Strategy

U.S. Open

European food retailers have tried and failed to crack the United States. But after ten years of global growth at Tesco, the UK firm's finance and ...
Tim BurkeMarch 3, 2008

South-east of Los Angeles and known as one of America’s most dangerous cities, Compton is not the first place you would expect to see British royalty. But last month Prince Andrew — the Duke of York and the UK’s “special representative” for trade and industry — made the visit. The reason was to attend the opening of Fresh & Easy Neighborhood Market, a new US chain of grocery stores launched by UK retailer Tesco.

In November 2007, after covert preparation that included building a mock supermarket in a local warehouse, Tesco cut the ribbon on six such stores in southern California. The company has since continued a rapid roll-out in the west with stores in neighbouring Nevada and Arizona as well as northern California’s Bay Area. A new brand for 79-year-old Tesco, Fresh & Easy will initially receive £250m (€336m) a year of investment from its parent and expects to break even sometime after 2009.

For a company focused on growth, the US is an attractive but daunting market. When Tesco announced plans to enter the US grocery sector in 2006, it estimated its worth at about $600 billion (€410 billion) and said it was forecast to grow by some 40% over the following five years. But Tesco will face plenty of challenges in a market dominated by domestic supermarket companies such as Kroger and Safeway as well as the “supercentre” hypermarkets of $345 billion Wal-Mart, the world’s biggest retailer.

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To add to the challenge, it is entering with its own brand, unknown to American consumers. Being the underdog is not something that Tesco is used to — in the UK it’s a household name with a market share of more than 30% and stores of all sizes selling not just food but anything from clothes to car insurance. It thinks it can carve a niche for itself in the US, however, selling own-label chilled and fresh food in small shops of about 10,000 square feet (900 square metres). Furthermore, some of the outlets will be in low-income neighbourhoods where customers have little access to other grocery stores.

It’s a big test for Tesco — and for Andy Higginson, who had been the company’s finance director for six years when the role of strategy director was added to his remit in 2003. The dual roles give Higginson, 50, a double interest in seeing Fresh & Easy succeed — first to prove that the numbers add up, second to show that entering the world’s largest, richest and most competitive food-retail market was the right decision. For companies wondering whether the finance and strategy directorships should be held by the same person, Higginson could be a high-profile test case — cracking the US will be the £47 billion group’s biggest international challenge yet. But after ten years of successes — and a few failures — in other countries, Higginson thinks Tesco understands the economies of launching overseas well enough to make its Stateside venture worth a shot.

The Hard Way

Tesco isn’t the first foreign food retailer to want a piece of the US market. As consolidation among domestic companies created national supermarket chains during the 1980s and 1990s, myriad European retailers entered America only to leave again. Those retailers included some of Tesco’s rivals from the UK. J. Sainsbury, for example, bought into supermarket chain Shaw’s in 1983 and took a controlling stake four years later. In 2004 it sold the company to US group Albertsons, citing increased competition in the market. Meanwhile, food and fashion group Marks & Spencer acquired Kings Super Markets in 1988 but offloaded it to an investment consortium after eight years, claiming it didn’t fit its core business.

Other European companies have fared better. Germany’s Aldi owns 850 stores in 27 states and has ties to the Trader Joe’s grocery store chain. This leads Jim Prevor, founder and editor of two American magazines for the food retail industry — Produce Business and Deli Business — to wonder whether failure to tackle the US is a particularly British problem. “A common language makes it easy to assume that you understand the consumer and the business environment. But that understanding is probably deceptive,” he says.

Tesco’s directors don’t need to be reminded of the potential downside to the Fresh & Easy venture. Sitting in his office at Tesco’s headquarters outside London, Higginson says with a laugh, “We’ve made it as hard as we can.” The company is starting a new business from scratch and will need “an awful lot” of its small convenience stores to get up to scale quickly, he explains. It would have been a “very bold step” to target the US before proving itself in other international markets.

This is familiar territory for Higginson. Apart from three years as finance director of UK retailer Burtons from 1994, all of his previous roles were in international businesses, including working as finance director of Laura Ashley and Guinness Brewing International as well as a stint with Unilever in Hong Kong. He joined Tesco’s board in 1997, replacing former finance director David Reid, who had been appointed deputy chairman to oversee the company’s embryonic international business.

