Tesco has announced its earnings — without breaking out separate numbers for its new U.S. concept, Fresh & Easy. This was a change from its original commitment to provide complete data from the start on Fresh & Easy. We discussed the switch here.
As we have mentioned many times, we would like nothing better than to see Tesco succeed in the U.S. In a consolidating market, a new retail concept rolling out nationally and inspiring others to launch small format chains will be a boon to the supply side. So if we were wrong in our assessment, we will joyfully eat crow. But we will hold on calling the baker to make the blackbird pie until we actually see full financials.
Overall, although profit growth was the slowest in eight years, the stock boomed in London with the biggest one day gain in almost six years. As much as anything, this gain may have been driven by Tesco’s announcement that its property portfolio had increased in value from 28 billion pounds to 31 billion pounds. Since at the opening bell, the whole company was trading for a valuation of around 31 billion pounds, investors were getting the whole Tesco operation for free.
This was a bit unexpected as many had expected the value of the real estate portfolio to shrink because of the troubles in real estate markets around the world. As we’ve written before, our assessment of the quality of Tesco management has often been less enthusiastic than those of other analysts precisely because the company’s earning depend heavily on a reservoir of real estate earning sub-par returns.
When it comes to Fresh & Easy, this is what Tesco had to say:
We are very encouraged by the start Fresh & Easy has made. The first stores opened only in November and we now have over 60 trading. Whilst it is still early days, the response of customers to our offer has surpassed our expectations — with our research regularly confirming that they like the quality and freshness of our ranges, as well as the prices and the convenient locations of the stores.
Sales are ahead of budget and sales densities are already higher than the U.S. supermarket industry average, with our best stores exceeding $20 per square foot per week. We are seeing strong growth in the early stores as we step up, as planned, our marketing programmes and as we build awareness of the brand. This is also reflected in the strong sales performance of recent openings in all of our markets in Southern California, Nevada and Arizona. Fresh foods and own brand products have sold particularly well, confirming that the core of our offer has already gained acceptance with customers.
Progress with real estate has been good and we have secured enough sites for our immediate needs — although the deteriorating property market, particularly in Arizona and Nevada, will mean that some of the third-party developments in which we had planned to open prototype stores later this year, will now be deferred. Nevertheless, we still expect to open around 150 new stores this year.
Our Riverside distribution centre (DC) and kitchen operation is gearing up well as volumes rise. As we announced last November, we have taken the necessary steps to secure the site and begin the process of obtaining the necessary permits to launch operations of our second DC in Northern California in due course. We expect a proportion of these costs will be incurred in the current year.
Last April, with our Preliminary Results, we said that costs of recruitment and training of staff for the stores, combined with the other pre-launch costs and initial trading losses, would involve estimated US start-up costs of around £65m in the financial year. We have delivered on this guidance — trading losses were £62m. We expect losses to rise this year to around £100m and then reduce thereafter as early stores begin to mature and we see increased overhead recovery from higher volumes.
US segmental reporting of sales and trading results within International will begin with our Interim Results in September.
Much of the commentary is not helpful — we are not able to know what it means about operations for Tesco’s management to be “encouraged” about the Fresh & Easy start. Same point with the notion that the response of consumers has surpassed the expectations of Tesco executives — we have no way of evaluating this statement.
That sales are ahead of “budget” tells us little since we don’t know which budget — the one made a year ago or the one made last week — nor do we know what dollar amounts these budgets represent.
The things that may be meaningful in the statement are these:
1) …sales densities are already higher than the U.S. supermarket industry average, with our best stores exceeding $20 per square foot per week.
2) Fresh foods and own brand products have sold particularly well, confirming that the core of our offer has already gained acceptance with customers.
3) …the deteriorating property market, particularly in Arizona and Nevada, will mean that some of the third-party developments in which we had planned to open prototype stores later this year, will now be deferred. Nevertheless, we still expect to open around 150 new stores this year.
4) …we have taken the necessary steps to secure the site and begin the process of obtaining the necessary permits to launch operations of our second DC in Northern California in due course.
