minds, there's a clear emphasis on quality.

Our work on range and quality has continued apace. Having re-launched Everyday Value last year, we've now completed most of our work on our core Tesco own brand, with over 1,750 new and improved products launched in the first half alone. It's an extraordinary effort by John Scouler, who's here today, our Food Commercial Director, and by his team. The performance of this, the largest of our pillar brands, has been a highlight of our progress so far in the U.K. this year. It's delivered 5 consecutive quarters of strengthening like-for-like sales growth, and it's performing significantly ahead of the business as a whole. It's firm proof, indeed, that customers like the changes that we're making.

Alongside this improvement in the perception of our products is the nationwide launch of Price Promise. It's played a key role in reinforcing our price perception in giving customers the confidence that their shopping won't be cheaper elsewhere on branded products, on own-label products and on fresh foods. And you can see a few of the results on this slide. The improvements are continuing, as more customers get to understand that Price Promise is here to stay. We've already seen good results on price trust and on overall perception of price.

More and more customers now are starting to see a new face of Tesco as we've continued to refresh our U.K. store estate. By the end of this year, we've refreshed -- we'll have refreshed just over 1/3 of our space to some extent. This refresh work can vary from changes to the look and feel of a store, to a much more fundamental remodeling. As such, the level of capital that's required and the associated improvement in trading performance can vary quite significantly. And as my team will attest, the common theme for all of our refresh investment is it will only be approved if it can achieve the high hurdle rates that we set, consistent with our approach to growth and returns across the group.

I think, and importantly, as we make the physical changes to the stores, we also change the culture of the store too. We have more colleagues who are better trained, they're more eager, and they're more able to serve customers.

A key and a growing benefit of our refresh program is the potential to improve our gross margin mix of the stores, whether by tailoring the range to the local catchment or by deploying our latest thinking on space allocation.

We've opened 2 new mega DCs, and we've closed a number. Reading's come on stream. It's the biggest DC we've got outside of one, actually, Magor. It's the most productive. It serves into the West of London. It's closed some very old, built in the 1980s distribution centers. That's giving us a big spurt in distribution productivity. And then we have a great opportunity, because Dagenham come on stream, which is our new chilled distribution center. It's replaced another DC that was actually owned in 1984, which was so cramped and so crowded. We were serving -- servicing a lot of convenience Express stores with a DC that was actually designed for big, out-of-town Superstores. So that's been a very big and a very important change. Chris is continuing to drive productivity through the application of in-store technology. Mike McNamara's here, spends a lot of time trying to find new ways of automating processes. The self- service checkout program has doubled in 2014. It's really loved by customers, but it drives up our productivity significantly.


Online/Click & Collect

Grocery online continues to get a lot of attention from Chris and the team. In the U.K., sales were up nearly 13%. We've got a share of around half the market. And remember, it's already a profitable business for us. We're continuing to innovate with more ways for customers to shop conveniently with Tesco, and have now rolled out Click & Collect drive-through grocery to nearly 200 locations, including to the first Express stores. Following the successful opening of our fifth dotcom-only store in Crawley this year, our sixth opens in Erith for London in a few weeks' time.

Grocery home shopping now is not just a story for the U.K., it's now launched in 9 of our international markets, it's across more than 50 cities outside the U.K. and Ireland, and it continues to grow strongly.


General Merchandise

The like-for-like in consumer electronics is approaching double-digit negative like-for-like, because we're backing out of so much. If you go to any of the stores, you'll see whether it's a Superstore, it's a convenience store or it's a hypermarket, the space is being reduced, the rent's being reduced, the Watford, Coventry signs. It's going to continue like that for a while. We're not planning the GM like-for-like is negative for the whole of 2014, '15 financial year, but we are planning to change the GM range and space in every one of our large stores in the U.K. in 2014. So we should be coming out of it strongly for the second half of next year. What's really important though for us is that our profitability from general merchandise is improving. No, we're in a situation 2 years ago, where around 15% of our sales in U.K., we didn't make any profit. We've dramatically reduced the losses of our Tesco Direct business. We've slowed down its growth, we've refocused it. And our profit opportunities in general merchandise remain very significant.



