The Erosion Of Tesco's Economic Moat

May.14.14 | About: Tesco PLC (TSCDF)

Summary

Tesco's market share appears to be shrinking from a peak in 2007 of 31.7% to 28.7% in 2014.

Despite a falling stock price, the company still trades at a premium in terms of a P/B of 1.6.

Tesco has operations outside the grocery market - such as banking, tablets and others - to reduce the threat posed by discounters like Aldi and Lidl.

Tesco (OTCPK:TSCDF) is a business that trades over the counter in the U.S. and is a member of the FTSE 100 in London. Although Tesco's shares have declined by more than one-third in the U.K., bringing the P/E ratio to single-digits, competition from rivals and discounters have put serious pressure on the margins. This is not a company that has an expanding economic moat.

Business Profile

Tesco has been growing its market share for a long time and has since peaked at 31.7% in 2007. Today it stands at 28.7%, and is still the largest supermarket in the U.K. New management has taken over this company for about four years, and its fortunes have changed for the worse. Tesco has significant overseas operations, unlike its rivals, but discounters Aldi and Lidl (originally from Germany) are building their U.K. operations by opening stores at a rapid rate. Tesco CEO Philip Clarke is a lifer at Tesco (having worked there since the age of 14), but things have not gone as planned as the business operations have deteriorated. The like-for-like sale of Tesco has declined by 3%, Sainsbury (OTCQX:JSNSF) has grown by 0.3%, and WM Morrison (OTCPK:MRWSF) has slumped by 7% in the latest set of results.

Intense Competition Equals "Squeezed" Margins

Although Philip Clarke has dropped his operating margin target of 5.2% citing "£s not %s are a measure of margin success," it does set off alarm bells for the Big Four -- this includes Asda, owned by Wal-Mart (NYSE:WMT), which I have not mentioned -- especially when Aldi and Lidl are growing their revenues at 36.1% and 20.9%, respectively. Worse still, both of these discounters are increasing their store numbers with Aldi increasing by 50 stores a year.

Tesco's SWOT Analysis

Strengths:

• Already established an online grocery presence since 1996, and with sales of £3bn ($5bn) this gives Tesco an online market share of 37% -- twice as much as its nearest rivals.

• Establishing its "Click and Collect" online business means shoppers can collect their shopping without leaving their car.

• A huge overseas presence and operates in 11 countries (it used to be in 13 before it exited Japan and U.S.).

• Already launched and successfully selling the "Hudl" tablet, with sales of these reaching nearly a million units.

• The first supermarket in the U.K. to open its own bank called "Tesco Bank." It has revenue of over a £1bn ($1.68bn) and operating profits of £191m ($320m), though this was down from last year.

Weaknesses

• Tesco is losing market share in its established U.K. operations to the likes of Aldi and Lidl.

• Refurbishing its existing stores in the U.K. (I will explain below why this is a weakness).

• No end to consistent fall of "like for like" sales.

• Tesco delivered £500m ($840m) price cuts in 2011, which materially didn't improve business operations.

• Tesco achieved over 31% market share in 2007; the company has since neglected its U.K. operation slightly and has lost 3% of its market share.

Opportunities

• The company launched its Blink Box (think Netflix) last year, and this could prove to be a winner as it is integrated to the Hudl tablet.

• Tesco is also entering into the smartphone market to compete with Samsung and Apple (NASDAQ:AAPL) later in the year. It's also expected to undercut its rivals by £200 ($336).

• Tesco is planning to boost its online presence in its overseas markets.

Threats

• Tesco's rivals Asda and Sainsbury are establishing their online presences further, copying the things that Tesco has implemented.

• Aldi has been selling its own version of the tablet as well.

• The increase of stores each year from the discounters will squeeze margins in Tesco, as well as others.

• Aldi's and Lidl's respective market shares were only 2.9% and 2.3% in 2008, just six years ago. Here is a table that details the changes in market share for Aldi and Lidl -- past, present and projected future:

Market share in 2008

Market share in 2014

CAGR

Projected market share in 2020 using the CAGR

Aldi

2.9%

4.7%

8.4%

7.63%

Lidl

2.3%

3.5%

7.2%

5.31%

Total

5.2%

8.2%

12.94%

Click to enlarge

The discounters could control 13% from 8.2% in six years' time, and that represents a major threat to traditional supermarkets, let alone Tesco.

Valuation

I think Tesco's P/E of less than 10 time earnings is a bit overvalued, and there could be further downside in the share price as the company enters a price war with its rivals. The company has already spent £1.5bn ($2.52bn) in price cuts, re-fitting and hiring since new management took over. This has had no effect on improving sales growth because its peers are doing the same things and much more. So I fear that operating margins will come under pressure even further.

I know that some of you may be thinking, "Why shouldn't Tesco be trading at 15 to 20 times earnings, like in the last decade?" It is because Tesco was winning their customers and building up its overseas operations. Its rivals are having a bad time and discounters pose insignificant threats to Tesco dominance. Also it's the first supermarket to have an online presence and to move into non-foods.

Although Tesco is still superior in many ways today, the real problem is having a tougher time stamping its authority and now feels encroached upon when it comes to food, prices, online, and non-food -- even the overseas operations are facing intense competition. The only things that differentiate Tesco from the rest are that it has opened up a bank and is moving into selling smartphones and other Tesco electronic devices -- though the latter will need time to succeed.

Therefore, I feel Tesco may see further downside to its current share price of $5.02 in the near future, maybe another 20%-30%. Because Tesco needs time to turn around its fortunes as it enters into new markets, but in the meantime, its business will face further pressure on the margins as the costs of price cuts will continue for some time.

Risks

Tesco's land and property value is roughly £24bn ($40.32bn), equal to its market capitalization (though Sainsbury's and WM Morrison's market capitalizations are valued at less than their property value). The P/B trades at 1.6, also well above its rivals, which are about 1 or below 1.

Tesco's net debt is still high at 0.52 and is much reduced from 0.75 in 2009. Tesco's relationship toward its suppliers could be put under pressure because the company takes 65 days to pay them (a good 15 to 17 days longer than its rivals).

As mentioned earlier, Tesco may see more downside in its share price along with other listed supermarket companies, until we see success in its oversea joint venture in India and China -- alongside the introduction of its own smartphone coming to market this year. Also, I feel the dividend payment will continue because it is already ahead of the pack. Also, it has already exited its loss-making operations in Japan and the U.S.

Conclusion

I like where Tesco is taking its business in the future because, after several missteps, it is finally getting a grip on the challenges posed by Aldi and Lidl as well as its main rivals. Tesco is right to focus on convenience and local stores, alongside enhancing its online capabilities. I believe it can use its brand to sell smartphones and be in the music streaming business, as it has done so well with selling its tablets. And with a bank in operation, the company's operating margins would be the least affected of the Big Four traditional supermarkets. So keep this company on your radar in the future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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