GLOBAL SUCCESS PROVIDES BASE FOR TESCO'S U.S. VENTURE

GLYNN DAVIS

LONDON - It takes a lot for Sir Terry Leahy, chief executive of Tesco, to get excited, so when the supermarket company here this month delivered record results for the first half of the year, it was no surprise that he was as downbeat as ever.

As it unveiled pretax profits of $2.06 billion for the first half, he must have fought hard to suppress his pleasure. But he did let the mask slip slightly with his bold comments about the success of Tesco's international operations, which grew sales by 21%, compared with 10% for the United Kingdom.

His suggestions that Tesco was better at adapting to overseas markets than its rivals and was getting stronger in comparison to their faltering highlight just how confident he is in the company's overseas business. This creates a solid platform from which to launch its U.S. venture next year, which analysts said could borrow some elements from the country's experience in other markets but will also be unique in many ways.

With only about $468 million earmarked for the U.S. - out of forecast capital expenditures of about $6 billion for 2007 - America represents only a fraction of Tesco's global plans next year. Those global plans include the opening of 392 stores (about 7.5 million square feet), of which 75% will be outside the U.K.

But this modest initial investment in the U.S. should not be misinterpreted as a lack of ambition, analysts pointed out, because aside from the monetary commitment, Tesco has thrown some serious management expertise at its fledgling U.S. business.

Board member Tim Mason, who is heading up the operation, has brought in Simon Ewins, who worked with him on marketing strategy in the U.K.; Tony Eggs, who has taken on the role of chief real estate officer; and Bryan Pugh, who was chief operating officer for the Tesco Lotus business in Thailand. They are part of a team of over 100 people at Tesco's El Segundo, Calif., headquarters.

"Tesco is genuinely excited about the U.S., as it believes it is on to something," said Clive Black, head of research at Shore Capital. "It's done about 20 years of research in the U.S., so it will not underestimate this large and sophisticated market. It's therefore [taking] a measured approach that won't break the bank if it fails."

International Experience

A senior analyst at a major U.S. investment bank who did not wish to be named added that Tesco is entering the U.S. market with "zero operational risk" and that the only downside was if customers did not respond to the offer.

The operational risk is deemed to have been removed because of the experience that Tesco has accumulated from running successful operations in a variety of countries.

Selective elements from these businesses will be used to create the U.S. infrastructure, analysts said.

Among them will be its well regarded "Tesco in a Box" strategy that was first deployed in South Korea in 2004 and effectively contains back-end technology systems and processing capabilities, which can be literally rolled out to a new country. Black said it will also bring its world-leading practices in labor scheduling, store format diversity and - crucially - its localized approach.

Unlike its competitors that have sought to rigidly transplant their domestic models in other countries, Tesco has preferred to tailor its offer to each local market and use local management. "In its 12 international markets, there are only 150 expatriates working. The senior management teams are local executives, which is seen as virtuous because it creates indigenous wealth," Black said.

Diverging From Strategy

What also helped Tesco initially roll out its stores in a number of international markets were its joint ventures and small-scale acquisitions. In China it teamed up with Hymall; in Japan it bought Fre'c Group; and it worked with Lotus in Thailand and Homeplus in South Korea.

However, it is entering the U.S. without any partnership in place, thereby diverging from its tried and trusted strategy. Ben Miller, program manager of international at food and grocery consultants IGD, said this is one of a number of differences in its approach to the U.S., compared with other markets.

He said it has also eschewed its regular criteria of only entering markets that are underdeveloped, that offer an opportunity for market leadership, and allow Tesco to not initially need the support of a central distribution infrastructure.

Since there are few pan-U.S. food retailers, Miller does not believe that the inability to aim for market leadership is of any concern to Tesco. He suggested that Tesco will aim to be No. 1 in a small number of U.S. counties.

The issue of central distribution is one of the most marked divergences from previous Tesco overseas forays, and has been prompted by its choice of introducing a convenience store format into the U.S. rather than hypermarkets (see related story, Page 42). A central distribution infrastructure is being introduced immediately in the U.S., rather than relying on direct-store-delivery, as it has done in other markets.

