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A Closer Look At Tesco’s Finances

Jim Prevor’s Perishable Pundit, April 19, 2007

It is fair to say that the entire industry is wondering if Tesco will have the same success in the U.S. that it has enjoyed in the United Kingdom. Tesco announced its most recent earnings report and was optimistic about the U.S. operation:

We are on track to open our first stores under the Fresh & Easy banner — on the west coast of the United States, as planned, later this year. Our El Segundo office is now staffed by over 150 people and the construction of our Riverside distribution centre on the eastern edge of Los Angeles (LA) is on schedule. Site acquisition for our 10,000 square foot convenience format stores is also going well and we expect to be able to open a significant number at launch across the LA, Phoenix, Las Vegas and San Diego markets.

Recruitment and training of staff for the stores will begin soon which, combined with the other pre-launch costs and initial trading losses, will involve a planned rise in estimated US start-up costs to around £65m in the current financial year. Thereafter, as previously announced, we expect initial trading losses to diminish and the business to move into profitability during its third financial year of operation. Our intention remains to commit some £250m of capital per annum to the US going forward, although given the phasing of our investment and the higher leasehold element of the early stores, capital invested last year was lower — at £89m. We will begin formal reporting of US performance separately within our International operations from opening.

And in fact, those 150 people now employed by Tesco in the U.S. have been busy, setting up supply chains, leasing stores and developing a U.S. website that you can see right here.

We’ve been covering Tesco’s appearance in America since the beginning, most recently with a piece looking at its real estate issues and didn’t find much new on the website.

But its earnings release pointed to a reason to believe Tesco will have trouble duplicating its U.K. success in the United States. In fact, it raised the question of exactly how profitable Tesco’s operations actually are in the U.K.

Warren Buffett, the world-renowned investor, through Berkshire Hathaway, the company of which he is CEO, has acquired a significant stake in Tesco, which has been interpreted as Buffett’s endorsement of Tesco’s chances of taking on Wal-Mart in America. The Pundit wonders if a better interpretation is that this famous value investor has noted Tesco’s substantial real estate holdings and decided that this value will eventually be unlocked.

Tesco owns a great deal of real estate and the City, London’s version of Wall Street, has been pressing Tesco to sell it. Tesco’s management has generally resisted such pleas, and when it has sold real estate, Tesco has tried to do it with complicated joint ventures through which it is impossible to know if Tesco actually got the maximum price for the property, as Tesco continues to lease the space on a basis negotiated before the sale.

Tesco CEO Terry Leahy was reported by Reuters as explaining his position this way:

“Tesco has a lot of property, but it is important to remember property ownership is an integral part of retailing and Tesco will always have a majority of its space as owned space.”

Actually, owning real estate is an excellent way for retailers to report earnings that appear sterling but are actually not providing an adequate return on deployed capital.

In retailing the relevant capital being deployed is not what a building cost 30 years ago or its depreciated basis; it is what the building could be sold for today.

As part of its annual report, Tesco announced that after some large joint ventures that transferred over 10 billion pounds sterling of property to ventures with the British Airways Pension Fund and The British Land Company PLC, Tesco still has real estate, mostly individual stores, worth 28 billion pounds sterling.

Here is the rub: The entire profit of the Tesco organization was just reported, before tax, at 2,653,000,000 pounds sterling. All else being equal, this means that if Tesco sold all the real estate and the new owners leased it back to Tesco on a net, net, net basis (meaning Tesco still had to pay the real estate taxes, insurance, maintenance, etc.) and demanded a 10% return on their investment, Tesco would lose money.

If the investors were content to make a 5% return on their money, Tesco would see its profits plummet by more than 50%. And all this assumes that Tesco’s report on the value of its property is accurate. Possibly, a true liquidation, without regard to lease terms for Tesco, would realize even higher values.

However one figures it, the mighty Tesco has an operating business that crucially depends on billions of dollars in real estate deployed at sub-par returns.

Yet in the United States Tesco doesn’t have this legacy of real estate investments and so will have to lease property at market value.

Which means, even if its U.S. operation is equally as successful as its British parent, it will be significantly less profitable than the British operation.

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