SAFEWAY TO TAP TESCO'S EXPERTISE AT NET SALES

DAVID GHITELMAN / Addditional reporting by James Fallon

PLEASANTON, Calif. -- Safeway here said last week it has formed an alliance with Tesco, London, that will give the U.S. retailer access to the U.K. company's Internet know-how and proprietary software.

U.S. analysts interviewed by SN said they believed Safeway and Tesco might be able to combine their expertise to establish a profitable store-based Internet grocery service.

British analysts told SN they welcomed the deal, saying it was a major vote of confidence in Tesco's e-commerce software and warehouse management systems.

According to Safeway, Tesco will make a $22 million cash investment in GroceryWorks.com, Dallas, Safeway's exclusive online grocery service, and provide it with proprietary software and expertise in return for a 35% share of the company's voting equity; Safeway currently holds approximately 50% of the voting equity in GroceryWorks.

Tesco's Internet grocery service, Tesco.com, is profitable in the United Kingdom, with almost 1 million registered customers, 70,000 orders per week and annualized sales of $420 million, according to Safeway.

GroceryWorks' service, which had been available only in Texas, was suspended last week to prepare for a relaunch, Safeway said; when service resumes, it will operate under the Safeway banner and will make its deliveries from stores, not warehouses.

Gary Fernandes, GroceryWorks chairman, told SN, "We want to get back as soon as we can," but declined to give any estimate of when service might resume.

He noted that GroceryWorks had in recent months been moving away from its original warehouse-based model to a store-based system.

"But we didn't have the technology," he said. "Tesco has it all developed."

Fernandes explained that in the Tesco.com model, the online grocer offers just about every item a supermarket does. "You need a different Web site," he said. "Our Web site can't handle all the items there are in a store.

"We also needed help with the automation used in picking items from stores. Tesco has proprietary software that makes it almost impossible to pick the wrong item or quantity.

"Basically, you have to build digitized maps of every item. These are downloaded to a device that's mounted on a custom-designed cart. All items appear on the display. It's hard for the pickers to make a mistake."

Debra Lambert, a Safeway spokeswoman, said the company expects to offer the online service "in most markets where Safeway operates. Our goal is to make it the best online grocery business in the U.S. We want to provide a high level of service, be profitable and build the business one block at a time."

Failing to return repeated phone calls, Tesco could not be reached for comment.

Ellen Baras, securities analyst, William Blair & Co., Chicago, told SN she was skeptical whether Tesco could export its version of online retailing to the U.S.

"Is buying behavior in the U.K. the same as it is here?" she asked.

"Frankly, I was a little surprised by this news," she added. "The fervor over online shopping has faded, and I was surprised that Safeway is seriously interested.

"Webvan and Peapod have demonstrated that there is a niche demand for the service with a certain household profile, and Peapod is now profitable in Chicago.

"But many people still can't imagine having someone else select their tomatoes. It takes a long time to change the consumer mind-set."

Andrew Wolf, senior analyst, BB&T Capital Markets, Richmond, Va., told SN he thought GroceryWorks' move to store-based fulfillment was a good idea.

"A hybrid between retail and e-commerce will over time yield some profitability," he said. "The store-based model is a better model for a slow-growth, low-demand business like groceries because it has a lower break-even point.

"It's the low-investment model that survives. The high-investment, high-spend model leads to the highly predictably burnout."

Meanwhile, in the U.K., some analysts speculated that the deal increases the possibility Tesco might eventually merge with Safeway to become a global player in the same big-league as Wal-Mart and Carrefour. Analysts in the past have said Tesco might have to merge with another major retailer if it wants to leap into the ranks of the world's top companies.

However, other analysts last week downplayed the possibility of a merger with Safeway, saying Tesco at the moment seems to be growing well on its own.