Tesco And The Buffett Test

5th Jul '14 by Mark Carter

30 comments 25038 reads

I found this interesting PDF (http://is.gd/D93PHD ^[1]) about Buffett’s purchase of Coca Cola from The Odd Lot blog (http://is.gd/6jGWEc ^[2]).

The idea is disarmingly simple: you want at least a 10% earnings yield (not actually defined by Buffett, but the reasonable presumption is EBIT/EV), AND you want to convince yourself that that the “coupon” will grow. The sustainability of the coupon will likely depend on a few key factors, and it’s your job to identify and resolve them.

So let’s look at £TSCO . According to Stockopedia, it has an EV of £30.75b, based on a share price of around 291p. Its Operating Profit reported on 16 April 2014 was 2631m. Taking that to be EBIT (and we can get into all sorts of arguments about how it needs to be adjusted), we get an earnings yield of 2631/30750 = 8.6%. This is below 10%. Could this be why Buffett was offloading some of it in late 2013?

TSCO’s mean operating income over the last 5 years was 3314m. That would give it an EY of 3314/30750 = 10.8%. So, arguably, it could be considered a purchase – although that depends on your view as to whether declines in profitability over the last two years is a permanent shift. Is it a price war that is only expected to be temporary, or are the likes of Aldi and Lidl changing the
landscape forever? Answers on a postcard, please.

Buffett increased his holding in TSCO on 13 Jan 2012, a day after TSCO announced its results, causing the share price to drop 19%. I’m not going to dig into filings, so let’s say that Buffett bought at 320p – probably close enough.

I’m being a bit broad-brushy, but let’s suppose Buffett was working with the latest available full year results at the time. So that would be annual fiscal data as of Feb 22 2014, with operating income of 3917m, net debt of 6790m and 8046m shares in issue. That gives me an EV = 6790 + 3.2*8046 = £32537m. Thus the EY is 3917/32537 = 12.0%.

So perhaps we should not have been surprised at Buffett topping up on TSCO at the time he did. His crystal ball seems to have gotten a bit hazier since then.

Happy investing to you all.

References

^{^}http://is.gd/D93PHD (is.gd)
^{^}

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emptyend

21st Jul '14

I'll be very interested to see how the new CEO works out. I think Clarke had something of a hospital pass taking over the business at the time he did, especially with the economic backdrop - so I'm not convinced that the new man will necessarily do much better.

However, he will be a breath of fresh air - and I'd guess would want to do some deck-clearing. One to watch over the next 6 months I think.

shanklin100

Given the headwinds faced by TSCO, I would have thought Van Gaal taking over from Moyes is in a much better situation than the new TSCO CEO.

Mark Carter

Tesco has a QV rank of 98 (but a Magic Formula Score B-), making it "good and cheap".

Some people are criticising the incoming CEO's lack of prior experience, but these things can cut both ways. They can often bring an "outsider's view". Look at what Harriet Green did for Thomas Cook, for example. Although she said "I don't know the travel industry well", she has done wonders at turning around the company.

Bonitabeach

Spot on roddy10.

If I may summarise TESCO lost sight of the basics of retailing. My local stores are dirty, disorganised and understaffed with miserable looking people who know a sinking ship; you can sense the decay and defeatism.

At the start of the World Cup my local 24 hour Tesco had acres of prime space devoted to mountains of indistinguishable lagers with just Doritos to alleviate the tedium!

Good riddance to Philip Clarke.

Fangorn

The appointment does indeed look interesting.In similar fashion to yourself don't know much about him. Supermarket sector is certainly looking an intriguing play - just how far LFL sales/Market share will fall at the main supermarkets is a hotly debated question. TSCO have the highest margins from what I recall

Not quite the time to invest but getting close I'd wager.

Dave Lewis, Tesco CEO - Biography
http://www.nfuonline.com/news/latest-news/dave-lewis-tesco-ceo-biography/?

Quite an interesting CV. Not bad for someone who went to Trent Poly ;-)

.....though, to be fair, Unilever is the cream of the crop for grad trainees with a marketing bent - and he seems to have done very well there.

