Description

If you are a hard-core value investor, you surely know that Berkshire Hathaway recently disclosed the purchase of about $330 million of Tesco, a U.K.-based retailer, and a stock we have owned for almost two years. We thought that with the Berkshire purchase (which was a pleasant surprise for us), this would be a good time to present this idea to the VIC community. After an exhaustive look at the company’s business, it is our opinion that it rivals Costco and Wal-Mart as the best run retailer in the world, offers better growth prospects than either of its U.S. rivals, and its shares represent a significantly better value than WMT, and at least as good as COST or HD, two other high quality retailers that we also own. Tesco is a big company and there is a lot to say about it, but of course in this format space is a constraint. However, there is plenty of information on the company website, with annual reports going back to 1997. As an additional resource worth mentioning, Wikipedia.com has a fantastic report on Tesco at http://en.wikipedia.org/wiki/Tesco

NOTE: Tesco has an ADR traded on the pink sheets (TSCDY.PK) and each ADR is equal to 3 shares of Tesco common.

Tesco is the dominant retailer in the United Kingdom, where it has utilized better execution to pound all of its traditional domestic food retailing competitors and is pulling away from Asda, the Wal-Mart-owned number two U.K. food retailer. Tesco is now rapidly expanding into Europe and Asia, and will shortly enter the U.S. market in California with a new “convenience grocery” retail concept sometime later this year.

Tesco has shown the ability both to innovate and to execute. Tesco’s customer loyalty program, first instituted in 1995, has become the standard for other retailers around the world. The company has had exceptional success in expanding first into non-food product categories, and then into services leveraging what has become one of the world’s most powerful retail brands.

Tesco was founded in 1924 by Sir Jack Cohen, who is sort of the Sam Walton of England. The first Tesco store was opened in 1929. Tesco Holdings went public in 1947, and soon after World War II Tesco adopted that crazy new American innovation in shopping, the self-service supermarket. By the 1960’s, Tesco was a well-known brand name in the UK, selling not only groceries but clothing and household goods. The company’s 16,500 square foot store opened in 1961 in Leicester went into the Guinness Book as the largest store in Europe (today’s Super Wal-Mart stores are more than 10 times as big). In 1967 Tesco opened the first “superstore”, a 90,000 square foot store on the outskirts of a major city rather than located in crowded city shopping areas. The company continued to emphasize the larger format stores throughout the 1970’s. By the late 1970’s, Tesco’s market share in the UK was about 12%, and in 1979 the company recorded its first £1 billion sales year. The company diversified its store formats in the 1990’s in order to capture additional market share. In 1992, Tesco opened its first Metro store, a smaller format designed for city shoppers. Later, the company introduced its Tesco Express convenience store format similar to 7-Eleven. Tesco Extra was introduced in 1997 as a large format, hybrid store with a greater selection of non-grocery items (think Super Wal-Mart). The smash success of the company’s Clubcard Loyalty program introduced in 1995 pushed the company into the number one spot among food retailers in the UK. At the end of 1995, the company held about a 17% share of the grocery market in the UK and encountered a crossroads – what do you after you’ve achieved a dominating share of your core market?

In 1997, the company set up a four-point strategy for future growth – building the core U.K. food market, expand into non-grocery products, add branded services such as financial services and on-line retailing, and expand internationally. The game plan itself isn’t a thing of genius; what’s exceptional is how well Tesco has executed. It’s not uncommon for successful companies to set aggressive goals for themselves, but it is exceedingly rare when they succeed. The strategy has been executed so well that by year-end 2004, international, non-food, and services business contributed as much profit as the entire core business made in 1997.

Since passing Sainsbury PLC as the UK’s number one food retailer in 1995, Tesco’s success in building on its leading position in its core food markets has been remarkable. From an estimated 19% share in the core food market in 1995, the company now enjoys a market share that has been estimated in recent articles to be as high as 29% among grocery retailers. Tesco has achieved this through a combination of continued strong growth in its Clubcard loyalty program, expanded sales of its own private label products to the point that a stunning 50% of all sales are Tesco-branded products, and leveraging of its buying power to pass on savings to customers to drive sales and build customer loyalty. Tesco has also used acquisitions to increase share when available. In January of 2003, the company bought 870 convenience stores from a struggling operator called T&S Onestop.

