Tesco's Tune-Up

ELLIOT ZWIEBACH

After what many observers described as a very slow start in terms of sales volume, Tesco is beginning to make changes in its Fresh & Easy Neighborhood Market operation.

Just this month, the Cheshunt, England-based company added Jeff Adams, one of Tesco's top executives, to the Fresh & Easy management team — a move some see as a signal that the U.S. banner needs tweaking.

Adams, an American, has spent the last 15 years working for Wal-Mart in Mexico; for Lotus in Thailand before and after it was acquired by Tesco; and for Tesco Express, its convenience-store chain, in the United Kingdom.

Fresh & Easy also broke with previous policy two weeks ago and began accepting credit cards — specifically, American Express — at its checkstands.

Observers contacted by SN said they believe other changes may be brewing, including more tailoring of stores to meet the needs of individual neighborhoods; the introduction of a loyalty card; and the addition of more national brands to the heavily private-label product mix.

Fresh & Easy, based in El Segundo, Calif., is a chain of 10,000-square-foot stores that feature a variety of chilled prepared foods, pre-wrapped produce and a limited assortment of dry grocery items, all priced at everyday low levels. Of 3,500 stockkeeping units, half are private label, which executives said accounts for 75% of revenues.

Since launching the concept in early November, Fresh & Easy has opened 59 locations in California, Arizona and Nevada, with 150 more scheduled to open through the balance of 2008.

The company has also announced plans for at least 37 stores in Northern California in 2009, including 18 in the San Francisco Bay Area and 19 in Sacramento, along with a distribution center in Stockton, Calif., to supply those stores and others it might open along the West Coast. There are also reports Tesco may be scouting store sites in Denver and Chicago.

According to several industry observers, weekly sales are running at $50,000 to $60,000 per store, for an average of $5 per square foot — well below the $200,000 a week and $14 to $22 per square foot the chain said last November it was anticipating.

Mike Dennis, a London-based analyst with Piper Jaffray, Minneapolis, said Fresh & Easy's sales at the 59 stores could be as low as $30 million, compared with the $100 million-plus he had originally projected.

Tesco is expected to disclose sales data for the U.S. operations on April 15, when it releases year-end financial results.

According to Dennis, Adams' task will be “understanding what's gone wrong with the [Fresh & Easy] concept and how they are to recover, if at all, their $700 million-plus investment so far.”

Another British observer told SN that “Adams is being brought in either to strengthen the U.S. management team, which would be a normal staffing move, or he's a guy with a lot of experience at Tesco Express whose track record suggests he has something new up his sleeve.

“As an American who's worked for Tesco, Adams certainly understands what Tesco wants to do and probably has a more intuitive feel for what the U.S. consumer wants, and that's a good combination. And even though he hasn't spent much time in the states over the last 15 years, the U.S. operation seems like a sensible place to put someone like him.”

Period of Adjustment

Fans and critics alike believe Fresh & Easy is going through a period of adjustment.

Tesco is likely to refine the stores as it gains more data, Mike Griswold, a former retailer who's now a Boise, Idaho-based consultant with AMR Research, Boston, told SN.

“If you think of the existing stores as Fresh & Easy 1.0, then we're likely to see 2.0 in the next several months and 3.0 a year from now, and those stores will be different,” he said.

“In 2.0, the company will focus more on operations and the supply side of things, and we might see changes in the product mix, including perhaps more national brands if private-label sales are out of line with expectations. And 2.0 might also include more tailored offerings in terms of product mix, and there may be changes in the promotional circulars the company puts out.

“By the time Tesco gets to 3.0, the focus should shift more to the marketing side, and we'll probably see a club card, which will drive all sorts of targeted programs.”

According to Griswold, the addition of more concrete sales data — with a loyalty card or without — should improve the stores' in-stock condition. “Right now there's no history to draw on to make sales forecasts,” he noted, which has created some out-of-stock problems, primarily in prepared foods.

