28 Oct 2011 FPA Crescent Fund - Q3 2011 Commentary ( Portfolio )
In the quarter, we were able to make new investments in two leading retailers. The companies have what we believe to be practically bulletproof balance sheets, attractive operating economics, competitively important real estate holdings, muted risk of internet-based business disruption, and a commitment to improving return on invested capital (ROIC) and to returning capital to shareholders. Both companies were purchased at less than 10x our estimate of normal owner earnings.

Tesco
Tesco PLC is the third-largest retailer in the world, behind Wal-Mart and Carrefour. It earns approximately two-thirds of its profit from the United Kingdom, where it has ~30% share of the grocery market. The other third of its earnings come from countries in Asia and Central Europe. The company holds a particularly strong #2 market position in South Korea, Thailand, and Hungary. Tesco appears to be at an inflection point in several countries where it has captured enough scale to drive high returns on newly invested capital. Tesco has long been considered a strong operator of a leading franchise in the United Kingdom, but international operations have lagged. The company recently committed to improving ROIC, with management putting its money where its mouth is (bonuses are now based on achieving ROIC targets). We purchased Tesco at a low ~10x 2012E core EPS (excluding amortization of intangibles and losses in the United States and Japan). As an additional margin of safety to our investment, Tesco owns the real estate underlying 75% of its stores – ownership that arguably provides some measure of asset backing.

Lowes
Lowes is the second-largest home improvement retailer in the United States. The company operates in a duopoly-like market with Home Depot. We believe Lowes is operating somewhere near the bottom of a significant industry downturn (home improvement spending is at the lowest % of GDP in 70 years). We bought Lowes at roughly 10x current (depressed) owner earnings. We expect earnings to improve materially when the U.S. economy improves. In the meantime, Lowes is aggressively repurchasing stock (10% of the company per year, based on our purchase price).