Investment idea: Short Tesco PLC (TSCO)

Thesis: At a macro level, that the grocery industry will continue to see secular pressure from the Discounters (Aldi/Lidl). At a micro level, over the last year, TSCO benefited from some specific events, which has started to turn against the company going into FY2/18. Short thesis below:

1.       Share shift to Discounters (from the Big4 – TSCO/ASDA/SBRY/MRW) has slowed down over CY16, but due to recent scares of Brexit and the re-emergence of inflation in the UK economy, the share shift has reaccelerated in CY17.

2.       TSCO benefited from ASDA weakness over FY2/17, which will be neutral or reverse for FY2/18.

3.       General weakness from Brexit will put pressure on gross margins due to the retailers’ inability to pass along rising costs in the competitive grocery environment.

Valuation Summary:

-          Base Case px = £1.62 – TSCO’s UK LFL is relatively in-line with Consensus, but with a lower Adj. EBIT margin expansion. Over the long-run TSCO has traded at ~10x 2-yr forward EBIT. Used 2-yr and not 1-yr because Consensus is expecting some margin recovery from announced restructuring efforts.

-          Bear Case px = £1.35 – In this scenario, margin recovery is harder to come by (due to increasing competition from Discounters)

-          Bull Case px = £2.09 – Because current sentiments towards TSCO is skewed bearish, if TSCO is able to meet Consensus Adj. EBIT margins in the tough competitive environment, stock will re-rate up as investors would start to believe TSCO’s guidance of 3.5-4% Adj. EBIT margins in FY2/20E.

Business Overview: TSCO is the largest grocery retailer in the UK. It does not manufacture any of its own products. ~45-50% of store sales is private label. TSCO has a retail bank operation in the UK. It also has some international retail operations.

-          Sales by channel: 93% retail / 7% online

-          Sales by segments: ~20-25% fresh / ~45-50% packaged goods / ~25-30% general merchandise

Thesis Details:

1.       The Discounters (Aldi/Lidl) will reaccelerate share gain from TSCO and the rest of the Big4 grocers (TSCO, MRW, SBRY, ASDA).

a.        Summary: Discounters have gradually increased their market share in UK grocery from 1% in 1993 to 5% in 2010 to ~12% today. Over CY16, the share gain by the Discounters slowed down, which led investors to believe that there has been a step-function change in the share gain by discounters. As of early CY17, the share gain of the Discounters reaccelerated along with inflation (from GBP devaluation/Brexit) because consumers increased their trade down habits to the Discounters as prices go up. Furthermore, in CY17 both Aldi and Lidl have indicated incremental investments within the UK markets to drive an acceleration in share gain.

                                                               i.      The table and chart below gives an overview of UK market share of the Big4 and the Discounters.

b.       Kantar (UK research provider) data shows the share shifts for the grocers and specifically the share shift from TSCO to the Discounters slowed dramatically in FY2/17. As inflation started to pick up in early CY17 – led to a reacceleration of share shift to the Discounters. The tailwind from Discounters taking less share in FY2/17 was a 10-70bps benefit for TSCO UK&ROI LFL, which has narrowed significantly in 1QFY2/18 and will be a headwind for FY2/18E.

                                                               i.      The chart and table below depict the benefit that TSCO received in FY2/17 from the Discounters taking less share and the reacceleration of share shift in 1QFY2/18 from TSCO to the Discounters.

c.        Discounters are priced significantly below that of the Big4. As the UK grocery environment becomes inflationary (partially due to weakness in the GBP post-Brexit), consumers have been trading down to cheaper alternatives (the Discounters).

                                                               i.      Chart below depicts the weekly pricing comparison done by www.thegrocer.co.uk. Note that the Discounters are priced at a significant discount vs. the Big4.

                                                             ii.      The two charts below show that during inflationary environments, consumers trade down in products.

d.       Aldi and Lidl have both provided commentary over the last 6 months emphasizing an acceleration in investment within the UK.

                                                               i.      Lidl:

1.       Article on 7/8/17: https://www.thegrocer.co.uk/channels/discounters/lidl-to-hit-top-gear-with-its-new-store-opening-schedule/554912.article

a.        Lidl is looking to double the amount of new store openings per year from 25-30 per year to 50-60 per year.