The success of the loyalty program cannot be overstated. Tesco Clubcard is the UK’s most popular loyalty program, with over 10 million Clubcard holders. When it was launched in the mid-1990’s, Tesco’s loyalty card scheme was the most successful of its kind. At that time, Sainsbury held the No. 1 market share position in the UK, but Tesco’s Clubcard program helped contribute to market share gains that led to Tesco’s market leadership position within six months of launching it.

Tesco has perfected the technique of offering its own private label products in addition to one or two leading brands in each product category. The company offers three distinct sub-brands in its private label lines. Tesco Value is positioned as the low-price point. The regular Tesco store brand competes with the brand leaders, and Tesco Finest is a range of premium products that are gourmet-quality and exceed the quality of the leading brand. This strategy has helped Tesco appeal to all income levels, helped defend against the marginal loss of sale to discounters, and helped the company to maximize its buying power.
The incredible result: Tesco branded products represent approximately 50% of Tesco’s total sales.

Much has been made in the UK media of Tesco’s success in capturing non-food sales in areas such as toys, clothing, electronics, books, music and video, and cosmetics and health care products. That success is a result of three things: a strong, trusted brand that has become more adaptable as it has become more trusted, significantly higher sales densities than exist in the U.S., where high traffic allows the incorporation of slower moving non-food items, and a lack of strong discount non-food competition. The U.S., of course, is not a country with weak competition in these areas. In any case, Tesco has had no trouble in extending its leading position in food to key non-food categories such as electronics, books, furnishings, and apparel. The company’s skin care product line is now the number one line in the UK. Tesco is expanding into electrical items, home entertainment, toys, sports equipment, cook and kitchen wares, and lighting and furnishings and plans to extend its private label Value and Finest brands into many of these categories. In apparel, Tesco not only extended its Value brand, it created a new brand, Florence and Fred. In September 2002 Tesco launched an exclusively licensed line of Cherokee brand fashion apparel designed specifically for the UK market. Combined, these three brands have been the fastest growing clothing brand in the UK since being introduced in 2002, and were growing at six times the market rate at year-end 2004. Tesco had become Britain’s fourth largest clothing retailer by year-end 2004. Tesco has also been very successful in translating its retail brand onto the Internet in its home market. The retail website Tesco.com was officially launched in 2000, and Tesco’s online grocery delivery service is now the world’s largest, with over £1 billion in sales and £56 million in profits in the last fiscal year.

As Wal-Mart has proven in the States, it is no cinch to extend even an exceptionally powerful retail brand into services. But this is just what Tesco has accomplished. Rather than allow banks to set up small branches in their stores as some grocery retailers have done in the U.S., Tesco essentially private-labeled its own bank and insurance company. Tesco launched its financial services business, Tesco Personal Finance (TPF) in July 1997 through two 50/50 joint ventures. Its banking joint venture is with the Royal Bank of Scotland, and its insurance joint venture is with Scottish Widows, a leading UK insurance company. After introducing credit cards initially, the personal finance business has been so successful that the company has rolled out all kinds of ancillary financial products that it sells to its customers at the stores or online. In addition to credit cards Tesco Personal Finance now offers standard personal bank loans and mortgages, saving accounts, and traveler’s checks. Insurance products include vehicle, home, life, pet, travel and emergency breakdown coverage. In the latest fiscal year, TPF had over 5 million customers, including 1.8 million credit card accounts, and produced profit of £142 million (of which Tesco gets half).

In 2003, Tesco teamed with British telecom giant Cable & Wireless to offer Tesco Telecom, which introduced Tesco-branded mobile and home phone service that can be purchased online or at Tesco stores. In 2004, the company launched a broadband internet service through the venture. Though still in start-up stage, Tesco Telecom ended the year with 1.5 million customers.

