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Memo to Sir Terry Leahy:
King George III Lost the War;
America Is Independent Now

If you want to know why Tesco chose this moment to announce a “pause” in the roll-out of its Fresh & Easy operation, you can credit an exceptionally sharp British analyst on the European food retail team at Citi in London. His name is James Anstead.

As if our substantial reporting on Tesco’s launch of its Fresh & Easy concept was not sufficient evidence that things were not all coming up roses, prior to Tesco’s announcement of a ‘pause’ we received word from London that Tesco is likely to attempt to hide the results of its new US venture within the results of its massive UK retail operation. In fact, Tesco has already done so surreptitiously in previous reports.

James receives the credit for catching this subterfuge, which shows he is both smart and minding his knitting.

He is also rather brave.

We learned this when he arranged for the Pundit to present a conference call about Fresh & Easy to investors looking to the Citi team to inform their investment decisions.

Many analysts tremor at letting a negative word pass their lips — because they fear losing access to important companies. Although he acted as Tesco’s advocate in our conference call — and a fierce and effective one at that — James still felt it important to allow Citi’s investors to hear other perspectives.

Now James Anstead has authored a report that made several salient observations:

  1. The expectation has been that Tesco would report separate numbers for its USA business:

    Until recently, we were under the impression that Tesco would create a fourth ‘reporting segment’ (in addition to UK, Europe and Asia) as soon as the first Fresh & Easy store opened. There were two reasons for us holding this belief:

    • We remember Tesco telling us this — and the fact that other parties also remember being told this suggests that our memories are not faulty.
    • The consensus sheet that Tesco regularly circulates presents the US as a fourth segment.
  2. But now Tesco is hemming and hawing on this point:

    It was therefore something of a surprise when, in our conversations with the company, Tesco would not confirm that it would separately report the US business as of 2H07/08. The company was non-committal about how it will report the results of the US business on 15 April, when it is due to release its FY07/08 results. However, we took the fact that Tesco would not confirm its intentions — in an area we had understood to be very clear — as a sign that the results of the US business will not be separately identifiable on 15 April.

  3. In fact, Tesco has — without bringing this to anyone’s attention — been hiding Fresh & Easy results in its massive United Kingdom business:

    If the US is not reported separately, then the obvious place would be within the UK. (Incidentally this is not unprecedented — Tesco’s one French store is disclosed within the UK, but that is one store in Calais catering to ‘boozecruisers’, not a potentially large part of the group!) We decided to double-check where the US was reported over Christmas and were surprised to hear that F&E’s sales were effectively disclosed within the UK over the six weeks of Christmas trading, within the contribution from net new stores. (It was also disclosed this way in 3Q apparently, although there were hardly any F&E stores open in that period.)

  4. Size of business would not justify this plan:

    The fact that F&E was disclosed within the UK over the Christmas period strongly suggests that this will be the case for the FY results also. Normally Tesco provides sales details for every country at the 1H and FY stage in its ‘broker pack’. Not only would we expect the US business to remain within the UK on the face of the P&L on 15 April, but we would not be surprised to see it absent from the ‘broker pack’ analysis. This cannot be justified on grounds of size, considering even small countries in the past have at least had their sales featured in the broker pack — eg £4m of sales in Malaysia in 1H02/03.

  5. Neither would commercial confidentiality:

    Given that this is a 180-degree turn from what Tesco had previously suggested, it would not be surprising for the cynics to use this as evidence that management is disappointed by the early results. Commercial confidentiality does not work as a justification because this consideration would have been obvious to management when they gave the original guidance.

  6. Conveniently, including Fresh & Easy numbers, even though small, in the UK numbers would have provided Tesco’s numbers a boost:

    The inclusion of F&E within the UK figures must have — very slightly — inflated the contribution from net new space; we tentatively estimate by 5-10bps. Although this is clearly not a huge number by any means, it would have boosted a line that had been showing slight signs of weakness earlier in the financial year.

  7. The market may react to a lack of candor on Tesco’s part:

    We would argue that the decision to account for the US within the UK over the Christmas period was somewhat disingenuous. We would have expected the company to be quite candid on this topic given its treatment was not what most people would have expected. Indeed, looking back at the trading statement, the company’s comments about the US were made within the international section, not the UK.

And the money quote:

…if Tesco does indeed delay breaking out the US business, it will intensify the perception that F&E has not had an especially auspicious beginning. It will also do nothing for Tesco’s reputation for openness, which is unfortunate. No doubt Tesco will be able to point to other companies that have ‘hidden’ start-up businesses for some time, but the point is that their position seems to have changed since this time last year and the only explanation in our minds is that Tesco is disappointed with the sales figures achieved so far.

Now the report goes on to emphasize that where things are reported has no effect on the actual performance of the business and that, long term, if the business is a success, nobody will remember this issue in five years’ time.

