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May 13, 2011

Talking shop: Has Tesco been “foolhardy” in the US?

Speculation is mounting over the future of Tesco's operations in the US. Investor Warren Buffett has described the venture as "foolhardy", while some industry watchers believe potential Californian restrictions on the sale of alcohol could be a hammer blow for business. Why has Fresh & Easy struggled so much in the US, and how likely is it that the loss-making venture will turn a profit? Petah Marian investigates.

Speculation is mounting over the future of Tesco’s operations in the US. Investor Warren Buffett has described the venture as “foolhardy”, while some industry watchers believe potential Californian restrictions on the sale of alcohol could be a hammer blow for business. Why has Fresh & Easy struggled so much in the US, and how likely is it that the loss-making venture will turn a profit? Petah Marian investigates.

Tesco has been beset by problems in the US almost since day one. The UK retailer opened its first Fresh & Easy store in 2007 just before the recession hit and, according to some, has made a number of missteps in the market. It initially planned to open some 200 Fresh & Easy stores by the end of 2008; two and a half years later, it only operates 145 outlets in the country.

The operations continue to haemorrage money, with losses widening in the most recent financial year by 9.7% to GBP186m (US$303.5m). However, Tesco chief executive Philip Clarke believes Fresh & Easy will break even by the end of 2013.

Analysts have speculated that culmative spending on Fresh & Easy will reach the better part of $2bn before it reaches break-even. The more sceptical analysts wonder if, even if Fresh & Easy does become profitable, it will all be worthwhile.

“What sort of profit?” questions MF Global analyst Mike Dennis. “You’re going to get $10m in 2015, or $20m in 2017, do you really think that 10 years on, cumulatively after the best part of $2bn spent you’re going to be happy with $10-20m operating profit?”

The retailer has reduced the number of stores it believes Fresh & Easy would need to break even from 400 to 300, citing the benefit of synergies generated through the acquisition of its fresh food suppliers 2 Sisters and Wild Rocket Foods. Another growth driver, Tesco says, is Fresh & Easy’s expansion into northern California and San Francisco.

Dennis remains unconvinced by the wisdom of the move suggesting that “building sales in another sub-scale market” is “virtually impossible” as Fresh & Easy “won’t be able to get enough critical mass to justify the overheads they’re still carrying”.

“Opening up in northern California is like opening up a store in Scotland, when you’ve got a store in Havant in the south of England,” he says.

According the the MF Global analyst, Fresh & Easy is “substantially sub-scale” in all of the markets that it operates in, with barely 1.5% market share in southern California, and 0.5% share of the Nevada and Arizona markets.

The retailer has struggled with its brand proposition in the US, with its smaller-sized stores catering for a demand that, some retail watchers argue, simply may have not been there.

McMillan Doolittle retail consultant Neil Stern says that Tesco entered the market originally insisting it was not going to compete in the same way it does in other international markets. Tesco, Stern says, wanted to “pioneer a new model”.

Stern says the way that Tesco approached the market “made you scratch your head a little,” with its decision to launch a single format that was not only “new to the US market, but also new to Tesco”.

Some of the “obvious things” that Tesco missed also caused Dennis to scratch his head. “They underestimated the size of the market for small stores and the reaction from the competition. They overestimated the US consumers’ willingess to trade in own-brand products. In an economic downturn, people tend to go with what they trust in branded promoted products,” he says.

Dennis finds it “amazing” that Tesco did not pick up on the fact that there was not wide appeal for “drive up top-up shopping”, or that consumers were not ready to accept a store range where 60% of products are own label. “It’s amazing that Tesco didn’t pick up on this, but since then, they have muddled along,” he says.

Even Clarke, who formally became Tesco’s chief executive in March, has, in his first days in the job, admitted that the Fresh & Easy concept “pulled away a little bit too much from the mainstream”. Clarke maintains, however, that Tesco is “putting things right”.

The move into northern California, with revamped stores, could provide the venture with more time to become viable. “Let’s call it Fresh & Easy 2.0,” says Stern. “With all of the improvements they’ve made to the operations, they can say to customers ‘here is Fresh & Easy’ and if that’s successful they have a better case to make to management to keep it going.” A success of the new stores, Stern adds, could make it easier for Tesco to say that, after taking on board the learnings from the first 100 outlets, it has got the model right and could push on with further expansion.

However, even if the retailer does get the model right in northern California, there are still potential dark clouds on the horizon. A bill has been proposed in California that will ban the sale of alcoholic beverages at self-service checkouts, which is the only way that Fresh & Easy allows its customers to pay for goods. The retailer, which sells beer, wine and spirits in nearly all its California stores, will need to implement manned checkouts in order to sell alcohol.

If the bill goes ahead, Dennis believes the move will mean the “beginning of the end for Fresh & Easy”. Dennis says the move would increase the retailer’s “already high cost issue” and very weak sales densities.

If the bill becomes a law, the retailer’s low operating margins will become even more stretched with the addition of manned checkouts.

“The sales growth they have been reporting in the last year and a half has largely come about through two mechanics, – a 30% increase in product units [SKUs] and that’s driven the sell rate up to a degree” as well as 30-40% discounts in store, which has “totally eroded” its gross margin. Tesco had a -38% operating margin, emphasises Dennis.

While some may see exiting the market as the best move for the retailer, concerns remain around the talent drain Tesco might face were it to withdraw from the US.

Dennis questions what the consequence will be for Tesco if it pulls out of the US, where its operations are headed by its deputy CEO, Tim Mason. “I think there is an extra layer of difficulty in extracting themselves from the US because they have a lot of their talent sitting in the US enjoying that West Coast weather… I think there’s a real issue between Tesco being honest to itself and trying to reconcile whether Tim Mason and his team will come back to the UK.”

Tesco will continue to face criticism over the venture until it either becomes profitable, or gives up. However the question remains, will the profit it generates have made its US foray worthwhile?

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