In May 1997 Tesco launched its new emphasis on international expansion when it acquired the food retailing business in Ireland from British Foods PLC for £643 million. Prior to 1997, Tesco’s only experience outside its home country of the UK was in France, where it owned a supermarket chain called Catteau from 1992 that was generally a poor business that never was able to turn consistently profitable. The company disposed of the Catteau business in February 1998 for £250 million. Beyond Ireland, Tesco set its focus on developing markets with weak incumbent retailers in Central Europe and the Far East, rather than on mature markets such as Western Europe and the United States where the retail markets are both highly developed and brutally competitive. Tesco chose to focus first on the former Eastern Bloc countries Hungary, Poland, Slovakia, and the Czech Republic, where communist governments had formerly prevented the emergence of any dominant local retailer. Tesco also identified Asia as a fertile area for expansion. In May 1998, Tesco acquired a 75% controlling interest in Lotus, a chain of 13 hypermarkets in Thailand for £206 million, including the assumption of £89 million in debt. Lotus contributed £170 million in sales and a small operating loss of £2 million in fiscal 1999. In March 1999, announced a partnership with Samsung called Samsung Tesco Homeplus to develop hypermarkets in South Korea. Tesco invested £130 million for an 81% stake in the JV. Samsung Tesco announced in January of 2005 that it would acquire twelve stores from a local company called Aram Mart, of which three are compact hypermarkets and nine are traditional supermarkets. Tesco opened a store in Taiwan in 2000, and in May of 2002 opened its first store in Malaysia in a joint venture with local company Sime Darby. In 2004, Tesco expanded into Turkey with the purchase of a local retailer called Kipa for £96 million, and also moved into Japan, which despite having a very mature economy has only recently begun building large store format superstores. Tesco chose to enter Japan by way of an acquisition, buying a Japanese superstore retailer called C Two-Network for £176 million for 78 stores. In September of 2004, Tesco purchased a 25-unit chain in Japan called Fre’c. Also in September of 2004, Tesco purchased a 50% interest in Hymall, a subsidiary of Chinese retailer Ting Hsin’s, which operated 31 stores in that country at year-end 2004. For the 52 weeks ending February 2006, Tesco’s international sales, which includes everything outside of the U.K. and Ireland, contributed 22% of sales and 21% of group operating income.

Now let’s talk about valuation. The price of the stock was recently 330 p for the London shares and $18.80 for the U.S. traded ADR (which is equivalent to 3 London shares.) Market cap was therefore approximately £26.3 billion. Adding in £4.09 billion of net debt, and you get an enterprise value of approximately £30.4 billion.

On a market cap basis, the £26.3 billion is approximately 17 times trailing reported earnings. While this does not in itself seem unreasonable for a company growing earnings at 12-15% per year, it is clear that Tesco is not being run to maximize current earnings or cash flow, given that most of its international operation is still early in its development and several country operations are not yet even profitable. The company also has invested heavily in young service initiatives in the U.K. that are either early in their profitable phase (TPF) or not yet profitable (Tesco Telecom). It is obvious that Tesco’s management is investing heavily for future growth and only has one eye on current profitability. Like many growth retailers, Tesco invests virtually all of its operating cash flow into capital spending for new unit growth, mostly to purchase the real estate for its new stores. The EV / OCF multiple (less interest expense) based on our estimate of US GAAP operating cash flow of about £3 billion is 10 times. Compare this to such high-quality growth retailers in the U.S. as Home Depot (12.5 times) Wal-Mart (13 times) and Costco (12.5 times). Tesco will spend £3 billion in cap-ex again in the coming fiscal year, of which at least £2 billion will be for owned property. The company has also earmarked £250 million for its initial expansion into California (and may lease the space there). The company recently announced that 85% of its book value of £15.9 billion is represented by owned real estate at historic cost. The company estimates that the market value of these assets would be as much as 50% higher (implying property value of £20 billion) and will look into monetizing some of these assets in order to free up cash for share repurchase or other return to shareholders. The management, by the way, appears to be very good at capital allocation, and from reading their annual reports it is clear that they use some flavor of EVA (return on capital employed minus a cost of capital) to measure their success. The company has also noted that after three years of building “dividend cover” during which leverage declined substantially, it intends to raise the dividend roughly in line with earnings going forward – or roughly 12-15% per year. The company announced an annual dividend for FY2006 just completed of 8.63 pence per share, for a yield of approximately 2.6%. Basically, what we are seeing here is a fast-growing, global retailer that is every bit the company WMT is, just with better growth prospects and a considerably better valuation. We also believe that the combination of an entry to the U.S. and the recent Berkshire purchase will serve to up the company’s profile with U.S. investors, as it is my sense that many U.S. investors have never heard of the company – though recent positive articles such as the long piece in the Wall Street Journal on June 6 will start to change this.

Catalyst

• Continued strong revenue and EPS growth
• Rising dividend
• Monetizing some real estate assets
• Eventual strong free cash flow
• Higher profile with U.S. investors from recent Berkshire purchase and entry into U.S. market