The report also emphasizes that it is not attempting to speculate on the actual operating performance of Fresh & Easy but only on how such performance as might occur will be reported.

Still the report does provide a quick summary of current thinking on Fresh & Easy:

…it would be remiss of us not to at least summarise our current thoughts. From our discussions with industry contacts — including, but not limited to, Jim Prevor (the ‘Perishable Pundit’) — we suspect that sales densities are so far in the range of US$5-10 per sq ft per week. We frequently read suggestions that Tesco was ‘expecting’ sales densities of US$20 per sq ft per week — against which US$5-10 would clearly look very disappointing.

However, the facts are that on the November investor trip, Tesco’s presentation indicated an expectation of sales densities of US$14-21 per sq ft per week and one would presume this was what they expected to achieve ultimately rather than immediately. While some commentators have suggested that F&E may be generating densities of US$5 per sq ft per week and that this is just 25% of what they ‘needed’, we would argue that while densities may be below where management had hoped they would to be, the gap is not quite so dramatic versus where they were expected to be at this stage. We need to remember that this is a radically new format that will take time to gain traction with consumers.

The good news is that Tesco is learning by its mistakes; for example, it has recently decided to start accepting American Express cards. And there will doubtless be plenty more changes going forwards, such as more store-specific ranging, a more flexible approach on self-scanning and more focus on the rather dull dry grocery and health & beauty sections within the stores.

We remain cautiously optimistic on the long-term future for Fresh & Easy, but it is a dramatically new format that may take time to build loyalty. Although we are disappointed by the likely lack of transparency on 15 April, at the end of the day this will not change the ultimate outcome one iota. However, management should be prepared for some criticism on this score.

We suppose the criticism might as well start here. To point out the obvious: The purpose for which public companies disclose financial information is to allow shareholders — the owners of the company — to evaluate how the company is doing and how effective the management team — paid for by the shareholders — actually is.

The decision to spend billions of dollars to open a division in the largest market in the world is precisely the type of decision that shareholders will want to use to evaluate both the prospects for the company and the wisdom and effectiveness of the management team.

Lumping together Fresh & Easy results with those of Tesco in the United Kingdom has the effect of both preventing shareholders from evaluating how wisely their money is being spent in the United States and of making less accurate any evaluation of how the core business they own in the UK is faring.

We hope that The City — London’s version of Wall Street — puts great pressure on Tesco to provide the kind of transparency shareholders have a right to expect and investment bankers in The City were promised.

Beyond future reports, though, the way Tesco has acted in the past — releasing Christmas numbers without telling anyone it had decided to include sales from America in a reporting segment clearly labeled UK and in a document in which discussion of USA operations was placed in the international section, not the UK section — was clearly misleading.

We don’t know British securities law well enough to say it is a violation, but it is not something we would want to have to defend before the SEC.

As far as Citi’s comments on current performance, our understanding is that Tesco expected sales of $200,000 per week, per store, although it had budget numbers that indicated it could eek out a living at $150,000 per week, per store. We also understood that to really perform well, Tesco needed each store to sell $250,000 per week, per store. Other analysts have said that Tesco budgeted for $200,000 per week per store but was prepared to operate profitably with a 10% shortfall.

Part of the problem is with the word “ultimately” in the Citi report. If, like Trader Joe’s, Tesco had opened one store and gradually built up a reputation and gradually built more stores over a period of decades, ultimately, the stores might do anything.

We are mindful, though, of the admonition expressed in the Willard Bishop report:

…(Tesco/Fresh & Easy) developed a very aggressive expansion plan and as a result must help shoppers appreciate their stores because they don’t have the time or flexibility to modify operations and retain efficiency.

In other words we are not certain Tesco has the operational flexibility in its Fresh & Easy division to make the kind of changes that are needed without suffering large losses. The current ‘pause’ may well be an attempt to evaluate if such a revamp is feasible. In other words we are not certain Tesco has the operational flexibility in its Fresh & Easy division to make the kind of changes that are needed without suffering large losses. The current ‘pause’ may well be an attempt to evaluate if such a revamp is feasible. It certainly is an attempt to show action on the Fresh & Easy front, before the April 15th reporting deadline and all the questions that will be asked.

James Anstead and Citi’s team of European food retail analysts certainly deserve a hat tip for pointing out this change of heart on Tesco’s part.

To us the whole issue — and particularly not telling anyone back when it released Christmas sales — speaks to an excessive desire to “manage” the release of the Fresh & Easy results. We hope Tesco’s investors will demand better treatment.

Of course, those investors may be less concerned with whether Fresh & Easy sales are classified in the UK or USA; they probably are hoping Fresh & Easy won’t have to be classified under the category reserved for “discontinued operations.”

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