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Tesco’s US Losses ‘Unnerving’

Our extensive analysis of Tesco’s journey to America continues as Tesco just announced its earnings, which included horrific results related to Fresh & Easy. J.P. Morgan in London summed the matter up this way:

The scale of the losses in the US is rather unnerving: $133m on sales of $212m in 2H08/9 after losing $118m on sales of $147m in the 1H. The company guides to a similar sized sterling loss in FY09/10 (implying an improvement in dollars from $250m to $200m), a year for which it originally envisaged themselves to breakeven.

Then elaborated on the point:

Tesco’s Fresh & Easy format in the US lost £82m on sales of £132m in 2H08/9 after losing £60m on sales of £76m in the 1H. The company guides to a similar sized loss in FY09/10, a year where they originally envisaged itself to breakeven (it now does not make any forecasts for when this point will be reached).

The scale of the losses in the US are … out of all proportion to what one would think reasonable. Working from the company’s guidance of c60 additional stores in FY09/10, we think $600m sales should be possible next year with sales densities perhaps advancing to over $9/sq ft per week by the end of the year.

The business was set up to operate with wage expenses equal to 4% of sales (based on perhaps $17/sq ft sales densities), so it is probably reasonable to assume double this in current conditions. Putting in these numbers would imply huge fixed costs, equivalent to c50% of sales next year on average: it is difficult for us to believe that Tesco would have devised such a cost structure when it knew that this was not going to be a $3-4bn sales business by 2010.

Table 3: Fresh & Easy, $ million

1H07/8 2H07/8 1H08/9 2H08/9 1H09/10e 2H09/10e
Stores 53 74 115 128 175
Average space 260,000 520,000 636,500 946,500 1,156,500 1,398,000
Sales 0 0 147 212 250 350
Sales/sq ft 8.88 8.61 8.31 9.63
Gross profit 29 42 50 70
Gross margin 20.0% 20.0% 20.0% 20.0%
Wages (12) (18) (22) (26)
% of sales 8.1% 8.4% 8.7% 7.5%
Fixed (136) (157) (143) (130)
% of sale 92.3% 74.2% 57.1% 37.0%
EBIT (30) (94) (118) (133) (114) (86)
% of sales 80.4% 62.6% 45.8% 24.5%

Source: Company data, J.P.Morgan estimates

Perhaps, alternatively and maybe more realistically, it is not the fixed costs that are high but rather the gross margins extraordinarily low. This would be consistent with the challenge of being a limited range discounter: the format has to offer prices far below those of regular supermarkets to get people in the store, but it lacks buying power to derive a decent margin on these sales. One response to such a situation is to increase the range, which Tesco is doing, but this will serve to undermine the discount business model trying to be achieved.

We have increased our estimated loss for 2009/10 from £100m to £140m, in line with company guidance.

In its report and associated briefings, Tesco tried to have it both ways. Sir Terry Leahy, Tesco’s CEO, pointed out that the recession was an opportunity for Tesco. Due to Tesco’s financial strength it could charge ahead when others, not as strong financially, had no choice but to pull back. In addition, the recession allowed Tesco to build new stores and distribution centers less expensively. Sir Terry Leahy specifically said that it was finding it could build things for 20% less than it was paying before the crash.

The logic of this, of course, is that if Tesco believes it has a winning format in the US, it should be pouring in the resources to ramp up its expansion. As Jack Welch said when asked how to approach competition during a recession, when it comes to competitors, now is the time to “Buy them or bury them.”

Yet, when it comes to America, somehow the same recession that is an “opportunity” for expansion elsewhere makes a rapid expansion along the lines Tesco had indicated it originally planned to be somehow “not yet prudent.”

Although Sir Terry Leahy points to the fact that former boomtowns such as Phoenix and Las Vegas are no longer booming, the scale back of Fresh & Easy has virtually nothing to do with those cities. The additional stores were heavily slated for northern California with a major new distribution center opening in Stockton. It is just smoke and mirrors to pretend that empty condos in Vegas are stopping construction of a DC in Stockton.

