Tesco and the Buffett Test

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.

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.

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.

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.

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.

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.

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.

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 :)

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.

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

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.

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.

Surprisingly the stock is up 2.5% odd on the back of the profits warning. A case of the pedigree of the incoming CEO outweighing that of falling profits.

My post last night seems to have been prophetic, this morning Philip Clarke is out as CEO and they have a profit  warning (well a veiled one at least).

http://www.investegate.co.uk/tesco-plc--tsco-/rns/appointment-of-ceo-and-trading-update/201407210700098226M/

One of the key messages in the announcement is that "the overall market is weaker" so we may see other food retailers coming under pressure today.

I sold out of TSCO after the Q1 IMS, as I thought the LFL sales performance of -3.7% was too much to bear. I had previously held out against the bear case in TSCO, maintaining that they were leaders in the sectors that are doing well in food retailing, namely online and convenience. However it seems to matter not, the existing large store portfolio appears to be suffering, squeezed between Aldi/Lidl at the discount end and Waitrose/M&S (and to a certain extend, Sainsbury's) at the top end.

Having said that, if there is a price war, then I expect TSCO to come out of it on top, they have industry leading profit margins. The question is how much damage they sustain in the meantime. A key question is that a twice covered yield of 5% is attractive, but it hasn't grown in a couple of years and could be in danger if continued price reductions eat into profit too deeply.

I think there are better returns to be had in the next couple of years, however I would still have faith in TSCO for the long term. If I was seeking exposure to the sector at the current time, I'd probably favour SBRY.

It has to remembered that Tesco has probably the largest exposure of the big supermarkets to non food items and whilst it has suffered most during the downturn as people did not buy flat screen TVs etc - it could have been a reasonable play on economic recovery if and when people do start buying these items again.

It now seems that Tesco are having a rethink on the future of larger stores which typically sold these non food items casting even more doubt on its non food strategy. Very uncertain times for Tesco.

I think one of the interesting issues that is implicit in this discussion is that one can identify a moat and that the moat is constant. I think that the current assault on UK grocery retailers by Lidl and Aldi is a reminder that the depth and width of moats is not constant. Secondly I think it is important to look behind published numbers to the substance.
In the case of Tesco questions I would want to look at are:
(1) Did management underinvest in maintenance capex in the UK store base over the last decade or two? (My wife avoids shopping at Tesco whenever possible as she feels the experience is not as nice as in Sainsburys or even Asda).
(2) Underinvestment might also apply to staff - the staff at Waitrose and M&S are distinctly more friendly etc
(3) Some of the apparent moat - ie location, size of stores etc - might actually turn out to be a disadvantage
(4) I have not got my head around the tax optimisation at Tesco and whether that is sustainable. I recall a while back there were some articles re Tesco routing some profits via Switzerland - not sure if that was UK profits or overseas profits
(5) The Tesco clubpoints programmes were meant to be an aggressive sales and customer retention programme - do they still work in the internet age or has management lost focus.
(6) Thinking about a single supermarket - actually a hypermarket of 100k sqft or more - I think it is important to recognise that there is no such thing as an average customer - there will be a wide range of customers. However some customers will have typically significantly bigger baskets than others. Some will also be less price sensitive and buy branded products vs eg own brand value products. If say 5% or 10% of the big basket price insensitive high brand value customers switch even 20 - 50% of their purchasing to online and move from Tesco to eg Ocado what impact does it have on the profitability of that specific hypermarket.
Consequent to the above what happens to the value of Tesco's real estate portfolio?
(7) This also raises a wider issue - if one was to remark Tesco's real estate to market value and then charge a market rent would the operating business make adequate returns?

To my mind Buffett has increasingly bought on his view of the overall economy rather than a fixed financial ratio for the actual investment. I was struck by a remark when he bought Burlington Northern that it was an effectively "an all in bet on the American economy".

I am not sure where Tesco fits in his thinking.He may think that the UK economy is too uneven and fragile for continued investment in an under pressure food retailer.

On a slightly different matter - followers of the food retailing sector may have noticed that MRW has fallen below its Price/TBV in the last few days. At some stage bid talk may be revived.

Great article Mark.

I had also stumbled across several blogs on this subject recently. There does seem to be far too many of Buffet's stock purchases that satisfy the 10 x pre-tax earnings hurdle to be a co-incidence.

The Brooklyn Investor has written about the same subject recently http://brooklyninvestor.blogspot.ae/2014/03/10x-pretax-earnings-case-studies-ko-bni.html

Of course you first need to find great companies with a moat and all the rest of the stuff Buffett likes, as well as pre-tax earnings that you are convinced will grow overtime, wait for the 10% hurdle and pounce.

Then comes the hard part. Holding it and sticking to your logic when things seem to be going against you and all the "noise" is negative. Tesco being a case in point at the moment.

I've changed my mind. I think Buffett uses equity rather than firm valuations, so I should be using pretax earnings to market cap. In this case the earnings yield is 2259/23050 = 9.8%. So it is slightly below the 10% buy point.

Alice Shroeder says that Buffett tends not to "project", but I think a decision would need to be down to whether or not you think 2259 is an abnormally low figure.

Here's how I think Buffett might project. You're looking for a 10% return. So, if you wanted to do growth "projections", you would use a market capital base of 23050 * 1.1 = 25355. So now you ask the question: will the company earn 10% on that next year. In other words, you'd need to expect the earnings to be at least 2536. I don't know if Buffett would factor in dividends, or not.

You see that, as you push out your projections into the future, there's a built-in "aggression" on the returns required. It also means that you don't have to do elaborate discounted cashflow calculations. It's just a simple 10% hurdle.

The mean income for Tesco has been £3014m over the last 6 years. So the shares would be purchaseable if you were conveinced of mean-reversion. I don't know if Buffett would find that acceptable, or if he would insist on 10% here-and-now.

Any insight into the way Buffett views all this would, I'm sure, be of interest to everyone.