Dave Lewis Has a Problem with Booze

Dave Lewis has been Tesco’s CEO since September 2014. As we said in an earlier post, his challenge is to counter the growing threat from discounters in the UK like Aldi and Lidl by holding on to a core set of customers who prefer Tesco’s variety and convenience over the discounters’ low prices. At the same time, he has to cut costs to support that still-big but smaller business. But Lewis is likely to find that harder to do than we first expected. That is because a £12.99 whiskey from Aldi won the top prize in a blind taste test, beating many of the famous brands that Tesco carries. Aldi has now received 12 major accolades in the past three years for its drinks, along with awards for many other products. The whiskey awards are a clear sign that ALDI is moving upmarket from a limited selection of low-priced generic products to a broader array of value-priced premium products. Aldi plans to offer nearly a third more premium products than it had in UK stores last year, and it’s broadening its appeal with more fresh foods. Aldi is after the customers Tesco plans to keep, shoppers who want higher quality and lots of choice. It’s following a classic strategy used by disruptors in industries from steel to groceries to disk drives. Successful new entrants get more resources, improve their capabilities, and start to move upmarket, drawn by higher growth and profits. They often keep a cost and pricing advantage as they move up, just as Aldi has vowed to do: “Whatever our competitors plan to do…we will not let them...

Tesco’s Not Even Close

Tesco just agreed to sell its South Korean operations for £4 billion, taking a loss of about £150 million on the sale. The deal will reduce borrowings by £4.2 billion over the next 18 months. That’s a step in the right direction, but it’s not enough. Tesco may also sell its operations in eastern European and in Thailand to cut debt even more. Analysts think they could be worth as much as £5.9 billion. But even that would not be enough. At the end of its latest fiscal year in February 2015, Tesco had £26.2 billion in adjusted debt, £4.2 billion in adjusted twelve-month EBITDAR, and shareholders’ equity of £7.1 billion. Adjusted debt to EBITDAR1 was 6.3x, and adjusted debt to capital was 79%. Proceeds from Korea would reduce those figures to 5.2x and 76%, while proceeds from Europe and Thailand would cut them to 3.8x and 70%.   As we said in an earlier post, because of the company’s high business risk we think it should be targeting debt to EBITDAR leverage of 3.0x and debt to capital of 40%. That means cutting debt by at least another £3.5 billion2 or raising EBITDAR to £5.3 billion and shareholder’s equity to £24.0 billion. We just don’t see an easy way for Tesco to get there. Cutting debt through asset sales is promising, but it has problems. If the company keeps taking losses when it sells assets, that will cut into shareholders’ equity, which already is at dangerously low levels. Asset sales take time. The Korea deal will span more than a year from deciding to sell to receiving payment and...

Terrifying Tesco

A few days ago Tesco announced its worst full-year loss ever and one that ranks among the biggest in the history of British business — £6.4 billion. The company took a cart load of special charges to account for three years of declining sales, profits, and cash flows and a financial reporting scandal. It also disclosed uncomfortably high leverage (adjusted debt to EBITDAR of 7.4x) and limited amounts of liquidity (a liquidity position of £3.4 billion). There are signs Tesco is getting better. It cut prices, improved service, laid off staffers, closed stores, and agreed to start funding its pension deficit. Customer traffic and purchases in the UK are growing again, and the rate of sales decline there slowed to (1.0%) in Tesco’s fourth quarter. Tesco’s CEO “Drastic Dave” Lewis made a lot out of this, saying, “They are pretty good vital signs,” and, “This patient is OK.” But he may be discounting his company’s immediate tactical problems. Worse, he may ignoring a long-term strategic threat. Tactically, Tesco is still in retreat. Discount grocers Aldi and Lidl are capturing more and more share from Tesco and the other mid-market chains in the UK. And they’re gaining at a growing rate.   We don’t think Lewis is trying to transform Tesco into a low-cost, low-price chain and win back lost market share. He’s trying to hold on to a core set of customers who prefer Tesco’s variety and convenience. He understands he has to shrink to a cost base that supports that still-big but smaller business. His plan may succeed in the short run but fail in the long run.  This has to do...

Breaking Tesco Out of the Box

Credit risk at Tesco Tesco disclosed details of its turnaround plan on January 8. The company was clear about its business problem — loss of share and profitability in the UK. And it was specific about the steps it is taking to tackle that problem — price cuts, store closings, and overhead cuts. Tesco was less clear about its financial problem — too much leverage. It promised to “protect and strengthen the balance sheet” through capital spending and dividend cuts, possible asset sales, and pension spin-offs.  But there was little sign of concern about the dangerous combination of risks we talked about in our last post, “Tesco’s in the Wrong Box,” nor was there a commitment to a better credit rating. Fully adjusted for off-balance-sheet debt equivalents like pension obligations and operating leases, Tesco’s leverage for its half-year ending in August 2014 was 5.0x debt to EBITDA and 50.8% debt to capital. That is too high. Given the company’s high business risk, we think it should be targeting debt to EBITDA leverage of 3.0x and debt to capital of 40%, putting it at the lower end of range of its peer group for those measures. Tesco can do that by improving earnings or reducing debt or both. We’re skeptical about a big or quick jump in earnings at Tesco. The challenge to its business model may be more than price and overhead cuts can overcome, there may be strong cultural resistance to change, and competitors are likely to respond with their own cuts. Cutting credit risk at Tesco That leaves paying down debt as Tesco’s most attractive option for reducing financial risk. At the...

Tesco’s in the Wrong Box

On January 8 Tesco announced more details of its plan to improve its competitive position in the UK, revive its profitability, and bolster its finances. It’s going to cut prices on popular brands, trim £250 million in operating costs, limit capital spending, stop the dividend, and sell assets. Some of the changes may already be working. The decline in UK sales is easing, with growth going from (5.4%) in the second quarter to (2.9%) in the third quarter to (0.3%) during the Christmas season. But January 8 brought more bad news as well. Moody’s downgraded Tesco’s credit rating to junk status (Ba1), and Standard & Poor’s did the same a few days later (BB+). Both agencies cited competition, profitability, and financial leverage as the reasons. Those are the risks we discussed in our January 5 blog post, “Testing Tesco.” But we think the rating agencies understate the risks. They don’t consider the difficulty of changing a company as large and as focused as Tesco. We see Tesco’s still unresolved financial reporting problems as symptoms of a damaged corporate culture that is likely to fight hard against change. The agencies don’t mention liquidity in their concerns about Tesco, but the declining trend in liquidity worries us at least as much as the increasing trend in leverage. The company’s liquidity position is at a four-year low, driven by growing current debt levels.   But our biggest worry isn’t any single risk or even the number of risks. It’s the compounding effects of Tesco’s risks, the way the company’s business and financial risks amplify one another. It’s common to think of credit risk in...