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Edinburgh Partners’ Research Papers

Case Study: TescoAn example of “Mistaking the Secular for the Cyclical”

Sandy Nairn, BSc, PhD, ASIP, CFAInvestment Partner and Chief Executive

Edinburgh Partners

2Edinburgh Partners Case Study: Tesco

Value trap summary.

Background

In the paper ‘Mistaking the Secular for the Cyclical’ we sought to lay out the conditions under which ‘value traps’ can emerge.

If we begin with the summary of the paper:

n We invest over a long-term horizon that can include the full economic and business cycle as well as more permanent changes in a company’s environment

n Recognising the difference between the ups and downs of the normal cycle and more fundamental changes in the environment is therefore a key skill

n Analysts have a tendency to mistake a longer-term change in a company’s environment for a cyclical one

n A common mistake in an ongoing downward trend is for analysts to be over-optimistic in forecasting a cyclical recovery in sales and margins

n Where secular trends are negative, historic comparisons are misleading and produce value traps

Clearly one would not deliberately invest in a stock which fell in to the value trap category. Normally it is something which happens when the original investment case is called into question. This note lays out how the Edinburgh Partners investment process operates by using as an illustration the example of Tesco.

Investment Process

Investment process constantly evolves and one change that we made a number of years ago was to try and counter balance a common behavioural issue. Where an analyst has made an investment case for a stock there is always a danger that it takes longer for him/her to react to a change in circumstances than it would for a different analyst starting with a clean sheet of paper.

3 Edinburgh Partners Case Study: Tesco

Original investment case.

As a consequence, where there is prima facie evidence of a change in circumstances (e.g. a large share price movement or a significant change in our estimates) we assign a second analyst to conduct a fresh review of the company in question. This is not in any way a criticism of the original analyst, it is simply recognition of the behavioural forces to which we are all subjected.

Tesco: Original Investment Case

Company DescriptionTesco plc is a food retailer. The Group operates stores in the United Kingdom, Republic of Ireland, Czech Republic, Hungary, Poland, Slovakia, Turkey, Japan, Malaysia, South Korea, China, Thailand, and the United States.

Source: Bloomberg Company Profile

The background to the original investment case in Tesco was a company whose domestic operating profit margins had averaged 5 to 5.5% over a 15 year period. The stability of these profits plus the size of its domestic market share at 30% had caused the company to seek growth outside of the UK as well as a degree of diversification within the UK. These efforts had not been successful and the investment case rested on improving capital returns overseas and reinvesting domestically to protect the existing business whilst at the same time growing roughly in line with GDP. This was not a particularly contentious set of views and probably consistent with the market consensus at the time. On the back of these assumptions it looked like shares would need to be purchased around 400p to achieve a satisfactory return given the risks involved.

Tesco: Investment Case Questioned

In January 2012, under the new chief executive Philip Clarke, the company issued a profit warning. Same store sales growth had dropped over the Christmas trading period despite £500m of price cuts. The company stated that the consequence of this would be minimal profits growth for 2012-13. On the day the share price fell from 390p to close just above 312p.


Harbinger of things to come.

The fundamental question was whether this was a temporary blip in Tesco’s fortunes or whether some secular change was taking place which would cause a permanent shift in both revenue growth and profitability. Not surprisingly, the company’s argument pointed to the ‘progress’ that was being made and measures that they were taking to return to historic growth patterns and improve capital use.

When our ‘new’ analyst produced his report we came to a different view. We believed that this announcement was a harbinger of things to come and that the historic operating margins and growth rates would not be repeated in the future. Competition from discount retailers, Tesco’s market share position and market segmentation all conspired to create the conditions where the margin decline was only the beginning of a reset downwards and not a cyclical decline occasioned by a price war and recessionary conditions. Given that the participants continued with capex plans against the backdrop of a stagnant total market the position was only going to deteriorate further over time.

The background of structural decline and the impact on future profits and hence valuation led us to the view that the holding should be sold. On a tactical view we felt that there was probably some short-term upside in the stock since there would be many who would remain of the belief that the trading issues were temporary. Hence we resolved to sell the holding into any rise which occurred. The holding was sold between 320p and 350p.

Tesco: The Market View

The market view is best expressed by reference to the Factset consensus numbers. Whilst this only accounts for one side of the equation (the sell side), it does give a flavour of what has happened. The expectations on sales remained a linear extrapolation of history but simply reset from a lower base each time. This is a very traditional picture reflecting the difficulty in adjusting to the view that there may be a new operating environment for the company and industry.


Market expectations.

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EBIT Margin FY1,2 & 3 Estimates Source: Factset

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Sales FY1,2 & 3 EstimatesSource: Factset


Short-term upside in the stock.

The picture on profi t margins is similar but perhaps not quite as clear. The historic cycle in margins is evident and typically analyst forecasts have been for margins to rise from whatever part of the cycle they begin. The scale of disappointment from expectations at the time of the 2012 profi t warning is clear since analysts on average were predicting moderate year on year increases consistent with overseas restructuring. With the warning forecasts dropped sharply, but as the chart shows there was still a tendency to assume they would recover somewhere towards the historic average.

