Buffett's Grocer Retreats From America, Wisely

For those familiar with the U.K. grocery store scene, few stores have a greater presence than Tesco (NASDAQ: TESO  ) . The food purveyor became more known domestically after a high-profile seal of approval from everybody's favorite investor and grandpa, Warren Buffett. The billionaire investor built up a more than 5% stake in the company earlier this year -- his only U.K. investment.

The argument for Tesco is a familiar one -- low valuation coupled with high margins. Unfortunately, the company's U.S. venture, Fresh & Easy, has been troubled since Day 1. Though met with enthusiasm from some shoppers, the stores have failed to produce the returns Tesco management and its investors expected. Last week, it was announced that the company's U.S. expansion will most likely be shut down. What does this mean for Tesco investors, and does this mean the store near my house is shutting down?

Sad day
After five years, Fresh & Easy stores just aren't cutting it -- remaining unprofitable every year of their existence on our shores. It's surprising, given the parent company's tremendous success in its home region and abroad. Tesco is the third largest retailer in the world as measured by revenues, behind only Wal-Mart (NYSE: WMT  ) and French company Carrefour. The chain has a long history of successful growth and branching out. In the mid 1990s, there were 500 stores following the pile-high, sell-'em-cheap model. Today, there are more than 6,300 stores.

So why did Fresh & Easy fail in the United States, and what does this mean about the state of the company?

Fresh & Difficult
For one thing, we all know that the supermarket business in the United States is a brutal one. With the exception of Whole Foods and The Fresh Market, the two stores with industry-leading margins and uber-sales growth, selling groceries is just hard. Tesco entered into the U.S. with the confidence of being the biggest guy in town in the U.K. and other parts of Europe, but that didn't mean so much on our shores. People needed a reason to switch to Fresh & Easy, and it seemed there wasn't one -- or at least one that was compelling enough.

In the U.S., we are spoiled with supermarkets that sell everything in the world and then some. (Unless you're at a Vons. I hate Vons.) For some, Fresh & Easy didn't have enough stuff to choose from. Common complaints include a lack of varied produce selections, not enough classic American snack foods (probably a good thing), and, overall, stores that just aren't as entertaining as some of the new modern stores available to U.S. shoppers. Other complaints mention a lack of coupons, which we Americans keep right next to our rifles and KFC. More far-reaching complaints mention that Fresh & Easy doesn't sound like an appealing food store, but more of a sanitary product.

It seems one possible reason Fresh & Easy didn't take off in America is that it wasn't born in America. And when something isn't born in America, it makes America angry. And as we all know, when America gets angry, it goes to Costco to feel better.

The future (or lack thereof)
The Fresh & Easy stores, all 200 of them, aren't totally doomed to closure. Tesco management notes that it has been approached by multiple groups, Wal-Mart among them, to take partial or complete ownership of the stores. The Fresh & Easy stores, which are most often found in urban and suburban areas of Southern California, may prove valuable to a large chain (again, Wal-Mart) that wants more exposure to the "neighborhood market" sector.

As for Tesco, this is most likely the best move. While the company has focused energy and funds on its U.S. operation, its market supremacy in Britain has eroded a bit. Investors in the company's LSE-listed stock responded well, sending the stock up more than 4%  the day the news was announced. It seems almost everybody, except maybe me, is OK with Tesco's withdrawal of its U.S. advance. I admit, I only like the store because it's within walking distance.

The U.S.-listed stock currently trades at a forward P/E of 11.32, far under that of Whole Foods and The Fresh Market, and a couple of points under Wal-Mart as well. If the management team is successful in its turnaround of the business at home and its continued expansion in places such as China, the stock today is most likely undervalued.

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