                                                             ii.      Aldi:

1.       Article on 2/28/17: https://www.thegrocer.co.uk/channels/discounters/aldi/aldi-opens-700th-uk-store-and-targets-1000-by-2022/549174.article?rtnurl=https://www.google.com/#

a.        Aldi will continue to open 70 stores per year until it has over 1000 stores by 2022. Over the last 5 years Aldi has invested £1.7bn, but for 2017 it will invest £450m – an increase in annual investments of 32%.

e.        It seems like TSCO’s mgmt team has also seen the reacceleration in share shift to the Discounters in FY2/18.

                                                               i.      1QFY2/18 earnings transcript

1.       “I think what we said is this is the German retailers. We did say we were gaining shoppers back from virtually every one as we went into the very end of last year. And what I said earlier is that, in the first quarter of this year, we saw that, that gain had stopped, and therefore, a need for us to invest yet more, which is what we've done, and we've started to see the volume performance. And in a little while, I'll see what the switching reports will show me for the last period. But the gains that we were making going into the end of last year, we were not making in the early part of the first quarter versus the German retailers.”

                                                             ii.      The shift away in demand from TSCO is evident in TSCO’s volume metrics as well. The chart below shows LFL volume growth at TSCO has slowed down to zero by year end FY2/17.

2.       ASDA has been a share donor to TSCO over FY2/17, which improved TSCO’s UK LFL metrics. Going into FY2/18, ASDA has improved its business and as of April 2018 is slightly gaining share at the expense of TSCO.

a.        The chart below shows the inverse correlation between TSCO UK&ROI LFL vs. ASDA LFL. Note that the strength from both TSCO and ASDA in the latest quarter is due to grocery inflation (discussed below)

b.       The table and chart below depicts Kantar switching data from ASDA to TSCO. Note that TSCO was a significant share gainer at the expense of ASDA throughout FY2/17. This led to a 30-70bps benefit to TSCO’s UK&ROI LFL in FY2/17.

c.        ASDA on WMT’s 2QFY1/17 earnings call said the following “In the U.K., fierce competition and food deflation continue to challenge the market, significantly impacting traffic and comp sales trends. During the quarter, comp sales, excluding fuel, decreased 7.5%. Our strategy remains focused on improving retail basics, simplifying and strengthening the offer through improved availability and assortment discipline, reducing costs through our cost analytics program and driving sales through strategic price investments where we remain committed to the previously announced 5-year GBP 1.5 billion price investment.”

3.       Brexit will negatively impact TSCO’s margins because it will be unable to fully pass along input cost increases in the competitive UK environment.

a.        Note: TSCO does not provide gross margin by geography so it is near impossible to get a good grasp of the FX/inflation pressure on gross margins. That being said, through some analysis, it is possible to make some inferences – analysis below:

b.       According to the UK’s Department for Environment, Food & Rural Affairs (Defra) ~50% of food consumed in the UK is sourced from OUK. Therefore, assuming that 50% of COGS will see ~10% increase due to FX, that is an overall negative impact to COGS by 250bps. This would require total sales to increase 250bps to maintain gross margins. CPI inflation for 1QFY2/18 was 1.6%, so that is ~90bps below the required price increases necessary for TSCO to maintain gross margins. Below is the chart outlining the delta between CPI inflation PPI inflation.

                                                               i.      There’s 2 things to note for the above “scratch math”: 1) CPI inflation does not take into account trading down on products (i.e. consumers buying a lower quality butter), therefore it overstates true inflation, 2) the definition of PPI is the change in price sold by a UK manufacturer to a UK retailer. If a retailer (i.e. TSCO) directly makes purchases overseas (i.e. Spanish tomatoes directly from a company in Spain), then it is not captured in PPI inflation. What this means is that the PPI inflation metric understates true PPI inflation and that there could be further gross margin pressure with the UK national statistics do not take into account.

c.        Furthermore, the 8^th largest grocer in the UK, Waitrose, has indicated that they expect to see gross margin pressure due to its inability to pass along input inflation costs.

d.       Using ASDA as another data point, gross profit margins started to decline beginning 4Q16, which is relatively in-line with when inflation started to show up in the UK. WMT’s negative gross margin impact could also be due in part to an increase in price investments per its commentary on WMT’s 2QFY1/17 earnings call (highlighted in above section).

e.        Based on diligence, it seems like TSCO hedges its purchases 9-12 months in advance. That would mean 1HFY2/18 will be the first half-year period where TSCO will begin to see COGS inflation flow through the P&L.

