Focus and Patience are Key to Tesco Turnaround
Our investment in international retailer Tesco PLC (TSCO.L) has not played out the way I initially envisioned, but the path to success in both retailing and investing can be non-linear. In this piece, my goal is to provide insight as to what has happened to our investment in Tesco, explain why we continue to see value in the company, and highlight parallels between success in retailing and success in investing.
From an industry perspective, grocery retailing possesses unique characteristics that make it intrinsically attractive. First and foremost, grocers don’t suffer from traffic issues that plague the majority of retail due to the perishable nature of the products and inelastic demand for food and household products. Across retail, the competitive landscape is both dynamic and intense.
Tesco operates in 11 markets and generates more than £59 billion and £1 billion in annual sales and operating profit, respectively. The United Kingdom (UK) is the most important market for Tesco, contributing more than two-thirds of consolidated sales and close to half of total operating profit. As such, a good understanding of our Tesco thesis requires a thorough review of the UK business, as we believe improving the performance of the core store base is central to Tesco’s turnaround potential.
The recent challenges Tesco has faced have been well reported, but to summarize: UK comparable store sales declined, profits more than halved, and UK market share slipped from 31% to 28%. Comparable store sales are a critical indicator of a retailer’s health in that the metric measures the year-over-year change in sales for the exact same store. Amid the deterioration in fundamentals, the company also improperly recorded £263 million in commercial income. This error precipitated the departure of the CEO and CFO, along with other key executives. These events were followed by the appointment of outsiders Dave Lewis and Alan Stewart to the roles of CEO and CFO late last year. Lewis and Stewart have taken incisive action to address Tesco’s issues.
Key among the headwinds Tesco faces are food deflation and competition. Per the Office of National Statistics, UK food inflation has averaged 2.4% annually over the last 18 years, but slipped into deflation over the last 18 months. Lower prices put more pressure on selling a greater volume to achieve the same level of sales and profits. However, just as higher volumes were needed to offset the impact of food deflation, Tesco lost market share to discounters Aldi and Lidl that offer customers a no-frills assortment at value prices.
Without the benefit of historical perspective, one could feel as if the discounters’ recent ascent is unassailable. However, Tesco has faced and overcome these same issues in the past. As illustrated in the graph below, Tesco fought—and won—against the discounters in the early 1990s through such actions as introducing basic value products, adding staff to reduce queue time, opening small format (convenience) stores, adding non-food products, and launching the Clubcard (loyalty card). There was no silver bullet, but a series of focused and patient efforts that won the day. The key takeaway is that deflation and competition historically have been cyclical phenomena, but today are being treated as secular or permanent issues by the market. These more transitory issues were overcome by proactive, focused measures to differentiate Tesco’s shopping experience from those of its competitors.
Source: Company presentation, February 2014
In addition to gaining historical perspective, my experience in following retail exclusively over the last five years has provided me the opportunity to observe two key elements common to successful turnarounds: focus on providing value to the customer on the basis of price, convenience, and differentiation; and patience to see the plan through.
On the mark of focus, Tesco’s management has simplified the product range by 15%, lowered prices, focused incentives on sales, and reduced supplier contract complexity. Additionally, the company has closed underperforming stores, bought back profitable stores from lease, and sold large-format store sites to reinvest back into the core business. In regards to patience, management has avoided selling assets at distressed prices, but taken a measured approach to simplifying the business by closing the money-losing Blinkbox media segment and selling the South Korean segment. In my opinion, management understands that building customer trust requires comfort with the non-linear nature of the process, as evidenced by CEO Dave Lewis stating, “We’re not expecting a straight line.” Finally, the company has done an exceptional job in managing market expectations by communicating candidly that building trust—and then realizing improved sales metrics—takes time.
As with successful retailing, successful investing requires focus on the long-term fundamentals of the business and patience in analyzing and weighing new information in light of the long term. Similarly, both require focus and patience when fundamentals don’t track toward one’s long-term estimates. A careful assessment of the integrity of one’s initial thesis and the potential for it to play out over the long term is also an important component of investment analysis. With Diamond Hill’s long-term perspective and discipline of buying stocks at a discount to our estimates of intrinsic value, we can take advantage of price volatility or cyclical issues if we think the key components of our thesis are still intact.
After careful study of the business, I determined the headwinds Tesco faced were cyclical, not secular. Even after lowering my fundamental estimates to reflect the current headwinds, the calculated price-to-intrinsic-value gap widened materially. In other words, where the market saw weakness and myopically extrapolated depressed fundamentals into perpetuity, I saw opportunity. Value investing works because it doesn’t always “work” in the short run, and as investors lose patience with the trajectory of short-term metrics, this creates opportunities for patient, long-term investors.
Despite disappointing near-term sales results, the initial pillars to my Tesco thesis remain intact:
- Tesco continues to maintain the top market share in the UK;
- Tesco’s store formats remain well positioned and balanced between hypermarket (large store), convenience, and online; and
- Tesco is committed to delivering value to its customer via a new combination of price, convenience, and differentiation.
Looking forward, I see a more focused Tesco that understands its customers and is working hard to win back their business to reassert its dominance and deliver attractive long-term returns to shareholders.
Originally published on December 16, 2015
The views expressed are those of the research analyst as of December 2015, are subject to change, and may differ from the views of other research analysts, portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.