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Thursday, August 24, 2006

Tesco Seems Tasty...Returns on Capital plus Real Estate

From Value Discipline

As you know, Berkshire Hathaway recently stepped up its investment in Tesco, tripling its position that it had established in the first quarter.

Berkshire Triples Stake in Tesco

Tesco may not be as well known on this side of the pond as it is in the UK, but it has dominated UK food retailing since the early 1990’s. The company has a rich history having been founded in 1924 by Sir Jack Cohen who used his gratuity from the First World War to fund an inventory of groceries in London in 1919. Tesco opened the first self-service grocery store in the UK in 1948, well after their introduction in the States. The first supermarket was opened in 1956.

Tesco had a Wal-Mart or Costco kind of a philosophy…it buys in bulk and keeps costs down in order to offer low pricing. Expressed simply, “Pile it high and sell it cheap.” But regulation in Britain allowed suppliers to insist that retailers charge a set price to all customers in order to protect small stores. Tesco introduced trading stamps in order to bring better value and effectively lower prices to consumers. Retail price maintenance or fixed pricing was abolished in 1964, largely through the urging of Jack Cohen.

Tesco in the late 1970’s decided to become a superstore concept, close its inefficient “High Street” locations and move to the suburbs. It broadened its inventory beyond groceries . During the 80’s, it became Britain’s largest independent gasoline retailer. It was early in recognizing the importance of nutrition by introducing in 1985 its “Healthy Eating” initiative. In 1992, it introduced “Tesco Express,” a gas station combination with a convenience store. In 1995, it introduced the first customer loyalty card in the grocery industry in the UK, the same year that it introduced the “Would I Buy It?” quality initiative. By 1997, Tesco formed a joint venture with the Royal Bank of Scotland to offer financial services as well as its own branded Visa card.

In non-food items, Tesco sells electrical appliances, televisions and home entertainment, as well as branded clothing.

The company is a global retailer, in fact, more global than British, with 54% of its total selling space outside the UK, but representing only about 24% of total revenues. About two-thirds of its non-UK stores are less than five years old and still growing rapidly. Its international territory includes Ireland, Poland, Hungary, the Czech Republic, Slovakia, Turkey, South Korea, China, Malaysia, and Japan. The company is the market leader in many of these countries.

The company has been a financial powerhouse with a target for ROIC of 14.8% and a current 12.8% ROIC. Contrast this with Safeway (SWY) at 5.8%, Kroger (KR) at 7.0% and Wal-Mart (WMT) at 14.6%.

EBITDA margins also provide an interesting study in contrasts. Tesco exhibits EBITDA margins of 7.89%, versus SWY at 5.69%, KR at 5.36%, and WMT at 7.41%.

The balance sheet is relatively underleveraged compared to the EBITDA that Tesco generates. The company could pay off all net debt in only 1.3 years. On a net debt to total assets basis, Tesco also appears underleveraged at 18% compared to SWY at 38%, KR at 34.3%, and WMT at 23.5%.

Working capital management and inventory management capabilities are also superior to most others in the business, critical skills in retailing. The only shortcoming appears to be in terms of total assets turnover, because of the preponderance of real estate that is owned. Sales to total assets are about 1.75X versus 4.3X for SWY and 5.3X for KR. WMT is at 2.26 X.

The real estate intensity though a disadvantage in terms of capital efficiency does provide hidden value. Tesco is the largest property company in the UK with a book value of some ₤ 16 billion. According to Tim Attenborough, who has completed an outstanding and thorough report on the company at Exane Paribas, the current value of the portfolio may well be 50% higher representing a hidden value of almost 75% of the current market price of the stock. The CFO at the annual analyst’s review meeting indicated that the real estate value was at least 50% above book. Please check note 12 of the annual report which supports this valuation…hats off to the IFRS disclosure standards here!

There is a pension liability which despite being fully funded in actuarial actuality, appears as a liability under the peculiarities of International Accounting Standards. Ah, the wonders of GAAP! At the CFO’s review of the year 2005, he noted that in a two week period in January, a 20 basis point drop in bond yields increased the pension deficit by ₤200 million!

The company has undertaken a massive capex program which has funded its international expansion. Though generating CFFO of about ₤10.7 billion in the last five years, capex was about ₤11.2 billion for the period. Over ₤2 billion was returned to shareholders, primarily through dividends of ₤1.8 billion over the period. The five year dividend growth rate has been 11.6% CAGR. The company has indicated that at least 1.5 billion will be spent on share buybacks, some of it funded by the sale of real estate

The UK competitive environment is tough with Wal-Mart proving to be successful (unlike its foray in Germany which it recently abandoned.) But unlike its weaker brethren, Morrisons (which is overleveraged post Safeway UK purchase) and Asda, Tesco is gaining market share in groceries.

Politically, there is some risk as the UK has initiated an investigation of the industry by the Competition Commission. This is the third inquiry in six years…such inquiries have given the industry a clean bill of health declaring it to be competitive. The investigation will target the interaction between retailers and their suppliers, competition within convenience stores, and land acquisition practices. Perhaps the only gray area will be the third, where Tesco’s real estate success has allowed it to build a considerable land bank for future development. However, since the land bank is primarily skewed toward non-grocery retailing, it seems unlikely that the company should find itself in the Commission’s crosshairs.

Finally, let’s focus on valuation. The company trades at a current EV/EBITDA based on TTM EBITDA of 10.7 times versus about 9 times for WMT which trades roughly in line with SWY at 8.7 times and above KR at 7 times.

On an EV/EBIT basis Tesco is 14.6 times versus WMT at 11.3 times. SWY is at 15 times and KR is at 11.3 times.

Tesco is quite transparent in its disclosure and in my view, treats its shareholders as partners in the enterprise.

There is a great deal of growth that remains in this internationally focused food retailer, in my opinion, probably better positioned than Wal-Mart in emerging economies. Of these names, only WMT comes close in the quality of its operations or the returns on capital. The operating profitability and working capital management are superior to most of its peers. The cushion of its vast real estate holdings also provide hidden asset value.

Disclaimer: Neither I, my family, or clients have a current position in Tesco or Kroger. I, my family and some clients do have a current position in Wal-Mart and Berkshire Hathaway. Some clients do own a current position in Safeway.

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