This expectation on reversion back to history allowed the share price to gradually begin to recover.

Initially the share price did recoup some of the lost ground and between 2012 and 2014 it traded between approximately 300p and 375p fl uctuating back and forward according to indications of same store sales growth. As the evidence mounted that it was a structural rather than a cyclical issue the price begun to slip, culminating in the departure of the new chief executive to be replaced by Dave Lewis and a further profi t warning/dividend cut.

The picture on profit margins is similar but perhaps not quite as clear. The historic cycle inmargins is evident and typically analyst forecasts have been for margins to rise fromwhatever part of the cycle they begin. The scale of disappointment from expectations atthe time of the 2012 profit warning is clear since analysts on average were predictingmoderate year on year increases consistent with overseas restructuring. With the warningforecasts dropped sharply, but as the chart shows there was still a tendency to assume theywould recover somewhere towards the historic average.

This expectation on reversion back to history allowed the share price to gradually begin torecover.

Initially the share price did recoup some of the lost ground and between 2012 and 2014 ittraded between approximately 300p and 375p fluctuating back and forward according toindications of same store sales growth. As the evidence mounted that it was a structuralrather than a cyclical issue the price begun to slip, culminating in the departure of the newchief executive to be replaced by Dave Lewis and a further profit warning/dividend cut.

Edinburgh Partners 6 Case Study:Tesco

The Historic Cycle in Margins is Evident


The investment proposition has significantly changed.

Conclusion

In the conclusions to our paper we made the point that “value traps are not necessarily distinguished by poor management, substandard technology or weak financial condition. More often than not, they are the victim of changing circumstances and an inability to adapt.” Whilst not a perfect description of Tesco it is an adequate one.

Next Steps

Tesco: does this mean one can never invest in the company?

No it definitively does not mean that the company is un-investable. It simply means that the investment proposition has significantly changed. No longer is this a company that can earn 5% operating margins, grow with GDP (and GDP+ if new stores are opened) and throw off excess cash.

In our view this is now a company that has to deal with a completely different market place dynamic. The market has segmented and Tesco needs to segment its offering to target each segment appropriately whether it be the price based end or the premium quality based end. The company has both the locations and the systems to do this if it desires. Revenue growth will be limited at best and margins will be substantially lower. However, from this lower base cash-flow will remain strong and distributable from a company with a high quality asset base and potentially strong operations both physical and on-line. In other words, there is a perfectly respectable case for investing in Tesco. It is very different from the case of the past 20 years, but like all investment cases, the key outstanding element is a share price that makes the risk/reward work.

That it might be edging closer to that level is potentially signalled by the useful contrary indicator that from a peak of 77% of sell side analysts recommending buy in late 2011 the figure is now less than 10%.

Sandy NairnSeptember 1st 2014


Postscript

Recent events illustrate how difficult it is to get ahead of the curve when there is a step change in a company’s circumstances. The share price fell a further 20% in September when the company announced its fourth profit warning and suspended several executives pending investigation of alleged profits mis-statement.


About the Author

Dr Sandy Nairn, Investment Partner and Chief Executive, researches global telecommunications and manages several client portfolios, including Edinburgh Partners Global Opportunities Fund. He is a member of the Board of Directors and one of the founders of Edinburgh Partners. He was CIO of Scottish Widows Investment Partnership (2000-2003). At Templeton Investment Management he was Executive Vice President and Director of Global Equity Research (1990-2000). He is an Associate of the UK Society of Investment Professionals and a CFA charterholder with AIMR in the United States, He has won multiple performance awards for the management of global equity portfolios. In 2001 he published the book “Engines that Move Markets: Technology Investing from Railroads to the Internet and Beyond”. He also co-authored the book “Templeton’s Way With Money” with Jonathan Davis of Independent Investor LLP, published in 2012.

About Edinburgh Partners

Edinburgh Partners is an independent fund management company which is majority-owned by its staff. We invest globally with an emphasis on absolute returns over a long-term time horizon. Our goal is to provide clients with superior long-term returns. We believe the creation of value for our clients depends upon the quality and experience of our investment team. Combining a high quality team with the ability to take a long-term view provides the basis for creating superior returns for clients.

Contact Information

Edinburgh Partners Limited

27-31 Melville Street

Edinburgh

EH3 7JF

Telephone: 0131 270 3800

Facsimile: 0131 270 3801

Website: www.edinburghpartners.com


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Past performance is not a guide to the future and the value of investment and the income from them can go down as well as up. Investors may not get back the amount originally invested. Exchange rates can also cause the value of underlying overseas investments to go down as well as up.

This document has been issued and approved by Edinburgh Partners Limited. Registered Office 27-31 Melville Street, Edinburgh EH3 7JF. Registered in Scotland SC243661. Authorised and regulated by the Financial Conduct Authority, 25 The North Colonnade, Canary Wharf, London E14 5HS.

NoteThomson Reuters and Factset make adjustments for certain items such as goodwill amortisation, extraordinary items anddiscontinued operations. This can result in discrepancies between the data from these data providers and the publishedcompany accounts data.

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