It looks to me as though a headhunter (as yet unnamed?) has done their work well!

However - that doesn't mean that success will be quick or easy. Tesco is 5x the size of his Unilever empire (in sales terms) and has 7,300 stores and half a million employees - and includes a substantial Asian business.

That will all take time to get to grips with - and the business management task is fundamentally quite different in not being product-centric in the way that his Unilever brand collection was.

Of course this move (and the FD replacement previously) was the result of shareholders agitating for change. I would simply observe that shareholders demanding change (aka a serious shake-up and major strategic shift) does NOT guarantee success. I'm particularly reminded of Weinstock's GE and what became of it when it was quickly morphed into Marconi......

intuitive6191

22nd Jul '14

Interesting article on Aldi below.

markets/article-2700337/Discount-retailer-Aldi-invest-600m-major-expansion-drive-UK.html

Even though its in the Daily Mail some of the article must be factually correct.

Absolutely spot on with your observations EE.

Tesco is such a leviathan when compared to the other sector participants it will always take so much longer to turn around. Personally feel Sainsbury is the best of the three majors. Don't shop in the Lidls/Aldi's of this world - the former is one of the worst stores I've ever seen, both in presentation and the availability of their offering which is seemingly arranged with no rhyme nor reason. The latter, there's simply no option available within reasonable driving distance. Sbry/Waitrose, and then Tesco for me in that order. Wont give patronage to Morrisons for political reasons.

What a shocking change for fortune GEC experienced once Weinstock was replaced by Simpson. A great bastion of UK engineering utterly destroyed by incompetent management.

Disc: Still have my Marconi share certificate on the wall along with a Ferranti one :)

WarrantStar

The retail sector is now extremely competitive. The expensive high street retailers (including Tesco) like to think that they are immune to the onslaught of discount retailers like Aldi & Lidl. They are mistaken and need to wake up! They are losing customers in droves. I can shop anywhere that I choose. I choose to shop at Aldi because its products are great & it's far cheaper than the likes of Sainsburies. Even Which? magazine says so.

We should also think about on line sales. It's only worth considering a retailer as an investment if you expect their sales & profits will keep increasing. How is that going to happen with discount supermarkets opening everywhere and many products being easier & cheaper to buy on line? Most people with money to spend are employed. Potential customers don't want to waste their time on looking for a hard-to-find parking spot, or waste their money on goods whose prices have been inflated by an inefficient supply chain.

My recommendation is to avoid the retail sector. It is being completely disrupted by all kinds of new entrants and has become very unpredictable.

23rd Jul '14

Good comments from both. I tend to agree with Warranstar's conclusion. There is disruption at every level (which is something that may well "do for" the Co-op model). The small convenience store offering is very much more competitive too these days, judging by my local Spar.

As to GEC, I knew the new management pretty well. Where shareholders went wrong was pushing for the shift in strategy at exactly the wrong time - ie too late in the tech boom. The outcome was that the new management paid top dollar (in cash!) for assets that subsequently could be seen to have become over-valued - and then they struggled for finance amid inevitable write-downs. It wasn't so much incompetence of management - it was the incompetence of shareholders in changing management and giving them the wrong remit for the point in the cycle they were at........ and I would fear that a similar result is being risked at Tesco.

Randval

GEC was an engineering company that didn't value it's engineers.
Keeping costs down was pursued with almost religious fervour.The engineering judgement of demoralised and underpaid engineers was inevitably compromised.
Weinstock's famed tight-fisted approach sowed the seeds of GEC's downfall.

Nemesis followed Hubris.

djpreston

Have to agree with Randval.

Yes, Weinstock was a very "tight" manager but starving the businesses of investment (very much needed in many of their areas) let alone R&D left their products falling further and further behind.

The huge leap to the other extreme was very unfortunate.

You need a good manager to be aware of both current and future needs. Look at the success of the team at Wassall/Melrose and how they acquired, rationalised, invested and improved businesses before selling for very good IRRs.