Tesco’s international expansion had already begun before Higginson’s arrival. That included stakes in Polish and Hungarian supermarket chains, and acquisitions of department stores from America’s Kmart in Slovakia and the Czech Republic. It had also entered France following a £175.6m deal to buy Etablissements Catteau and, a few months before Higginson joined, agreed to pay £630m for 109 of Associated British Foods’ retail stores across Ireland.

But cracks in the strategy were beginning to appear. Higginson recalls that it was at his first board meeting that the company decided to sell Catteau. The difficulty of obtaining planning permission for new hypermarkets in France pushed up the price of acquisitions and meant that Tesco struggled to grow the business organically. It bailed out with a £250m sale to French group Promodes in 1997, and thanks to rising asset prices, it was able to recover its full investment.

Globe Trotting

The team did not allow disappointments such as the French failure to dampen its enthusiasm for growing overseas. The board knew that it had to sell goods other than food in markets other than Britain to continue growing. As the finance chief puts it, “selling food to 60m people on a small island in the North Atlantic was going to be limiting.”

In the late 1990s, the group’s hypermarkets across Europe helped to boost sales from the region by almost 25% to £1.3 billion, and increase operating profits by 26% to £48m in fiscal 1999. Furthermore, starting in 1998, Tesco opened stores across Asia. Over a six-year period, the group entered Thailand, Taiwan, South Korea, Malaysia, Japan and China.

In 1999, the company told analysts that its small international business would make a £160m profit within three years. At the time, Tesco’s supermarkets in central Europe were in the black while its fledgling Asian stores were losing money. For Higginson, making promises about their future performance broke the rules. “I always had that mantra that if you give them a date, don’t give them a number; if you give them a number, don’t give them a date,” he cautions today.

Tesco gave them both — and delivered. In fiscal 2003, its European and Asian businesses made a £212m operating profit. By 2007, that more than doubled, to £565m, while the company’s dominance in its domestic market continued. Not that it was always plain sailing. In 2005, the company offloaded Taiwanese stores and sites worth €132m in an asset swap with rival Carrefour, taking on the French firm’s stores in the Czech Republic and Slovakia, a deal that fuelled speculation in the press that Tesco found it couldn’t compete against the incumbent French group in Taiwan.

But for the most part, its strategy has been a success. Today Tesco has shops in 12 countries outside the UK. The international business is larger than the UK business in terms of selling space and generates turnover of more than £11 billion, helping the group to become the third-largest food retailer in the world behind Wal-Mart and Carrefour. And while the European and Asian businesses account for just 25% or so of the company’s sales, Higginson adds that they make up about 40% of its growth.

That could be important. Concerns about consumer confidence in Britain and the impact of any downturn or even recession on Tesco’s UK business might mean that the international division is called on to support the domestic operation. “The strategy, in a sense, has spent ten years waiting for this moment,” Higginson says.

Tesco Organic

Higginson and colleagues have learned several lessons about international openings that they can bring to bear on the US launch. The first is that size matters. Tesco built its UK business on supermarkets, but needed to turn to larger hypermarkets to compete on the Continent and to give it the physical shop-floor space to branch away from selling only food. Tesco’s strategy for the US is a variation on that theme — the stores themselves may be smaller than national giants, but what they lack in size, they will make up in sheer numbers, hence the rapid consecutive launches in the autumn.

Another lesson concerns how the company enters a new market. Tesco — like many companies — has used three routes into new markets. It buys a business, as it did in Ireland; it sets up a partnership with a local company, such as the hypermarket-development business it formed in South Korea with conglomerate Samsung; or it starts from scratch, as it did in Taiwan and is doing in the US.

The third route isn’t always easy, concedes Higginson. It takes a long time to achieve scale, and early supply chains are “relatively inefficient,” he says. But he adds that there are often good reasons for going it alone — “although it takes you a while to get up to profitability, the sums involved are not huge by comparison to an acquisition.”