You have to really look to the numbers because so much of the verbiage Tesco officials spout is just spin. Sir Terry Leahy was explaining to analysts after the earnings release that when it comes to Fresh & Easy, “We built the business we wanted to create” — a bizarre thing to say unless the business Tesco wanted to create was one that loses a lot of money.

In truth, the problems of Fresh & Easy remain as they always have been:

  1. A uniform merchandising offer across a diverse group of consumers with different incomes, ethnicities and geographies is a loser.
  2. The failure to accept checks and manufacturers’ coupons puts them outside of consumer expectations.
  3. With the exception of specialized upscale retailers, such as Whole Foods, and the exception of certain categories, such as pizza and rotisserie chicken, the whole “ready-meal” offering is a bust. Americans eat take-out from restaurants instead.
  4. The concept comes across to Americans as commissary-produced food — not “fresh” — because items such as sandwiches and rotisserie chicken are not made fresh on premises but are made roughly the way they would be made to be put in a vending machine.
  5. Small store formats are inconvenient — “not easy” — for most shoppers because these formats don’t carry enough assortment to fully meet the shopper’s desires and so they become just another stop to make.
  6. Fresh & Easy has no identity. People walk in with some seeking an experience similar to Whole Foods, others Trader Joe’s, still others Aldi, and a hundred other things. Even after visiting the store, it is unclear if the priority is to be a bargain or to be green, for example.
  7. There is not enough parking in most stores to support the volumes they need to succeed.
  8. In the rush to sign leases, Fresh & Easy is stuck with a lot of bad locations.
  9. The concept is mostly an urban concept with the most successful stores in more urbanized areas. The concept has little place in Las Vegas.
  10. The stores are too expensive. Our Wal-Mart Pricing Report in Los Angeles, which you can see here, clearly showed that despite all Tesco’s talk of Whole Foods quality at Wal-Mart prices — they couldn’t beat a chain such as Stater Bros. and Safeway — forget about Wal-Mart.
  11. The marketing has attracted the wrong customer. Nothing wrong with giving the consumer good value… in fact low prices make perfect sense. The fixed costs are paid for so any gross margin generated may help. However, instead of offering consistently the best prices in town, the strategy is to overcharge and then give coupons. But the coupons $5 off $20 purchases, $6 off $30 purchases, etc., have attracted a clientele that loves coupons more than they love Fresh & Easy. Every time they try and turn off the couponing, sales collapse.

These problems might be solvable. After all both Aldi and Trader Joe’s run successful small store formats in America. But Tesco has put itself in a bind:

By electing to open up with an enormous distribution center and to transplant British vendors and British management, Tesco created a ‘brilliant or bankrupt’ situation for Fresh & Easy. It had to roll out fast because the overhead was so high. But that fast roll out, in addition to meaning Tesco had to accept sub-par sites, also meant that it had no opportunity to tweak its concept. It is like trying to fix a car while you are driving it — almost impossible.

The there is the arrogance of the approach to America that has made many who could help them elect not to. We’ve written before about small things, such as Tesco’s refusal to join the produce trade association, both local and national. That type of behavior is representative. A company looking to be part of the American industry would pay a few thousand dollars in dues because Safeway, Kroger, SuperValu and Wal-Mart do and because their vendors would appreciate it. Instead Tesco elects to thumb its nose at these associations and at the way things are done in America. It seems, though, that the executives at Tesco are oblivious to the price their shareholders pay for their arrogance.

Tesco has a lot of money, and with the son-in-law of the former Chairman of Tesco running the Fresh & Easy division and Sir Terry Leahy’s prestige tied up in the rollout, they may kick this can down the road a bit and avoid dealing with reality. The truth, though, is that whatever happens in the future, hundreds of millions of dollars have been unnecessarily wasted.

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