5) We expect losses to rise this year to around £100m and then reduce thereafter as early stores begin to mature and we see increased overhead recovery from higher volumes.
Sir Terry Leahy, Tesco’s CEO, also gave a presentation mostly repeating the same points, but he added some graphics. His main comments are inserted below each slide:
167 days since first opening
Project lasting a generation
Customers love the stores
Some becoming completely dedicated
Sales ahead of budget
Growth in weekly turnover per store
Graphic covers 27 stores we open just before Christmas
Independent Data Commissioned by a shareholder
IPSOS market research interviewed 200 Fresh & Easy customers in Las Vegas could not find a single dissatisfied customer
Fresh foods, prepared foods and ready meals,
own brand sold well
People transfer out of fast food to Fresh & Easy
Move faster and move into northern California
So what do we make of all this?
We have studied Tesco/Fresh & Easy extensively and in dealing with this company we have learned that in many cases what they don’t say is more important than what they do.
Sir Terry Leahy is really admired in the UK, and it is clear why — a long record of performance and a smooth-as-glass manner that allows him to say, in a very believable tone, something like they are beginning to see “people transfer out of fast food” into the Fresh & Easy product. This kind of statement is certainly true — at least two separate people answered a survey saying today they decided to try a sandwich at Fresh & Easy instead of going to McDonald’s — but to what extent; whether that behavioral change was verified or simply self-reported is all left to the imagination. And it is this kind of communication effort that is leaving many industry members in America skeptical of whatever Tesco has to say.
The release of select sound bites pre-determined to make Tesco look favorable in lieu of full financials as was originally intended is likely explained because if the data was released in full, analysts would find things that Tesco prefers they not find.
We take away the following:
There are two big pieces of news in the release.
First, ‘sales densities are already higher than the U.S. supermarket industry average, with our best stores exceeding $20 per square foot per week.’
Second, ‘we expect losses to rise this year to around £100m and then reduce thereafter as early stores begin to mature and we see increased overhead recovery from higher volumes.’
We think these two points are related.
We can’t find a place in the documents where Tesco specifically states what it considers the U.S. supermarket industry average is, and it is unclear from the documents if Tesco is referring to the U.S. average for stores in their first year of operation or if it is referring to the U.S. average for all stores or for mature stores. These are three very different numbers. The investment bankers in London are all using the same $9 to $10 per square foot figure, so we’ll assume that Tesco gave them that guidance.
This would indicate sales of $90,000 to $100,000 per week, per store, which although still a big shortfall from the $200,000 a week per store Tesco expected, would be significantly higher than the $50,000 per week per store that Willard Bishop estimated, that a correspondent told us, a store manager confirmed and that we deduced from a statement by Safeway’s CEO.
It is also substantially more than Piper Jaffrey estimated, and it is also more than we were thinking when we pointed out that there were few customers in the stores.
Assuming the Tesco number is accurate, what would explain the discrepancy? Well it is possible we were just wrong, but we don’t think so. And when all the financials come out, we think a few other considerations have come to affect the numbers:
First, as we pointed out to investors in our conference call with Citi, we expected reported sales to be significantly higher than our baseline sales estimates. Baseline sales are the sales following the end of the grand opening period. Depending on the store and the chain, this can be a period of four to eight weeks. It is not uncommon for sales to drop by anywhere from 20% to a third after this period. Because all of these stores had their grand opening period included in the results, we would expect reported results to be higher than average results.
Second, the baseline results only represent a snapshot. They start increasing immediately. As we wrote here:
Stores go through a normal maturation period. We would expect to see sales increase 20% the first year and on a new concept that is gaining success, as much as 35%. This doesn’t happen in one day on the date a store turns a year old. It happens gradually during the course of the year.
So if we had a store that sold $90,000 a week during its grand opening, then it dropped by a third down to $60,000, if it was going to grow as a new concept can at 35% per year, we would expect sales to grow by an average of $403.85 a week.