American Dream

Whichever the route, the ultimate focus is on organic growth. In a low-margin, capital-intensive business such as Tesco’s, that’s crucial. “We have a lot of capital invested in each store and margins are 5p to 6p for every pound, which are not high by any industry standards,” Higginson says. “So making a return is a fine line, and the difference between building your own store — which might cost you 30% to 40% of the sales — compared to acquiring a store — which might cost you 70% or 80% of the sales — is often the difference between whether you make a good return or you don’t.”

It’s too early to say whether Tesco’s other international experiences will help Fresh & Easy succeed. There’s certainly no shortage of pressure. In Shopping for a Market: Evaluating Tesco’s Entry into Los Angeles and the United States, staff from the Centre for Food and Justice (CFJ) in Los Angeles suggest that the launch comes at an important moment in the development of food stores in America. “Tesco’s entry into the United States is the latest and perhaps most vivid example of the globalisation of the food system,” says the CFJ’s report. “For the first time, a global company is taking on what had once been a pre-eminently local segment of the American food system: the neighbourhood market.”

Higginson insists there’s “plenty of room for everybody” in the US food-retail market. And in 2007, Citigroup noted that in focusing on small stores for local neighbourhoods, Tesco is “not setting out to compete formally with hypermarkets or supercentres, but is looking to meet a demand that is currently not filled. It is looking to seize on an opportunity that US retailers have chosen to pass over.” Some, such as Jim Prevor, suggest it’s been passed over only because other retailers don’t believe there is a “lucrative opportunity” there.

Entering with an entirely new brand is a daring move, although it’s possible that Tesco did not want customers to associate its US stores with the Tesco name, viewed by some in other countries as a behemoth capable of crushing local competition. The group must hope to make Fresh & Easy as recognisable a brand in the US as Tesco is in the UK, where it uses its name across different product ranges and store formats to create a sense of continuity.

Time Will Tell

Some analysts give Fresh & Easy a nod of approval. London-based Blue Oar Securities was one of several firms invited to visit the first West Coast stores a few weeks after they opened. In a December research note published after the trip, it said the concept was well thought out and could be “hugely scalable.”

Tesco will invest up to £1.5 billion in Fresh & Easy and considering the company’s size, that’s not a bank-breaking sum. “If it all goes horribly wrong, even if you assume there’s no residual value — and of course with shops there’s always residual value — a billion-and-a-half is something the company could afford,” Higginson says. “I’m not sure our careers could, but the business could certainly afford it.”

Higginson goes so far as to muse that if the strategy works, Tesco will have “a business that could go national in the United States, [generating] billions and billions of shareholder value.” That’s a tall order, but as Citigroup noted in a September report, “few observers would have imagined that, within a decade, Wal-Mart would have gone from selling almost no food to become the biggest food retailer in the US. The opportunity is huge.”

Domestic food retailers certainly have good reason to look over their shoulders. “While the US supermarkets could copy the format, they will not have the infrastructure — systems, depots or fresh-food supply chain — to be able to compete in this segment of the market in the short term,” reckon Blue Oar Securities. “The traditional supermarkets (Kroger, Safeway and Albertsons) should be very worried if the format takes off.”

Indeed, other analysis suggests that some of Tesco’s competitors should already be concerned. Nielsen, a consultancy, has studied the California, Arizona and Nevada markets and analysed the areas where Fresh & Easy stores will compete with incumbents for the same customers. It says that Kroger stands to lose up to $6.7m a week to Fresh & Easy, while SuperValu, Safeway, Bashas and Wal-Mart could lose $4.3m, $4m, $2.4m and $1.5m respectively.

The group won’t report sales figures for Fresh & Easy until 2009. That could be a controversial decision, although Higginson says there would be nothing to compare the early figures to, regardless of whether they appear good or bad. At the company’s trading statement in January, there was little mention of the US, only a claim that customers’ reaction to Fresh & Easy has been “very encouraging.”

The finance chief estimates that Tesco will need at least 18 months before it can say with any certainty whether Fresh & Easy is a hit. It took nearly 80 years to build the UK business, he quips, so it will take a little time to get off the ground in America. But he’s confident that the past ten years of growing Tesco around the world will stand the group in good stead for the challenges ahead. “We’re bringing a lot of learning, a lot of cuts and bruises from the mistakes we’ve made,” he says. “And hopefully we’ll avoid making some of them twice.”

Tim Burke is senior staff writer at CFO Europe.