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In London, Pessimism
Spreads Over Fresh & Easy

Our long-running coverage of Tesco’s journey to America has attracted much controversy, particularly, our estimate that sales levels for the Fresh & Easy stores, after their grand opening period, are running at roughly $50,000 a week — although we did expect that they will rise from that level.

This week in London, an analyst with Piper Jaffray came out with a report that grabbed much attention:

Tesco US foray is struggling, claims broker

TESCO’s plans to make it big in America were called into doubt today when a major US stockbroking house claimed the Fresh & Easy stores are struggling.

In the first in-depth research into Tesco’s assault on the US market, Piper Jaffray said sales are far short of target and the stores need an urgent overhaul. Tesco opened Fresh & Easy in a blaze of publicity in November, after years of research.

But Piper’s Mike Dennis warned: ‘The Fresh & Easy concept is not right and they need to quickly find out what the issues are and reset the concept.’

Dennis said it could cost Tesco £400 million to exit the US — a dramatic move the supermarket insists it is not contemplating. Dennis claims the 50 Fresh & Easy stores opened so far are averaging sales of only $170,000 (£86,500) a week. He thinks Tesco was aiming for closer to $200,000 initially, rising to $270,000 later.

‘The overall indication seems to be negative,’ he said. ‘This begs the questions of how bad it could be for Tesco’s Fresh & Easy stores across California, Arizona, Nevada and what it would mean to Tesco’s long-term growth rates and international strategy in the US.’

City analysts seem aware Tesco may be having teething problems. One said he had already begun referring to Fresh & Easy as ‘Ambient and Quite Difficult’. Tim Mason, who moved to the US with his family to run Fresh & Easy, recently sold £1.3 million of Tesco shares.

Said Dennis: ‘Maybe he knows what the impact of a poor US sales performance could do to Tesco’s shares in 2008, but any official explanation is probably not going to give clarity.’

A Tesco spokesman said of the Piper Jaffray note: ‘This appears to be a bit of scaremongering particularly as Mike Dennis hasn’t even spoken to us about Fresh & Easy’s performance.

‘It is ridiculous to make judgments just four months after the first store opened. I don’t know when Mike last visited California but the up-to-date picture is one of growing sales, increasing customer numbers and more repeat visits.’ London-based Dennis is in fact in America at the moment. Marks & Spencer, Dixons, Next and Sainsbury’s have all seen attempts to grow business in the US collapse in recent years.

The report by Piper’s Mike Dennis is quite intriguing, but not for reasons the press highlighted. The $170,000 per week sales number is not an actual estimate by Piper Jaffray. It is better described as an assumption used to run through Piper’s analytic models and estimate the impact on the profitability of the Fresh & Easy format.

The report is ambiguous on the point. Although in its Key Points Summary, the report does say, “We believe the 50 stores opened to-date could be averaging sales of $170k per week,” the word “could” is unclear. If you go to the text of the report, it says things such as “…if the overall sales run-rate per week is closer to $170k…” At no point in the report do you see a line saying Piper Jaffray or Mike Dennis estimate Fresh & Easy sales at $170,000 per week per store.

We think Tesco executives would be doing a jig on the rooftop (would that hurt the solar voltaic cells?) of the California distribution center if they were doing $170,000 a week per store. Since that number is so dramatically different from what we have estimated as well as what independent analysts have found as we discussed in Pundit Analysis Buttressed: Tesco’s Fresh & Easy Sales Only 25% Of Plan, Says Willard Bishop Report, we wanted to find out more. So we sent Pundit Investigator and Special Projects Editor Mira Slott to try to explain the discrepancy.

Mike Dennis was quite graceful and shared his methodology:

“We based our $170k sales on the fact that Tesco aimed for $200k and only anticipated a variance of +10 to -10, so we used -15 to see how that impacted margins and returns.”

In other words, being that the feedback is now pretty substantial that Fresh & Easy is underperforming expectations, and being that Tesco expected first-year sales of $200,000 per week, per store, what Mike actually did was say that since Tesco, in its planning, figured on a 10% variation either up or down, Mike looked at what the numbers would be like if Fresh & Easy underperforms by, say, 15% — which would be outside of Tesco’s expectations. Here is how Mike Dennis explains his intent:

Now we want to discuss what a 15% drop in average weekly store sales from $200k to $170k means in terms of store operational performance, flexing costs and ultimately CROI.

One reason the report is so intriguing is that it shows that even a relatively small deviation from plan can have devastating financial consequences. This 15% underperformance on sales translates into a dramatic change. Piper estimates that with an initial sales base of $200,000 per store per week, in Year 5 of the project EBIT margins — Earnings Before Interest and Taxes — will be 6.5%.

Yet a drop in first-year volume by 15% cascades into future years, reducing Year 5 EBIT margins to only 3.7%.

And CROI — Cash Return On Investment (earnings before interest, tax, depreciation and amortization, expressed as a percentage of net invested capital) — would collapse. At an initial $200,000 per week, per store, Piper sees a CROI in Year 4 of about 15%, but adjust the initial years sales level to $170,000 a week per store and Year 4 CROI drops to about 10.5%.

It is a fascinating report, not because it contains any real estimates of how Fresh & Easy is doing, but because it provides a model to assess the implication of that performance on Fresh & Easy and, ultimately, the Tesco share price.

Piper didn’t run its model with sales estimates at around $50,000 a week, per store, but it is fair to say that the analysis would show red ink as far as the eye can see.

Tesco keeps insisting its expansion is on track. Yet Tesco could put the whole controversy to rest in two minutes by revealing sales numbers, as Tesco did for its UK stores in the UK, but Tesco refuses to do so.

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