Of course, [Central Europe] is extremely challenged by the macroeconomic environment. I don't think any of us would have expected Ireland to go back into its second recession in 5 years, and Poland's growth to drop from 5% to 1%. Having said the macros are tough, we've got leading positions in most of those markets, with the exception of Turkey. As a group and with Ken's leadership, we've been very disciplined about the amount of capital that we've been putting in over the last 2 years, which is quite a change to the historic style. So the cash flow's positive. It's not a drain on us. We know that we've got these leading positions. We're doing everything that we can to adapt our business, which is really a large-store format, selling a big discretionary category. I mean, about 15% of our European sales are clothing and general merchandise, to one that's more focused on the Internet and small convenience stores and a much stronger food business. So we think we can work our way through the current macroeconomic environment. It will take a while for that macroeconomic environment to correct itself, but we don't feel, in any way, the same as we felt about the U.S. and Japan.

As planned, we've opened around 200,000 square feet in Europe, a 75% reduction in the amount of net new space compared to last year. This reflects our more disciplined approach. We're investing capital at a level close to maintenance and focusing on high-returning formats such as online and convenience.

Poland is also a large market for us. We described our plan to invest in the offer when we spoke to you back in June. This investment operationally de levers the Polish profits until the sales lift actually comes through. The plan follows actually the same principles as the U.K. plan such as investment in price, quality of fresh food. And it's already showing encouraging signs. Our smaller format stores exited the first half with positive like-for-like, and I'm pleased that overall like-for-like for Poland has moved into positive territory in the first weeks of the second half.

The investment that went into Poland in the first half of the year never gave the business enough time to get the benefit out of that investment, and it was into price, it was into quality, it was into service. So if you like the investment that went in, it wasn't enough time for the sales performance to come through. So it operationally de-leveraged Poland roughly GBP 20 million.

Effectively, our business in Turkey can be viewed as 2 parts. The largest part, in and around Izmir, has much better economics than the business as a whole. Our performance in these parts of the business improved through the half. The other part, which includes some of our largest and most easterly stores in Turkey, has far worse economics. In fact, the sales densities of these stores are broadly half those of the stores in Izmir. We closed 8 stores in Turkey within the half. It's never an easy decision to do this, but it's an important part of our work to refocus the business. In addition, we've made 3 important changes to the business more widely. First, we've significantly strengthened the trade plans with a particular focus on fresh food. Second, we've accelerated our efficiency programs to address costs in our stores, supply chains and head office. And third, we've made some important changes to strengthen the management team. We have seen an improvement in trend of like-for-like sales for the country as a whole.

We don't intend to get out of Turkey either, but we do have a business of 2 parts, as I described, one which is very profitable around the more affluent areas on the Mediterranean coastline, another business that's really out towards Ankara or in Italia, where, actually, the social demographic profile is very different. Our stores are bigger, and our sales densities are half. So that is where Ken and Jeff [ph] and the broader group team are doing most of their work, to work out what's the best approach to what is amounting to about 30 stores of that total portfolio.



With the significant growth opportunities in Korea, Malaysia and Thailand, I described Asia's trading growth to be towards the top and higher end of the range, specifically excluding the impacts in Korea restricted opening hours. Now if you add back the GBP 40 million impact, our adjusted growth rate in Asia is 4.4%, showing again that we're making progress towards this midterm guide rail.


China JV

I think it's worth, at this point, reiterating that CRE has chosen Tesco to form this partnership. They have the opportunity to choose many. CRE recognized our world-leading strength in systems, in online and loyalty, and supply chain in product development. That deal gives us a 20% stake in China's largest food retailer, with 3,000 stores approaching GBP 10 billion of sales working alongside an organization with unrivaled local expertise.

And let me be clear, this is a step towards, not a step away, from the huge opportunity that exists in China. It is, of course, a new model for Tesco. We do have a minority stake, but it is a true and an active partnership. We'll have 2 seats on the board. That'll be Laurie and myself, and we've clearly defined rights concerning funding, dividend payments and any potential future changes in the ownership structure.

In summary, the joint venture with CRE gives us a clear route to a sustainable, profitable growth in the world's most populous market. Importantly, it allows us to focus more of our resources on the 3 priorities of strengthening the U.K., of establishing multi-international leadership and a disciplined international growth.


U.S. Exit

We concluded the sale of Fresh & Easy to Yucaipa. Once the sale is completed and the remaining stores have been disposed of, the total cash cost of exit will be no more than GBP 150 million. Now this does include a loan to Yucaipa of GBP 80 million, which will be repaid in the future. We could have chosen to conclude the review a little earlier, but I was determined not to enter into a deal, which would result in liabilities coming back to haunt us in the following years. I firmly believe that the outcome we have secured, which, of course, removes the drag of the U.S. losses going forward was worth waiting for.


I do not hold a position of employment, directorship, or consultancy with the issuer.
I and/or others I advise hold a material investment in the issuer's securities.


Time for management's operational and capital deployment changes to come through in its sales and earnings over the next few years. 
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