Bull Case (and Mitigants):

1.       At TSCO’s 1HFY2/17 half-year earnings report, they mentioned a £1.5bn (gross) cost cutting initiative, which will help TSCO achieve Adj. EBIT margins of 3.5-4% in FY2/20. The £1.5bn represents 2.7% of FY2/17 Total Sales. If TSCO is able to flow through half of these savings to the bottom line, then it will achieve the low end of mgmt’s FY2/20 target of 3.6% Adj. EBIT margins – would lead to a meaningful bump to the stock price.

a.        Mitigant #1: The UK minimum wage is set to increase by 4.2% in CY18 and then grow at a CAGR of 4.7% until CY20. In total, wage inflation will add an incremental ~£860m to TSCO’s operating expenses and has yet to take into account any cost inflation for rent. Net of wage inflation, the gross cost savings of £1.5bn is only expected to add 50bps to Adj. EBIT margins.

b.       Mitigant #2: Prior to mgmt announcing the £1.5bn gross cost savings on the 1HFY2/17 earnings call, they made it pretty clear that incremental cost savings will be very hard to come by on the 2HFY2/16 earnings call.

                                                               i.      From 2HFY2/16 earnings call:

1.       Q: “…If I think about the last 12 months, you did price investments, loads of staff investments initially. Very tough conditions. You also have the cost savings and good volume growth. And it allows you to have two consecutive half years of 80 basis points margin improvement twice in a row…this year…you have material tailwinds…You probably have lower operating costs from the smaller ranges, higher volume growth. So how come, as you suddenly go from twice 80 basis points up sequentially, they're going flat? What has really changed in the next 12 months that suddenly stopped that margin improvement going forward? And why would it suddenly come back later again?”

2.       A: “I don't think we feel that the headwinds have got less. I think we would add to all these, we'd talk about where wage inflation is coming in. We'd talk about what the rate review may or may not happen. We would see a need for us to offset some of the investments we have by further cost initiatives, but they're not as easy and as straightforward and as quick as the £400 million that we delivered this time.”

2.       TSCO should have a higher UK EBIT margin than MRW because it is much larger and therefore should command better buying through volume discounts. TSCO FY2/17 UK EBIT margin is 2.3% which is lower than MRW’s EBIT margin of 2.6%. Should expect TSCO to have significantly higher EBIT margins than 2.6% going forward.

a.        Mitigant #1: Although at first glance it might look like MRW has higher EBIT margins than TSCO, after making 2 meaningful adjustments, it’s clear that TSCO always had a higher PF EBIT margin than MRW and has already recouped most of the margin compression. The first adjustment is rent: MRW owns the vast majority of its retail locations whereas TSCO is closer to 50% owned. Therefore rent expense as a % of revenue at MRW is ~60bps vs. TSCO at ~210bps. The second adjustment is fuel sales: Fuel has minimal margins and make up ~20% of MRW’s revenue vs. ~15% of TSCO’s revenue. After making these two adjustments, it’s clear that TSCO has already regained the majority of its margin delta vs. MRW. The chart on the left shows un-adjusted EBIT margins whereas the chart on the right shows PF EBIT margins for both rent expense and fuel sales.

b.       Mitigant #2: While it is hard to quantify, MRW manufactures more ~50% of its fresh food sales in-house (i.e. bakery, slaughter houses, etc.). Because of this vertical integration, MRW should be expanding its margins as it grows its in-house manufacturing capabilities. Also, MRW is located more in urban centers and has higher productivity, which would also help narrow its EBIT margins with TSCO. MRW’s sales/sqft is ~$1.15k vs. TSCO sales/sqft at $1k.

3.       TSCO’s EBIT margin is now below SBRY, whereas it has historically been much higher than SBRY. The Bulls would argue that TSCO’s EBIT margins will expand past SBRY’s. TSCO FY2/17 UK EBIT margin is 2.3% which is lower than MRW’s EBIT margin of 2.4%. Should expect TSCO to have significantly higher EBIT margins than 2.4% going forward.

a.        Mitigant #1: After adjusting for rent expense, but not for fuel as SBRY does not disclose what % of sales is fuel, its clear that TSCO’s EBIT margin is still below SBRY. The reason for this change in margin dynamics is that SBRY’s market share has remained relatively stable whereas TSCO has lost significantly more share to the Discounters. The table and chart below depict the market share changes at TSCO vs. SBRY along with its PF EBIT margin profile.