Jim Prevor, a consultant based in Boca Raton, Fla., said Fresh & Easy can start making changes by accepting manufacturer coupons “and perhaps checks. And it needs to shift the focus and use more borrowed equity by handling more national brands while it builds up its own brands.”

He said he was also surprised that the stores opened without a frequent-shopper program, “which, although it adds complexity, also adds intelligence that would be helpful.”

“But simple fixes may not be enough,” Prevor said. “Given its size and format, Fresh & Easy may have to consider becoming two companies: one that's more of an Aldi clone [for downscale areas], and another that's more of a Trader Joe's clone for affluent areas.

“And maybe it needs to explore less expensive distribution options, [because] building separate distribution centers for each geographic area could take years.”

The company's first distribution center, in Riverside, Calif., has the capacity to service about 220 stores, Prevor said, “and it can be expanded to handle another 400 or 500.”

Jonathan Ziegler, a Santa Barbara, Calif.-based analyst with Dutton Associates, El Dorado Hills, Calif., said he regards the current Fresh & Easy format as a test. “Tesco must make changes,” he said.

“For example, since it can't design stores to be all things to all people, why not put more square footage into fresh, and make staples more of an in-and-out treasure hunt?”

He also expressed concerns with the 84-inch-deep dry grocery shelving, which holds a lot of inventory. “I agree with the concept that those fixtures enable you to cut labor hours on shelf stocking, but the adjacencies run down at different rates, so you end up with a lot of empty real estate next to full shelves, which is an inefficient use of square footage,” Ziegler said.

“Self-checkouts are also a productive way to use labor, but is that what every customer wants? Are customers intimidated?”

Limiting the SKU count to 3,500 to keep costs down makes sense, Ziegler added, “but unlike Costco, which also limits selection, Fresh & Easy only has customers buying for personal use, not for resale, and those people have other attractive supermarket options where they can shop if they can't find everything they want.”

More Advertising

According to James Anstead, a London-based analyst with Citigroup, New York, there are a lot of things Tesco can do over the next two to three years to boost sales. “For example, once the company achieves critical mass, it may decide to get its brand better known through wider advertising,” he said.

“Tesco has achieved a lot in a short time, and it will make things better, particularly in the areas of inventory management and supply chain management, once it gets more of a track record on sales history.

“One major area it will improve in is tailoring stores to each area. Tesco is capable of doing that, but instead chose to roll the stores out more quickly.”

Anstead said he has no clue when Tesco will begin tailoring its stores, “though I would have thought it would do it sooner rather than later. But it's a delicate balance, and by rolling out quickly with a more standardized model, it may be building critical mass, but it may also be antagonizing some potential customers along the way.”

Jim Hertel, managing partner with Willard Bishop Consulting, Barrington, Ill., told SN he agrees that Tesco will eventually need to tailor the stores to the needs of each neighborhood. “It's probably the plan to open all the stores the same, then go back and tailor them, because as neighborhood markets you can infer the assets would be different and designed to cater to very specific local needs,” he explained.

According to Dennis of Piper Jaffray, “Tesco might need to spend a lot more on advertising and work harder to understand why its EDLP packaged-goods offer is not gaining customer attention in a weak consumer environment.”

While fresh produce is performing relatively well, Dennis said, the stores lack penetration in other categories. “The fresh offer has only marginally underperformed plan,” he said, “while dry grocery, frozen, and beer, wine and spirits have all fallen 15% to 20% below budget — indicating that the range, concept or marketing are not attracting customers or inducing the right shopping behavior, [and] maybe the offer, the format or the store environment is wrong and might need modifying before the next 150 stores are built.”

Dennis also expressed concerns about distribution costs. “The idle distribution capacity [in Southern California] and rising distribution costs from a second planned distribution center in Northern California would impact the group's profits to a far greater extent if the store concept is not working to plan,” he said.

According to Prevor, the stores were designed with high volumes in mind, “but Tesco won't get to those [$200,000-per-week] volume levels, except possibly in downtown urban areas with high-density populations,” he said.

