Tesco (OTCPK:TSCDY) is one of the world's largest retailers with operations in several countries across Europe and Asia. The company has a market capitalization of $47 billion, and is traded in the U.S. in the over-the-counter market. One of its largest shareholders is Buffett's Berkshire Hathaway (BRK.B) holding close to 5% of its capital. Mr. Buffett is known as the world's most successful investor, and it's usually a good bet to follow his investments. However, regarding Tesco investors who have replicated Buffett's move over the past couple of years aren't feeling very happy, as Tesco's stock price has posted very weak returns and has considerably underperformed the S&P 500 (SPY) during this period.
Berkshire Hathaway has held Tesco shares since 2006, and Buffett has upped his stake over the last few years. In 2010, Berkshire's holding went above 3% which at the time was a clear vote of confidence in the new CEO Philip Clarke. This is something usual as Buffett favors committed managers who are passionate about their companies. Mr. Clarke has spent his whole career at Tesco, which means for almost 40 years now, and should have been certainly the right person to assume Tesco's leadership.
Buffett continued to buy Tesco stock in 2011 and said that if the price came down, he would buy more. When Tesco issued a profit warning at the beginning of 2012 its stock collapsed by close to 20%. For most investors this would have been a strong catalyst to sell, but Buffett increased his stake to above 5% instead.
So, why does Buffett think Tesco is such a good company? Basically, Buffett likes Tesco for its dominant position in the U.K. retail market, which is similar to Wal-Mart's (WMT) leading position in the U.S. retail market. Tesco is by far the dominant player in its home market with a market share close to 30%, giving tremendous economies of scale and bargaining power with suppliers. Given that retail is a low-margin sector without many competitive advantages, this gives Tesco a big advantage and has enabled the company to deliver above average business profitability.
However, as retail is mainly focused on price and the macroeconomic landscape in the U.K has been weak over the past few years, Tesco is feeling great pressure from its competitors which are lowering prices to grab customers.
Tesco has more than 6,000 stores worldwide, being present in Europe and Asia. It is the largest retailer in the U.K., with its domestic market accounting for about 60% of its sales. It also offers financial services through Tesco Bank, but its weight on the group's sales is still relatively small. Tesco entered the U.S. market in 2007 but this operation was never profitable and the company recently reached an agreement to sell it. Tesco was one of the most successful players in the retail sector of the last decade, achieving best in class business profitability with an EBIT margin around 6%, which is among the highest in the industry. However, momentum has deteriorated over the past two years due to fierce competition and weak consumer demand in Europe.
Tesco is the leader within a concentrated market, where the top four retailers dominate around 80% of the market. Within the U.K. retail sector, Tesco is more exposed to economic activity than some of its competitors due to its higher non-food exposure. Given the sluggish U.K. macroeconomic environment over the past couple of years, it isn't surprising that Tesco has reported weak financial results since the beginning of 2011. Tesco launched a plan to improve its domestic business at the beginning of 2012, which consists of adding adding staff to enhance customer service, refreshing stores, cutting back significantly on new space, and improving other metrics such as customer's quality and pricing perceptions.
In its fiscal year 2012/13, which ended on February 2013, Tesco's sales increased 1.3% to $116 billion. Asia posted the strongest performance with sales increasing by 6% compared to the previous fiscal year. In Europe sales declined by 5.5%. In the U.K., Tesco was able to increase its sales by 1.8% but at the expense of lower prices, which resulted in a 8% drop on profit. Tesco achieved an EBIT margin of 5.3%, the lowest over the past decade. Its earnings-per-share [EPS] declined by 12%.
Although the company has taken some positive steps, it has not yet stabilized the situation in the U.K. and should continue to report lower profitability over the next few quarters. Even though Tesco's strategy is preserve its business profitability, it should continue to be pressured to lower prices due to fierce competition that only can grow through market share gains. Moreover, the company is also facing issues abroad, with same store sales declining in all nine markets during the first six months of 2013 and European profit plunged. Therefore, it will not be easy to relaunch growth while preserving fairly high margins.
One positive factor about Tesco is its dividend yield of 4%. Tesco has consistently increased the dividend over the past few years until the 2012/13 fiscal year, when the dividend remained unchanged from the previous year. However, Tesco's dividend policy is to grow its dividend broadly in line with underlying earnings. Taking into account the numerous issues the company currently faces, its dividend does not seem secure over the long-term despite its good history. On the other hand, Tesco's balance sheet is strong given that its net-debt-to-EBITDA ratio of only 1.27x, which can support the dividend in the short-term.
Warren Buffett is a brilliant investor and therefore it is quite natural for individual investors to follow closely his investments and replicate them. However, regarding Tesco it has not been a good bet over the past couple of years, and the company does not appear to offer much value due to its fundamental issues. For income investors it offers a good yield of 4% and management should be reluctant to deliver a dividend cut, but its sustainability over the long-term is not assured unless Tesco's operating environment improves considerably across all its businesses.