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Terry Smith demolishes Tesco

Terry Smith, CEO of Fundsmith, did a great job of demolishing the business of Tesco yesterday in the Financial Times (FT Money 6/9/2014). He explained why he won’t be buying Tesco even though the shares have fallen to a level that equals what it was in 2003 and investors have been imploring him to buy it.

Even though Warren Buffet has owned some shares in Tesco of late, he quotes from Mr Buffet’s 1979 letter to shareholders thus: “The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital  employed (without undue leverage, accounting gimmickry, etc) and not the achievement of consistent gains in earnings per share“.

Mr Smith points out that the decline in Tesco’s return on capital commenced not under the recently departed Philip Clarke, but under his predecessor Sir Terry Leahy. It fell from a good 19% ROCE to “a less than adequate” 10% during the Leahy years. To quote from the article: “To drag the average ROCE down so dramatically it is likely that returns on new investments in those years were not just inadequate, but in some cases negative – as the ill-starred US expansion proved to be“.

So while EPS grew in those years, ROCE declined, and Tesco even changed its definition  of ROCE eight times in that period.

Free cash flow has also declined in the last 18 years (from when Terry Leahy became CEO), and it is suggested that Tesco was financing growth via debt. So debt rose from £894m to peak at £15.9bn in 2009.

In essence the allegation is that Sir Terry Leahy turned what was a good business into a bad one, in terms of financial structure, and one cannot but agree with that claim. Return on capital is exceedingly important and differentiates the quality businesses from the poor ones. If you are not clear why then read Joel Greenblatt’s The Little Book that Beats the Market.

Regrettably there is too much emphasis by market analysts on growth in earnings rather than the quality of those earnings, how they are being achieved and the underlying cash flows. Unfortunately the incentives given to managers in long term and short term performance schemes are often the wrong ones – with a focus on earnings per share or TSR. Likewise management often prefer grandiose expansion into more real estate or new ventures rather than improving return on capital. How Tesco could justify their US venture I could never understand and if Mr Clarke had any failings one of them was surely that he did not withdraw from it even sooner.

Those holding Tesco at present might be thinking what does one do now. Is Tesco capable of being reborn or should one dispose of the shares as a lost cause? The simple answer is surely this: look to see how the new CEO, Dave Lewis, tackles the above issue – not just what he does to improve the company’s retail competitiveness and market share which everyone else is claiming as the main problem at Tesco. The real problem is that it would seem that a lot of capital is being deployed to no great purpose, and the usual remedy to that is a bout of downsizing and restructuring. Perhaps the sooner he starts the better.

Roger Lawson

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