"In other markets Tesco has gone in with hypermarkets and then introduced central distribution later on [when it has critical mass]," said David McCarthy, analyst at Citigroup. "But with its small-store strategy in the U.S., it cannot rely on direct distribution to individual stores, so it has to first build a distribution center."

With its initial distribution center in Riverside, Calif., expected to measure 1.4 million square feet, Tesco should be able to service up to 300 stores, according to Miller. And since its first-year U.S. investment will potentially pay for between 100 and 200 stores, Tesco is understood to have already acquired the land for a second warehouse, in Arizona.

Its ability to scale up quickly is seen as a major attribute, and has been used to great effect to build critical mass in South Korea, where it has overtaken Carrefour, and also in Thailand.

Although Tesco is regarded as a late entry onto the international scene, it has quickly become the market leader in half of the 12 countries in which it operates, compared with only a quarter for major rival Carrefour.

Private Label

Despite this rapid growth, Tesco has been methodical in the way it has introduced its well-respected private-label ranges into overseas markets. Its private-label proposition is similar to one that has recently been evolving in the U.S., with not only a discount "generics" range, but also a variety of sub-brands that cover different price points and specialty foods. Along with the discount private label there are labels for a core selection, premium, organic and healthy eating.

"Private label is very important for Tesco, and although it is getting bigger in the U.S., it is still undeveloped," Miller said. "Tesco could launch into the U.S. market with its value or core range and then introduce premium later on."

This slow build would follow the strategy employed elsewhere, which is partly due to the fact that 90% of private-label ingredients are sourced locally, so it takes time to develop a pipeline of products.

In Hungary, Tesco's discount label was introduced four years after it first entered the country and was only followed by its core private label another two years later, and then a further three years lapsed before its healthy-eating label first hit the Hungarian stores.

If U.S. consumers take to these private-label variations as they have done elsewhere around the country, then it will provide a major point of differentiation for Tesco and play a part in its success.

If this proves to be the case, and in five years' time Tesco is pleased with its performance on the West Coast, Black predicts that the company will have upped its investment in the country to significantly more than $468 million per year. And it will also probably then be casting its eye over opportunities in New York, New England, Chicago and parts of Florida, which would surely excite even Leahy.

Tesco's Model Seen as Flexible

Tesco will undoubtedly benefit from the fact that its U.S. stores are being modeled on its Express format, as it has the experience of developing this concept in a variety of markets. After initially opening in Hammersmith, west London, in 1995, it is now an established format in seven different countries.

"Although lots of overseas experience has been hypermarket-based, Tesco has increasingly opened multi-formats and especially smaller stores in the Far East," said Steve Davies, retail analyst at Numis Securities. "It has Express stores around the world, although its U.S. version will be larger at around 10,000 square feet rather than the U.K. average of 5,000 square feet."

The company is therefore looking for stores with a gross area of 20,000-25,000 square feet that would give a selling space of 10,000-15,000 square feet and could be either new builds or existing sites in strip centers.

Since the stores will run to a "tight footprint" with Tesco keen to specify exactly where things like back entrances are sited, David McCarthy, analyst at Citigroup, suggests that acquiring batches of stores will not be on the agenda in the early stages of Tesco's U.S. plan.

Beyond that, McCarthy said the company will be running a sufficiently flexible model to basically "try anything." The choice of a convenience outlet came after much research and was deemed to be innovative enough for the U.S. market.

"Although you can't invent something that's new in retail, they will be innovative on little things so it will be all about quality, fresh and healthy as the U.S. tends not to have this [in its convenience stores]," he suggested.

It will be seeking to raise the game in that part of the market by targeting mid- to upper-income consumers with a whole food offer, but from a discount perspective. Since the Tesco strategy is not to squeeze margins, McCarthy said it is a "question of how low can we go" with the pricing. This thinking is based on Tesco's preference for using its brand premium to drive sales rather than enjoy juicy margins.