While Tesco expects the stores to be profitable at sales levels of $14 to $22 per square foot, “the break-even point may be as low as $10 to $12,” he added.

Griswold said he believes Tesco has an exit strategy, though he doesn't see Tesco giving up on the U.S. in the foreseeable future. “Tesco is an extraordinarily determined group that has developed a set of metrics to measure success or failure, and only when it achieves — or doesn't achieve — those metrics will it decide whether to get out,” he said.

According to Dennis, any exit by Tesco from the U.S. would damage the company's credibility among its global competitors and severely limit its long-term growth options outside the U.K.

He suggested Tesco might improve its financial position and possibly book a profit by doing a sale-leaseback of its existing distribution facility, “and so provide the U.S. operations with more time to fix the concept.”

The Fresh & Easy strategy was always going to be relatively high-risk, he added, “since Tesco chose not to go with a joint-venture partner, [which] would have allowed it to benefit from another retailer's infrastructure.”

One potential partner was Safeway, with whom Tesco once operated GroceryWorks.com in a joint venture, he pointed out. “But Safeway bought out Tesco's stake in GroceryWorks in October 2006, after Tesco had announced its U.S. plans,” Dennis said.

As a joint venture, the Fresh & Easy stores could have served as a test, without the investment of $250 million or more in distribution and office facilities, “which in a joint venture might not have become such a huge liability,” Dennis noted.

Little Impact So Far

So far, Fresh & Easy has had little impact on established supermarket operators, though that could change over time, said Hertel of Willard Bishop.

While smaller-format stores like Fresh & Easy are likely to carve out a niche for themselves, he explained, “they won't revolutionize food retailing as we know it, though they will take trips, sales and share from established players.”

Steve Burd, chairman, president and chief executive officer of Pleasanton, Calif.-based Safeway, said the sales impact of one small-format store within 1.5 miles of a Safeway location is equivalent to one-tenth the impact of a conventional store opening. Jack Brown, chairman and CEO of Stater Bros. Markets, San Bernardino, Calif., said his stores have felt minimal impact from the 20 Fresh & Easy stores they compete with — “maybe $1,000 a week, and that's giving them the benefit of the doubt,” he said.

Anstead of Citigroup warned U.S. competitors not to be overconfident.

“People have underestimated Tesco in the past, but that's rarely been a profitable move, and U.S. supermarket operators would be naive to be anything other than paranoid about what Tesco may do,” he said.

Though current sales levels may be lower than Tesco had hoped, “to start writing them off — as successful as Tesco has historically been — would be a dangerous thing to do. In fact, the smaller formats being opened by Safeway and Wal-Mart are strong endorsements that Tesco has spotted a gap in the market,” Anstead said.

Safeway has announced plans to open the first of several small-format stores — with a perishables focus — in May in Northern California; and Wal-Mart Stores, Bentonville, Ark., plans to open four smaller-format stores, under the Marketplace banner, in Phoenix later this year.

In both cases, the stores will reportedly be 20,000 square feet — twice the size of Fresh & Easy units.

While some observers believe Fresh & Easy will be a long-term winner, its sluggish sales have raised doubts among others.

“It's still too early to make any long-term predictions about the viability of Fresh & Easy,” said Griswold of AMR Research. “While the financial community seems convinced the stores aren't doing the kind of sales Tesco originally projected, the stores I've been in were all quite busy.”

Philip Dorgan, head of research for Panmure Gordon Ltd., a London-based investment banking firm, said he believes Tesco is entitled to more time to work the kinks out of its operation. “It was very brave of Tesco to show us all around [last November], so soon after it opened. But now it deserves a period of privacy while it beds down, makes mistakes, learns from them and moves on,” he told SN.

“To be fair, most of its new ventures in Europe, including Tesco Express, Tesco Direct [an online shopping business], Tesco Financial and Insurance and Tesco Mobile Network, have been characterized by a slow buildup before an eventual move into profits,” Dorgan pointed out.

Tesco has already said it expects Fresh & Easy to account for losses of approximately $130 million (65 million pounds) for the fiscal year that ended in February.

