Like St. Augustine praying for chastity — but not yet — Tesco has declared that its Fresh and Easy division shall make a profit — just not yet. Tesco management has declared that its US division shall become profitable in fiscal year 2012/2013.
Of course, such predictions are curious as Tesco has never acknowledged any significant flaw in its rollout of Fresh & Easy. Instead it has claimed that the general economy has been the problem. Of course, if the general economy is the problem, precisely how does Tesco know that things will be OK two years from now? Maybe they will be worse!
Tesco believes it will be profitable because stores will mature and thus have higher sales and, by that time, it expects to have about 400 stores — more than twice what it has today. This will max out, it says, its distribution center capacity.
One can take these projections or leave them, as at various times, Tesco projected hundreds of stores to be open by 2009 and 2010 that never materialized. Of course, while Tesco announces plans in the out years to open a store a week or more, it is “mothballing” 13 stores right now. The implication is that Tesco opened stores in outer areas that it had expected to fill up with people, and because of the housing crash, these areas are not filling up. Thus Tesco is closing down these stores until some day in the unknown future when more people might move near the stores.
It is reasonable enough to look to locate stores in areas where the population may grow, so this claim may even be true. The meaning of “mothballing,” though, is suspect — one wonders if it is some scheme to avoid having to write-off the stores. One wonders what British accountants would say? Is the professed intent to reopen a store at some indefinite date in the future sufficient to avoid an immediate write-off?
We now learn the shockingly high price paid: £52 million, or $82 million, for 2 Sisters and £64 million, or $101 million, for Wild Rocket.
Now Tesco discloses that in addition to asset values that we would consider wildly overvalued, Tesco paid so much that about £82 million, or nearly $130 million, in goodwill arose as a result of the acquisition. Yet these companies that practically only sold to Fresh & Easy have nothing that merits such a goodwill evaluation.
Tesco writes in Note 10:
On 18 June 2010 the Group acquired the trade and certain assets and liabilities of 2 Sisters Food Group, Inc. for consideration of £52m. On 19 July 2010 the Group acquired 100% of the ordinary share capital of Wild Rocket Foods, LLC for consideration of £64m. The table below sets out the provisional analysis of the net assets acquired and the fair value to the Group in respect of these two acquisitions.
Pre-acquisition carrying values
Fair value adjustment
Provisional fair values on acquisition
|Net assets acquired||40||(6)||34|
|Goodwill arising on acquisition||82|
The goodwill represents the benefit of supply chain efficiencies, production economies, the ability to develop new and innovative products and further third-party revenue potential.
Tesco paid £45 million, or $71 million, in cash plus £71 million, or $112 million, in non-cash consideration for these two companies. Tesco is cryptic about what this enormous non-cash consideration could be. Did the company give Tesco stock? Did Tesco own some percentage of the British sister companies and pay that out? We once noted that Tesco had a lien against Wild Rocket. Could it have had a note, perhaps guaranteed by the owners of Wild Rocket that it threw in, as part of the deal? In fact, could the whole deal have taken place to avoid a write-off of a loan to Wild Rocket or to both of the transplants?
In any case, it is now clear that this was a bailout more than an acquisition. The non-current assets were written down slightly from £45 million, or $71 million, to £41 million, or $65 million, but we would guess that in an actual sale, they would struggle to get a fraction of that for their facilities.
Goodwill in a third-party sale would be almost completely dependent on the terms of the contract with Fresh & Easy. It is like a sales leaseback — the value is entirely based on the terms of the lease. If there was no contract, the very fact that one company accounts for 100% of the business would make it a tough sell.
Our estimate is Tesco paid more than five times what these companies would have gone for to a third-party vendor not protected by a contract with Fresh & Easy.
The high prices paid for these assets still leaves one to wonder if there was not some informal agreement to bail out the ownership of these transplants if things didn’t go well. This is significant because such an agreement, if it existed, would have misrepresented to shareholders the risks the company was taking in America and the losses it was actually experiencing. One wonders if the UK’s Serious Fraud Office will ever take a look at this.
In another part of the report, Tesco claims that its Fresh & Easy “like for like” sales — or as Americans would say, same-store sales — are up 10% and sees this as “good progress,” but it is not. We wrote way back in February 1, 2008, that stores have a natural maturation process, which we detailed like this:
When a new store opens, sales commonly drop, not increase, by 20 or 30% within the first four weeks.
Then, they can start to grow, but rarely by leaps and bounds. If these stores have stabilized at $50,000 a week after being open a month or two, you would expect to see sales at $60,000 a week a year later, $69,000 two years later, $80,000 after three years and, say $90,000 after four years.
Now if the concept really takes off and gains wide acceptance, instead of a gain of 20% and then 15% each year, you could get a gain of, initially, 35% and then 25% after that.
Operating grocery stores is a tough business, but it is not rocket science. The big problem Fresh & Easy has is that the stores do not make money. In fact, losses have increased. Tesco announced that in the first half of its 2010/2011 fiscal year, Fresh & Easy lost £95 million, or $150 million. This is up from a loss of £85 million, or $134 million, in the same period last year. Tesco blames its acquisitions of suppliers and paying rent on stores it has elected not to open for aggravating these losses. Of course, other retailers manage to rent almost only stores they actually open and only do acquisitions if they are accretive to earnings.
We have done much analysis on Fresh & Easy. Now we sense the arrogance of pride that so often comes before a fall. Sure Tesco is a wealthy company, and it can spend money as long as it wants. But we are hearing grumbling from employees at Tesco in the UK and other places that the annual quarter-billion dollar losses are starting to grate on people.
We also think Tesco is wildly optimistic about the success it will have in other regions. Northern California is becoming a highly competitive — and very expensive market — to operate in. Wal-Mart is about to announce a new small-store initiative drawing on its experience in Mexico and modeled after its urban entry agreement in Chicago.
Yet the Tesco report seems to envision success as coming through a “steady-as-she goes” philosophy. Yet a stagnant concept gives competitors a chance to practice and discover vulnerabilities. As tough as Fresh & Easy’s entry in Southern California, Phoenix and Las Vegas has been — and it has been tough — going into Northern California will be tougher. Safeway has some pretty sharp people and pretty decent resources and they have been practicing now for three years.