Jim Prevor’s Perishable Pundit, December 20, 2007
One of the issues that keeps coming up in our discussion of Tesco’s new operation in America is real estate.
It is fair to say that retail and real estate always intersect.
We previously pointed out that Tesco was going to have a problem and wind up with a lot of sub-standard real estate simply because it is impossible to roll out stores on Tesco’s schedule, yet do it only with great sites. In fact, we contrasted the way Tesco was working with Kroger’s approach.
We also ran a piece entitled, A Closer Look At Tesco’s Finances, which pointed out that substantial holdings of real estate can distort earnings:
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.
The other day, in our piece, Tesco Observations From a Retail Pro, we published this point:
As you would expect, in order to make a real estate impact Tesco took every dark site available. Many of these sites are dark because someone else could not operate them profitably.
Hubris, or as the Greeks wrote it, ὕâñéò, is typically translated today as an exaggerated pride or self-confidence. We think of it, typically, in the context of “Hubris against the Gods,” which is the character flaw of the heroes in Greek tragedy.
These heroes commit an “act of hubris” known as Ate — in Greek àôþ — which is commonly translated as “ruin, folly, delusion.”
This action is the cause of the “nemesis” — in Greek ÍÝìåóéò — translated as destruction or downfall.
From this we get our modern sense of the word as overconfidence and arrogance often drawing on an ignorance of history and a complete lack of humility.
The question is really whether Tesco, in looking at these dark stores where others failed, approached the situation with humility or arrogance.
It is the easiest thing in business to assume that others failed because they weren’t any good — they didn’t merchandise well, they didn’t build the right distribution center, they didn’t position themselves properly — and then plunge in, assuming you know how to do it better.
Every once in awhile it is true — but, mostly, it is false. Mostly it is a hubristic attitude. The most reasonable approach is to assume that competitors draw on similar talent pools, have a similar cost of capital, etc., and, most crucially, that they are good at what they do. In this case, that American firms operating those very sites knew what they were doing.
Then one looks at that empty store front with humility and moves cautiously.
To some extent, the fate of the whole Fresh & Easy venture May depend on whether Tesco acted with hubris or humility in evaluating these sites.
For Tesco’s sake, we hope it is the latter. For if it is the former — if it was an act of delusion, of Ate, to lease these sites — then we can expect its American competitors to act robustly. They May remember the scene in Shakespeare’s Julius Caesar in which the Goddess known as Ate appears, a symbol of vengeance. Mark Antony, speaking of Caesar’s murder predicts:
“And Caesar’s spirit, ranging for revenge,
With Ate’ by his side come hot from Hell,
Shall in these confines with a monarch’s voice
Cry “Havoc!” and let slip the dogs of war …”
Caught in a series of sub-standard locations, Tesco May find that hubris, as it must, brings its price as its American supermarket competitors decide to fight back and thus “…let slip the dogs of war…”