Losses are unlikely to be a problem for Tesco, Griswold said. “Losses probably won't have a material impact one way or the other this year,” he told SN. “With just under 60 U.S. stores in a company of $80 billion, Fresh & Easy won't be more than a rounding error for Tesco. Besides, the company said it plans to spend $2 billion over the next five years in the U.S., and I have no reason to doubt it won't carry out that plan.”

Based on current projections, Dennis said he expects Fresh & Easy will be dilutive to the company's overall international cash return-on-investment “and potentially cost a lot more to operate than first planned, with potentially larger operating losses [through 2008 and 2009].

“And if the concept is wrong, then it could get worse if the U.S. moves into a full recession,” he added.

Hertel said he doubts Tesco is discouraged about the U.S. results.

“I assume it hasn't been spooked by what's happened so far,” he told SN, “and apparently it has a large appetite for major financial risk.

“It takes confidence and discipline for an operator to act as Tesco has. Most people trying to build a company would probably open one store and make sure they understood how revenue growth was coming, and that everything was on track, before building a second one. But Tesco must have anticipated it would start off slow and build.

“On the other hand, while most of what it's doing is fairly different, it's not patented, so it may have felt that if it didn't roll stores out quickly, it might be pre-empted, and that's what's keeping the company on a fast-growth track, with a willingness to fix things and grow along the way.”

Patti Edwards, a Seattle-based analyst with Wentworth, Hauser & Violich, San Francisco, said she likes the Fresh & Easy stores she's seen, and while she doubts most consumers would want to do all their grocery shopping there, “they could probably do 75% to 80% of it there. And because it's generally so easy to get in and out of the stores, I think many people would prefer to shop there after work than at a supermarket, where they'd have to cross a large parking lot and then negotiate through a large store.

“It also offers an opportunity to compete in more urban spaces,” she added.

One weakness Edwards sees at Fresh & Easy is the lack of national brands. “Brands sell, and when people see private label, that still translates to lower quality or lower value,” she noted.

'Potential Disaster'

Some observers said they don't see much long-term success for Fresh & Easy.

Ziegler of Dutton Associates said he doesn't believe the concept has legs.

“Given what Safeway is doing with its lifestyle stores, what Costco does every day and what Whole Foods does better than anyone, Fresh & Easy seems like a concept that's being squeezed in, and it will take only minimal share,” he told SN.

Tesco may already have lost a portion of the Hispanic trade because of a lack of information or cultural sensitivity, Prevor said. “Red prickly pears are popular with Mexicans, the primary Hispanic group in the western U.S., but the stores stock only white prickly pears,” he pointed out. “And you never get a second chance to make a first impression.”

Another industry observer, who asked not to be identified, told SN he found the stores confusing in terms of their target audience.

After doing as much research in advance of opening as Tesco claims it did, he said, “you'd think it would have come out with a much clearer message from day one. So the brand is already damaged to some extent — though with so few people coming in and shopping, Tesco still has an opportunity to turn things around.”

Dennis of Piper Jaffray said he sees that opportunity narrowing. “The Fresh & Easy concept is not working to plan,” he said in a written report. “It would seem Fresh & Easy has a less robust business model than we first thought, [and] footfall remains weak.”

If that is the case, Dennis said, “then Tesco must be concerned that the concept is not right, and they need to quickly find out what the issues are and reset the concept or ranges, especially if the everyday-low-price product offering is not attracting customers in a near-recessionary environment.”

The lack of traffic “might partly be a reflection of the weak consumer environment,” he said, “but, more worryingly, [it could be a reflection] that the concept is not working, [which] would imply Tesco needs to hold off on a further store rollout and check their offer, brand positioning and pricing. If weak sales are more universal across Southern California, Nevada and Arizona, then Tesco has a potential disaster on its hands.”

Another analyst agreed, saying it will only be a matter of time before Tesco pulls the plug on the Fresh & Easy banner in the U.S.

“It's just a question of whether their pride gets in the way and makes them hang onto it longer than they should,” he said.