Has Tesco lost it?

 Tesco has been the doyen of the supermarket sector in the UK for the last decade. Other groups have struggled - Sainsbury, for instance, lost market share, while Morrisons had a couple of terrible years after the over-ambitious acquisition of Safeway - but Tesco seems invincible.

Or at least, it did seem invincible. But this year, for the first time, it's seen sales growth falling below the other supermarkets - and has started losing market share. At the same time, other supermarkets seem to have become stronger - Sainsbury has begun to turn itself around, Asda has been a strong competitor under Wal-Mart's ownership, and Waitrose - which you might have thought would be a recession victim with its upper middle class customer base and quality, rather than price, promise - has seen some truly stunning performance after it introduced its own budget range.

Waitrose has also made a land grab for the online market, having gained 20 percent share of online supermarket sales - far ahead of its 4 percent of the total supermarket revenues - with its Ocado operation. Still, online sales only make up 2 percent of the total grocery market at the moment, so that's not likely to worry Tesco management unduly.

September saw Tesco fighting back, with strong sales - up 4.5 percent on a like-for-like basis [ref] The Grocer, 14 October: http://www.thegrocer.co.uk/articles.aspx?page=articles&ID=204209 [/ref] . According to Nielsen, this boosted Tesco's market share to 28.5% according to Nielsen. Even so, other rivals are growing faster - Asda at 6.6%, Sainsbury at 5.7%, Morrison at 8.4% and Waitrose, almost incredibly, at 11.6% [ref] Reuters, October 13 - http://bit.ly/3UwqjJ  [/ref]

The interim results disappointed investors, with the weakest first half profit growth in 11 years [ref] Bloomberg, October 6 2009: http://www.bloomberg.com/apps/news?pid=20601087&sid=aHa5woouQX3A [/ref] - a mere 1.5 percent increase in declared pretax profits. (That figure is, true, a little ungenerous, as there were one-off expenses that need to be taken into account - the writedown of goodwill on operations in Japan, together with costs of the Tesco Bank acquisition. Take those costs out, and you'd see a 9 percent increase in profits - not dusty at all.) 

Analysing the first half into its quarters also shows that growth had slowed from 4.3 percent to 3.1 percent in Q2, predominantly the result of weakening food price inflation. That doesn't give a lot of confidence for the rest of the year. But management hasn't lost faith, that's for sure. The dividend was hiked 9 percent - which is notable in an environment where many firms are cutting their dividends, or even stopping them completely.

The economic climate in the UK hasn't helped. CEO Sir Terry Leahy says the introduction of a discount range last year led to a fall in the value of sales - that had already been foreseen, and should be rewarded in future by making Tesco more competitive against its rivals [ref] Interview with Sir Terry Leahy on Tesco corporate web site: http://bit.ly/21qcs4 [/ref]  through net new store openings.

Tesco has done one thing rather well recently, and that's been developing its own banking business - in which it bought Royal Bank of Scotland's stake last year. Rumours about Tesco buying part of the Northern Rock business might be wide of the mark, but it will certainly continue to develop its banking side actively - including opening up to business as well as personal customers.

It's the group's international expansion that is perhaps the group's biggest weak point. Tesco will find it increasingly difficult to expand in the UK - it can't acquire its way to further growth, as its market share is so great it would automatically run into competition issues. So it's been expanding overseas for most of the last decade. But it doesn't seem to have a lot to show for it.

Ireland and Hungary, for instance, proved to be exactly the wrong two countries to have in the portfolio this year, as both countries were savaged by recession. That led to a 5 percent fall in European sales. The US, too, has proved a difficult market to get into. While Tesco is still expanding its West Coast 'Fresh & Easy' operations at the rate of one store opening a week, and has doubled its revenue, it's still likely to lose the same amount this year as last - some USD 259m. So far, it doesn't look as if management wants to give any hostages to fortune in terms of a prediction of profitability for 2010-11.

Though Tesco now makes 36 percent of its sales outside the UK, the international division only contributes 23 percent of trading profits - and uses 36 percent of the stores space. It simply isn't as efficient as the UK.

Of course the other way of looking at the international operations is that Tesco has built a highly diverse geographical portfolio that should help it become a truly global company. It has operations in Asia, Europe (including Poland, Hungary and Turkey) - and once they get as efficient at generating profit as the UK, Tesco should be a powerhouse indeed. It isn't going to happen overnight though.

And because of this geographical expansion, Tesco's net debt has doubled. It's now dropping again - the supermarket business is nothing if not cash generative, taking cash payments from customers while settling with suppliers on 60 day terms - as Tesco generates cash and sells off property. (Mind you, if, as many think, we've actually reached the bottom of the commercial property market, this might not look such a clever move in five or six years' time.)

Tesco has been as low as 285p in the last year - it's now trading at 415p, close to its 52 week high but still some way off the just under £5 prices seen in 2007-8. (By comparison, Sainsbury(j) is trading at nearly half its 2007-8 highs.) That presumably is a testament to the group's operational strengths - this isn't one of the recovery plays that have led this year's market rally, after all.

But the group remains quite reasonably valued despite good performance. On a PE multiple of 14 times last year's earnings, it's sitting at just the average for the food and drug retail sector - no premium for its historic record of progressive earnings and dividends.

The 3% yield isn't particularly high, but is in line with most of the good fixed rate bonds you can get on the high street - so assuming the dividend continues to increase over the next few years, you'll end up ahead of a comparable cash investment.

There are good arguments on both bull and bear sides of this stock. Perhaps the most convincing bull argument, as far as I can see, is that return on capital employed has continued to increase despite the high cost of expansion into new countries, and into banking. That shows management hasn't taken its eye off the ball - it's still focused on delivering value to shareholders, rather than world domination through shelf stacking. (And of course return on capital is one of those sacred ratios that Warren Buffett looks at, and that all value investors should take into account when selecting their investments.)

Despite a recent buffetting, I get the feeling that Tesco will weather the storm. It moved very quickly to get the value ranges into stores, taking a courageous and smart decision to accept a one-off decline in the value of sales in order to maintain its market positioning. (That's paid off nicely, since Lidl and Aldi seem to be losing some of their market share gains as shoppers trickle back to Tesco.) It's kept its profits moving ahead, though admittedly at a much slower rate than used to be the case. And though I still hate shopping in my local Tesco Metro - I take the motorbike to Waitrose, but that's more for fun than shopping - I have to admit that Tesco has got mass retailing broadly right.

Am I a bull? Not really - I can't see what will galvanise the share price in the immediate future. But I don't think Tesco has completely lost its mojo - and the attractions of an adequate and progressive yield, together with a reasonable PER rating, make it a stock I'd be happy enough to have in my portfolio.