We think Tesco's scale allows the firm to operate more efficiently than competitors, and its convenient locations and loyalty program should continue to drive traffic. However, we don't have enough confidence in Tesco's ability to sustain excess returns over the long term to assign the firm an economic moat.
Switching costs are non-existent in grocery retail, and competing on price while sustaining excess returns is a tough proposition. Moaty defensive retailers tend to have clear cost advantages, and because Tesco's competitors have sufficient scale to remain competitive on price while touting points of differentiation many of which could be replicated over a decade, we don't think Tesco (TSCO) has a material leg up on its peers.
Tesco is the largest food retailer in the U.K., where it also sells gasoline and higher-margin general merchandise in multiple channels, including traditional store formats, online, and convenience stores. The U.K. grocery industry is highly consolidated, with Tesco, Asda, Sainsbury (SBRY), and Morrisons (MRW) controlling a large portion of this £160 billion-£170 billion market.
The industry is very competitive, and rivalry has intensified over the past few years. Most firms spent the better part of the past decade increasing square footage to drive sales growth, but some of these investments failed to produce expected returns, particularly when the global economy slowed and consumers started spending more in alternative channels.
Tesco also operates more than 3,500 stores in Europe and Asia. We think the firm remains well positioned in Korea, Malaysia, and Thailand, but results in other regions have been more challenging. The company recently decided to exit the U.S., where its Fresh & Easy concept failed to gain enough traction to support adequate returns on invested capital.
It also exited Japan in 2011, as deflationary pressures, cost-conscious consumers, and fierce competition weighed on profitability. China and India remain areas of opportunity, but achieving results comparable to those in the U.K. will be no small feat given regional market dynamics.