Anyway, coming back to Tesco - it isnt going to be a quick turnaround but Id much rather be backing the 600lb Gorrilla when it comes to a price war. Clarke, despite what some may say, was on the right tack IMO - stopping the expansion of the megastores, continuing to build out the convenience stores (by far the largest player) and then attacking the Lidl/Aldi low cost offerings with low prices on every day items.

With their delivery service now cut to £1 per slot (or £3 for as many as you want per month) they have a very good offering their. They have also put MRW to the sword attacking them with the fuel saver plan (MRW's fule sales accoutn for over 20% of the total). Then there is the banking and other services that Tesco offer.

Yes, it may take a while but with a very good dividend Im quite content to wait. A bit like buying HSBC at the current levels and fogetting about it for 20 years.

roddy10

4th Sep '14

It would be a very interesting exercise to do the following:
(1) revalue Tesco's real estate to current mkt prices
(2) then look at return on capital

Or alternatively:
(1) put a nominal rent charge on Tesco's real estate and then look at margins

My suspicion is that Tesco's success from 2000 might have been due to having invested a lot in real estate over the previous decades - possibly sometimes buying sites many years prior to using them.

This raises the question how much of Tesco's performance was due to operational management and how much due to shrewd investment in sites and so locational positioning.

Also I do wonder at the behaviour of analysts looking at supermarkets after stripping out fuel sales. At my local Sainsburys for instance my wife gets fuel vouchers everytime she shops - indeed I wonder if there is an issue of cross subsidisation worthy of investigation by the monopolies commission on this point?

It seems to be that each supermarket has positioned itself for a different price / value point and to a different audience eg Morrison's to price; Asda was price but trying to move up; Sainsburys to quality and value; M&S higher quality; Waitrose to quality. In comparison Tesco has sought to differentiate on price but missed out the whole shopping experience (under invested stores etc).

Aldi and Lidl are really symptomatic of the fact that eg Tesco no longer has the lowest price but has increasingly sought to appeal to price sensitive customers.

I also wonder why there is now less emphasis on the ClubCard - has it lost its edge or is it that management have taken their eye off the ball.

VegPatch

26th Jan '15

Why did Buffet buy Tesco's in the first place?
Well he is famed for looking at Return on Net Operating Assets. Historically in his letters he has looked for premium returns in this metric, typically above 20%.
Net operating assets are the assets needed to produce the profits, BEFORE the capital structure is taken into account ie level of cash or debt on the balance sheet.
So for Tesco's in 2012 this was Group EBIT generated from PP&E of £25bn (pre any grossing up of leases) and investment property of £2bn. ie This is the physical asset base pre Goodwill and pre banking assets. Why I (personally) think Buffet liked Tescos was the huge amount of negative working capital which reduced the costs of roll out of new stores. The Group had inventories of £2.7bn, Trade receivables of £2.5bn, cash of £2.5bn and trade receivables of £11.1bn. Therefore working capital was c£3.5bn NEGATIVE, because it paid suppliers on say 90 days and collected cash off customers and other trading partners at say 45 days. Therefore any working capital needed for new stores is funded by Tescos suppliers. If you take the £3.5bn of negative working capital off the physical asset base of £27bn, you get around £23.5bn. So the Group was earning in 2012 EBIT of £3.45bn / £23.5bn Physical assets = 15% pre tax RoNOA. Good, but not in the pantheon of greats.

I agree with Mark Carter that he probably took the low valuation into account when buying the shares. Also lets face it when you are "Big Elephant hunting" with $50bn of reddies stuffed in your back pocket you cant look at net nets like Gencor or the like. You have to go mega cap just to get the liquidity.

I suppose what I am keen to understand is what can we learn from this ?