Yet these adjustments would not be sufficient to bring sales to the Tesco number. There are two broader explanations that can be divined from the data Tesco released and they have opposite implications for the future of Fresh & Easy:
One possibility is in the claim that some stores are selling over $200,000 a week. Without quantification this means little. Two stores? Twenty stores? And how much over $200,000? $250,000? $300,000? This happens to be one number Tesco would legitimately like to keep quiet for competitive reasons.
All chains have a range of locations of varying success. Everyone knows that in retail, as in real estate, the adage is location, location, location. If a few high performing stores are boosting the numbers, this might have been missed. For example, the Willard Bishop report was done entirely in Phoenix, so if the high volume stores are in California and Nevada, they just wouldn’t have been on that radar screen.
If this is it… if location is the wild card and certain locations are wildly successful for Fresh & Easy and others a flop… then the path to success for Fresh & Easy becomes clearer. Its losses can be seen as a learning mechanism, and if it adjusts its real estate criteria it can start leasing more successful locations. If this is the scenario, we are likely to see not only the 150 new stores Tesco expects to open this year, but also some closures as it rationalizes its real estate portfolio to only include locations it can succeed at.
Of course, even this path is not without difficulties. For one thing, even knowing perfectly where stores may succeed doesn’t help if those locations are not available. Tesco still has a big warehouse and wants to defray its costs over a large store base. Closing a bunch of stores and waiting years to secure locations or paying big “key money” to get great locations may not be viable.
Also, the best selling stores are not always the most profitable. Sometimes those high volume stores are high volume precisely because they are in great locations that can demand high rents. So execution in this area can be difficult. Still, the idea is plain: if the problem is a real estate problem, the answer is a real estate answer.
Another possibility, and one we think more likely, is that all the studies of volume were on target when they were done and that the publicity given the low sales figures led Tesco to take immediate action to goose the numbers.
The two big changes since the assessments were done are A) That Tesco is offering a $5 coupon off a $20 purchase. It is difficult to determine policy but, in practice, these are given away freely at check-out and given in multiples. So if you have $20 basket, they charge you $15, and if you have a $40 basket, they charge you only $30.
B) The other big change is that Tesco began a practice of sharply discounting perishables to sell them before the “best if used by” date. We have seen discounts of 25% the day before expire and 50% on the day of expire and have reports of some stores doing 75% discounts.
We can’t really assess the value of the consumer study of 200 people done by a shareholder without being given the whole study. What we can say is that the consumers we hear from tell us over and over again about the discounts on perishables and the $5 off coupons. When asked, many tell us that the day they will stop shopping at Fresh & Easy is the day those discounts stop.
If this is true, if Tesco decided it needed to move quickly to boost sales and did it through deep discounting, it may be in serious trouble. Sales may have risen dramatically and fast but only because its customers are hooked on the “crack” of 25% off coupons. That is an addiction that will not be easy to shake and withdrawal can get really ugly.
The sparse information in the release contains a clue that this may be the situation. The guidance that Tesco expects Fresh & Easy to lose “around £100m” or around $200 million this year is shocking. This is around four times the consensus estimate.
Although verbally Tesco tells investment bankers about “start-up” costs, especially if it is going to proceed with a DC in northern California, in writing it says losses will go down “…as early stores begin to mature and we see increased overhead recovery from higher volumes.”
In other words, Tesco is counting on increased sales per store and more units to become profitable.
This makes sense as most of the major start-up costs, say building a new DC, are capitalized and Tesco has every incentive to distinguish between start-up losses in northern California and profits in the existing division.
Our bet is that the quadrupling of the operating loss over consensus estimates is due to the massive discounting Fresh & Easy has to do in order to maintain and build sales volume.
This assessment puts the report in a new light. It is very hard to sell food at a profit; it is easy to give it away. Perhaps for this year Tesco will average 100 stores open for the full year. If so, a loss of about $200 million translates into a loss of about $40,000 per week, per store. For a little 10,000 square foot store, that is an enormous loss.
The viability of the Fresh & Easy concept depends not solely on the dollar volume of sales but on the profitability of those sales. Nothing in these comments just released from Tesco provides any reassurance on this point.