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Tesco Continues To Be Challenged

Tesco stock did well after its announcement of the slowest same-store sales numbers in its core UK market in 16 years. Why? Investors feared it could be even worse.

Due to an acquisition in Korea, total sales grew 11.7% — that is the good news. The home market was, however, a challenge:

… in the UK, the picture is not so rosy. Total sales grew by 5.9 per cent over the quarter, but the sector focused on like-for-likes sales, excluding fuel, which at 2 per cent represented Tesco’s worst performance for 16 years.

The underlying sales figure of 2 per cent is way behind the most recent figures posted by Asda — 6.9 per cent in the third quarter — and Sainsbury’s — 3.9 per cent in the first half. Aldi, the discounter, has also hurt Tesco this year.

Jonathan Pritchard, an Oriel Securities analyst, said: “They are hemorrhaging customers to Aldi and Asda. This has become a more sustained trend and it appears that momentum is with others at the moment.”

According to TNS Worldpanel data, huge swathes of Tesco customers, based on the value of sales and not volumes, are switching to its rivals.

Many emphasized that the recession was not really a valid explanation as Tesco’s competitors seemed to be outperforming:

Yesterday, the UK’s biggest supermarket said that third-quarter like-for-like sales, excluding petrol, rose by just 2pc.

The figure lagged its main competitors’ recent sales growth by some margin. Wm Morrison’s most recent like-for-like sales rose by 7.6pc, excluding petrol, while Sainsbury saw sales rise by 4.3pc. Third-quarter sales at Wal-mart-owned Asda rose by 6.9pc, using the same metric.

All of which make Tesco’s figure look distinctly sluggish.

Now Tesco tried to make a very convoluted case that things were better than they appeared:

…the company argued that its figures tell a different story. Although UK like-for-like sales growth is at its lowest level since 1993, Tesco said that the volume of goods it is selling has increased. The reason the headline sales figure is so low, Tesco argued, is that it has taken advantage of falling raw material costs and cut its prices heavily in order to help cash-strapped customers. And lower prices mean less money in the till. If you were to count the number of goods customers buy, then sales are rising, Tesco said.

However, the City in London — the UK equivalent of Wall Street — seemed skeptical, as this quote from the J.P. Morgan Food Retail team indicates:

No inflation number provided: “volume” growth questionable. After providing inflation data for most of the last two years, we note that management chose not to reveal this on the conference call when asked. Despite not providing an inflation number, management say that their 2% LFL was almost entirely volume (in contrast to the 4% in 2Q that was mainly inflation). However, we would treat the encouraging noises being made about “volume” with caution. We normally think of LFL volume growth as LFL value growth less inflation (ie., the change in price of identical items). However, Tesco’s management are saying that due to price and mix changes customers effectively were paying the same prices on their basket as last year and hence most of the 2% was “volume”.

If we define inflation that way then the industry generally probably has physical “volume” growth (a point Justin King made at Sainsbury’s interims) and Tesco is by no means outperforming. By definition “downtrading” is the act of customers substituting cheaper products for more expensive ones. Tesco is in fact suggesting the idea that “downtrading” is “deflation”.

Fresh & Easy in the US didn’t get much attention in the report. Tesco pointed out that as the earliest opened stores are now starting to be over a year old, they are starting to be included in the Same-Store-Sales figures — or what the British call Like-for-Like. Typically stores see a big boost in sales as they mature. Tesco made no claim to be outperforming US supermarkets in this regard.

The announcement confirmed that Fresh & Easy won’t meet the 200-store level it had said it would meet in February 2009. Instead it looks like they will have about 124 stores open instead. Other than making claims that can’t be defined such as that the performance of Fresh & Easy is “pleasing,” the report said little and so left people to analyze Tesco’s decision to slow down the planned growth of Fresh & Easy that we looked at here and here.

It is, of course, difficult to know what effect this will all play in the continued development of Fresh & Easy. On the one hand, problems in its core market may call for a pullback to focus on turning things around. On the other hand, poor results in the UK indicate that diversification outside the UK can be valuable.

One thing is for sure: Nothing in the announcement gives any credence to the idea that a recession in America is causing a slowdown in expansion in the United States. Tesco is an immensely wealthy company, and it is expected to spend up to £4 billion on capital expenditures in its fiscal 2009/10. It just sold a £2.4 billion Eurobond issue and has additional banking facilities, which remain undrawn. Its problem is not the ability to spend money; it is the ability to find ways to spend it that will produce adequate returns.

There is every indication that if Fresh & Easy were a winner, Tesco would use this time when other, weaker companies would be hesitant to invest to gain market share and drive out of business those financially weak players.

How bad are things at Fresh & Easy? Well, we have written before about Wild Rocket Foods, the British transplant that is the produce supplier for Fresh & Easy. We mentioned in Will Tesco Pay Wild Rocket’s Bills? that the company did not have a reasonable credit rating.

Now we are getting calls from people saying they were laid off at Wild Rocket. Now this may just be a function of low sales at Fresh & Easy, combined with the decision to slow down store openings. Quite probably Wild Rocket was staffed up for the volume Tesco had told it to expect; now that this clearly won’t happen for a long time, Wild Rocket executives may have decided to “right size” the organization.

However, there is some question as to whether Wild Rocket can properly operate on a “right-sized” basis. If by the end of February, Fresh & Easy will have 124 stores, that is roughly only the size of seven Wal-Mart Supercenters. It seems hard to imagine that it could produce efficiently a full range of fresh-cut produce to serve such a small store base — especially when issues of food safety and regulatory compliance are considered.

Which leads us to this possibility: There is a law called the Worker Adjustment and Retraining Notification Act (WARN). The rules are complex, but they basically require that an employer with 100 or more employees must provide 60-days’ advance notice to employees who will be laid off due to a plant closing or other mass layoff.

Many executives would consider this notice requirement is onerous — not only do the employees have to be paid and get benefits during this period but, because they are working, there is always the possibility of theft or sabotage.

What if the decision has been made to close down this fresh-cut operation and buy from outside vendors as long as volume doesn’t justify a separate production facility? In fact, now that Fresh & Easy is, as we discussed here, starting to buy in producers own packaging, what if it doesn’t need the Wild Rocket facility at all and wants to consolidate in its own distribution center?

Layoffs now could be part of a strategy to bring Wild Rocket to under 100 employees — not that hard to do as those who work less than 20 hours a week don’t count toward the limit. Then, after waiting a bit, if they close the whole facility, they would be exempt from WARN and would not have to provide the 60-day notice.

Do we see in activities at Wild Rocket an indication of what the future holds for Fresh & Easy and, thus, Tesco in America?

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