One plausible answer to me is that investing outside your home market is definitely more difficult. Seasoned investors who live in the UK know that Tesco's pricing architecture was wrong for a long while. Why ? because if you ever went in there to shop in the last 3 yrs you got a money back voucher on 1Brand Match.eg I spent £168 on a pre Xmas shop and got a £9 voucher back off my next shop. Thats 5% ! and as that was only on the branded goods it means they were even further out of kilter on these. Also you couldnt escape from knowing just how cheap Aldi and Lidl had become, whilst increasing their quality. It all added up to a v difficult market environment. Maybe WB didnt quite know how competitive the UK market was becoming.

So it will lead me to become more circumspect when investing overseas. Thats not to say one cant earn super returns, maybe my margin of safety will just have to be just that little bit wider to compensate for what i dont know.

Richard,
I would strongly disagree that Food retail has largely variable costs. The fact that tescos et al have been unable to deal with falling volumes and thus LFL sales of -3 to -5% is shown by profit reductions of c50%. A business with true variable costs would be able to defray the lower sales numbers. Traditionally This has been is a highly capital intensive business with high fixed costs: land. Buildings, distribution network and even labour. Witness Tescos having to put more labour back I to stores in the last 2 years in response to falling sales. Hopefully Dave Lewis can listen to his staff, something that I didn't feel Phil Clarke was likely to do.

Richard Goodwin

Thanks Vegpatch. I understand where you are coming from but CoS divided Sales by is 94%. I assume that Cost of Sales is largely product moving through the stores and hence variable cost ( am quite willing to be corrected).
I assume therefore that the real issue is that margins are so thin that a small reduction has a big impact in profitability.
Yes Tesco have fixed costs but this basic analysis suggests that market pricing is the real problem - which comes back to competition. A small change to fixed costs will indeed make a substantial difference to profits but a small improvement in Gross Margin would have an impact many times larger.
I have to say that I'm not a retail expert and have no idea how this stacks up against other retailers but it seems to fit with a general picture of pricing-led competitors who include Walmart, Aldi etc.

Tesco has been famously poor in providing disclosure. They dont give a real / true COGS figure which allows you to calculate Gross Margin. Instead they give revenue £64.8bn and state cost of sales, which is inventory, distribution, rents, staff costs - basically everything - as £60.7bn. This is not what most retailers would regard as the Gross Margin.

However, If you want to calculate a rough Gross Margin in the truest sense of the word, take revs of £64.8bn, and subtract the "Cost of inventories recognised as a expense" of £48.67bn in Note 3 of the 2013 Report and Accounts (pg 86). This results in gross profits of £16.1bn or a GM of 24.8%.

I agree that this should be a business with high levels of variable costs, but given all costs are fixed in the short run and it has thin margins, it really is prone to go backwards very fast when things unravel. Especially when it has been "run too hot" by management.

Thank you Veg patch. Most enlightening. I did take a quick look at the notes to find the definition of CoS at the time of my last contribution but found nothing to explain it.

Interesting compare / contrast exercise in corporate disclosure and general management mission statement is to compare the Tesco annual report with that of Next plc. Its a real chalk and (own label) cheese experience. One tells you why they do things in an unbelievably clear fashion and how they intend to make returns for shareholders. The other doesn't.

A prime example: One breaks down the 5 line items that contributed to costs rising by £59m in the year (pg 11) giving detail down to £4m, and shows the 6 areas that contributed the £72m of cost savings during the year. The other bleats on (pg 5.) about "Establishing multichannel leadership in all of our markets" with lots of cool marketing speak like "Customer journeys are becoming more complex. Customers bounce between channels and devices in whichever way they choose and they expect a seamless experience. Our goal is to provide a zero-defect, end-to-end experience however our customers want to shop. While this presents
challenges, it brings lots of opportunities too. Our scale, and our existing strengths from the first curve world, mean we are uniquely placed to lead in this new world." (err first curve world???)

http://www.nextplc.co.uk/~/media/Files/N/Next-PLC/pdfs/reports-and-results/2014/Next%20AR2014%20web.pdf
http://www.tescoplc.com/files/pdf/reports/ar14/download_annual_report.pdf

I suppose thats the great think about the Stockmarket. You pays yer money and takes yer choice !
I admit I own one, not the other.

Tesco and the Buffett Test

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Mark Carter

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