In 2011, Berkshire Hathaway (NYSE:BRK.A) invested $1.7 billion building up a 3.6% stake in Tesco Plc (OTCPK:TSCDY), the world's third-largest retailer, according to Warren Buffett's annual letter to investors earlier this year. In January 2012, after Tesco's first profit warning in nearly 20 years, Berkshire Hathaway took advantage of the share price falls to increase its stake to 5.08%.
Last week, on 3rd October 2012, Tesco announced its second quarter results for its 2013 accounting year which ends in February 2013. It reported its first profit fall in 18 years which resulted in multiple downgrades from analysts and left the share price 17% below the average price of £3.79 paid by Berkshire in 2011 and even below the £3.16 it paid when it added to its stake in January this year.
So, was Buffett wrong to have made such a large investment in Tesco? For a long-term value investor, the answer to that question relies heavily on whether Buffett and investors in general believe that Tesco's profits will continue to stagnate or that management's current strategy will result in a turnaround in the retailer's fortunes.
The following analysis therefore seeks to review the current state of Tesco's business, the on-going impact of management's turnaround strategy and the attractiveness of the current share price based on the medium-term outlook for the business. This leads to the conclusion on whether, or not, Buffett was ultimately right to back Tesco.
Tesco operates in 14 international markets and is ranked 1st or 2nd in nine of those markets. The UK is by far the largest driver of the business, generating 66% of both revenue and profits, and Tesco is by far the dominant player in that market, holding a 30.8% share of the grocery market according to Kantar retail data.
Internationally, Tesco has built a significant and profitable presence in Eastern Europe as well as in Asia. More recently, since 2008, it has expanded in to the US although profitability has proved elusive to date in that market.
Tesco weathered the initial onset of the recession in 2008 well and continued to increase profits in the face of consumer headwinds until the second half of last year. However, when one analyzes the financial results, the share price drop appears overblown.
|Group Figures £ bn||2009||2010||2011||2012||H1 2013|
|Revenues (excl. VAT)||54,327||56,910||60,931||64,539||32,311|
|Op. Profit b/f tax||3,169||3,457||3,917||3,985||1,809|
|Profit After Tax||2,133||2,327||2,655||2,806||1,283|
|Net Profit Margin||5.1%||5.5%||6.0%||5.9%||5.4%|
|Cash Flow from Ops||3,960||4,745||4,239||4,408||1,244|
Margins & Profitability
As can be seen from the above figures, while trading margins have been severely impacted dropping to 4.9% in the first half of 2013, actual profits remain solid at £1.283 billion. On an annualised basis, this remains comparable with results in 2010 when the share price was approximately 40% higher than today's price.
P/E multiple & Market Capitalization/Equity Book Value
The most notable indicator of the overreaction to recent results is the P/E multiple which is 9.9 times annualised first half profits compared to range of 12.3-14.8x between 2008 and 2011. In addition, the market capitalisation/book value has fallen to 1.45x compared to a Wal-Mart (NYSE:WMT) which trades at over 3.5 times its 2012 equity book value of $71.3 billion.
|Valuation £bn||2009||2010||2011||2012||H1 2013|
|Equity Book Value||12,995||14,596||16,535||17,775||17,433|
|Market Cap/Equity BV||2.02x||2.30x||1.98x||1.43x||1.45x|
|# shares diluted (M)||7,912||7,972||8,061||8,045||8,029|
Management's Turnaround Strategy:
- On-going losses in the US business which has sucked up an estimated £1 billion of capital and lost a further £74 million for the first 6 months of this year.
- regulatory changes abolishing 24 hour trading in South Korea, one of the company's most profitable international operations
- slowing consumer demand in China
- weakening UK market due largely to competition and lack of effective execution of strategy by management.
A key issue has been management's focus on expansion which has been drastically curtailed recently. The US business has been given an ultimatum to get to profitability or risk being shut down, a view that many investors would welcome. Further domestic and international expansion has also been moderated.
The real key however lies in turning around the UK domestic business which is the backbone of the business. It was experiencing like-for-like sales falls in the first quarter 2012 which have now been stabilized with 0.1% l-f-l sales growth in the second quarter. Management are investing £1 billion in capital expenditure to improve the stores as well as hiring additional staff to improve the customer shopping experience. Initial results seem to be validating this strategy.
|UK Figures £bn||2009||2010||2011||2012||H1 2013|
|Revenues (excl. VAT)||38,191||38,558||40,766||42,798||21,407|
As can be seen from the figures, the UK business has suffered from decreased trading margins although management are confident that they have stabilized the fall and with increased focus, the odds are good that margins will improve in the second half of this year.
So, was Buffett wrong to invest in Tesco?
Tesco has a market leading position in the UK, a strong management team, underlying profitability and a credible turn-around strategy. Based on the current financial metrics of price to book value and price to earnings ratio, it appears that Buffett has found himself, once again, a currently unloved and undervalued business.
Over the next six months, I expect the market to realize this and for the share price to revert to its longer time price/earnings ratio of 12.5-14.5 times (WMT is currently 15.8x) which will generated potential upside of 25-45% assuming no growth in earnings. An investor will equally receive a healthy 4.7% dividend yield while they wait.