Food MarketWatch

COMPANY SPOTLIGHT: TESCO PLC Tesco: US launch is its boldest venture yet
After years of studying the habits of the US consumer, Tesco has opened its first six Fresh & Easy stores in California, in what promises to be its most significant adventure yet. Despite the obvious attractions of the US, it has often proved to be a graveyard for UK retailers and as such it will be the constant refinement of Tesco's offer that will help it to succeed. There have been few such retail ventures that have been so closely watched by the media and retail spectators alike, and in the coming months all eyes will be on Tesco as it continues the roll-out of the Fresh & Easy format across California, Nevada, San Diego and Phoenix. Promising to offer a new concept in grocery shopping, Tesco's Stateside venture shares few similarities with its typical UK store format, with the retailer deliberately choosing a new brand, leaving behind the familiar red and blue logo. At just 10,000 square feet, the Fresh & Easy stores are significantly smaller than the typical US grocery store, combining elements of rival chains such as 7-Eleven, Trader Joes and Whole Foods. While it may have a stronger focus on organic, fresh and free range food than traditional UK Tesco outlets, value remains paramount and Tesco hopes its winning formula will be the convenience of fresh foods at competitive prices. In typical Tesco style, the retailer has ambitious, if not aggressive, plans for Fresh & Easy in the US, with rumors suggesting its purpose built distribution centre in Los Angeles could supply some 400 stores. Nonetheless, Tesco needs to build critical mass quickly, otherwise it opens the door of opportunity for rivals to quickly replicate its offer before it builds the loyalty it needs. One similarity Fresh & Easy does share with the UK operations is its middle market positioning, with stores located in both poor and affluent suburbs, and Tesco hopes to become all things to all people, in much the same way it has in the UK. However, although this has proved a winning formula in the UK, middle market American retailers such as Kroger are being squeezed by those that offer lower prices and those that favor quality, in a market that remains more polarized than the UK. Tesco's enviable reputation for success both at home in the UK and in the international arena will cause US retailers to watch developments closely. And, while Tesco cannot be faulted on doing its homework, it will need to fine tune and develop the format to ensure that it meets the demands of American consumers.

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Business Description

Table 2:

Key Facts

Address: Tesco House Delamare Road Cheshunt Hertfordshire, EN8 9SL GBR

Products include: Food General merchandise Electrical goods Clothing Household goods Home furnishings

Telephone: Fax: Website: London Ticker:

44 1992 632 222 44 1992 630 794 www.tesco.com TSCO

Services: Gasoline stations Broadband internet connections Telecommunication services Financial services

Employees:

318,283

Online shopping and financial service provision

Turnover: Financial Year end:

42,641m February

Source: Datamonitor

DATAMONITOR

Tesco is one of the largest food retailers in the world, operating over 3,260 stores. The group operates through multiple store formats, including Extra, Superstore, Metro, Express and hypermarkets. The group operates in the UK, other European countries, Asia and the US. Its stores stock roughly 40,000 food products. In addition, the group also sells nonfood items including electrical goods, home entertainment, clothing, health and beauty, stationery, kitchen utensils, soft furnishings and seasonal goods such as barbecues and garden furniture in the summer. The group also markets products under its own labels at three levels: value, normal and finest. The group operates over 1,988 stores in the UK, its largest geographic market. Apart from regular groceries, the UK stores also have gas stations. The group has become one of UK's largest independent petrol retailers. Furthermore, the group has a joint venture with Royal Bank of Scotland to provide personal finance (Tesco Personal Finance) in the UK. The group has operations in the rest of Europe, including the Republic of Ireland, Hungary, Poland, Czech Republic, Slovakia and Turkey. Tesco operates approximately 95 stores in the Republic of Ireland, 280 stores in Poland, 101 stores in the Hungarian market, 84 in Czech Republic, 48 in Slovakia and 30 in Turkey. Tesco also has operations in Asia,

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including China, Japan, Thailand, South Korea and Malaysia. The group operates around 47 stores in China, 109 stores in Japan, 370 stores in Thailand, 91 stores in South Korean and 19 in Malaysia. The group provides online services through its subsidiary, Tesco.com. The group also provides broadband internet connections (Tesco broadband) and telecommunications services (Tesco Mobile and Home Phone) through a 50-50 joint venture with O2, a mobile phone company. The group also provides its financial services through its website.

SWOT Analysis

Table 3:

SWOT Analysis

Strengths

Weaknesses

Market leadership Strong performance of Tesco.com Strong brand image

High dependence on the UK and Europe Weak returns Weak inventory turnover

Opportunities

Threats

Retail environment in the Eurozone Opportunities in private label and non-food markets Opportunities in India and other international markets

Rising labor wages in the UK High interest rates in the UK Intense competition Difficult conditions in the international markets

Source: Datamonitor

DATAMONITOR

Strengths
Market leadership Tesco is the largest retail group in the UK. The group had 26% share of the UK grocery market as of December 2006. It accounted for 56.1% of all UK supermarket shoppers in 2007. In October 2006, 66.2% of the online food and grocery shoppers purchased online from Tesco. Tesco operates 3,262 stores. The group has 30 distribution centres, of which six are dedicated to non-food and clothing. The group operates through multiple store formats including Extra, Superstore, Metro, Express and hypermarkets. The group has a stronger market presence in South Korea as compared to its competitors. One of its competitors Wal-Mart sold all of its 16 stores in 2006. Another competitor Carrefour also divested its operations in South Korea in 2006. Wal-Mart and Carrefour had to exit from the South-Korean market owing to their inability to cater to the taste of the South Korean

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consumers. In addition, they failed to win more customers as it was slow to open retail outlets in the South-Korean market. Wal-Mart also failed in South-Korea owing to its inability to compete with aggressive Korean discounters. The group is planning to invest $3.9 billion during 2007-2011 in South Korea. The group's leading market position enhances its brand image, provides economies of scale and makes it easier to launch private label brands. Strong performance of Tesco.com Tesco.com is the largest online grocery shopping services in the world. It is the fourth biggest online retailer in the UK, behind Amazon, Dell and Argos. Its revenues grew by 29.2% in 2007, reaching 1,226 million in turnover. Tesco.com serves 850,000 regular customers in the UK, which include households from both urban and rural areas. It gets more than 250,000 orders every week. In the UK, for parts of the country where Tesco has few stores or where those it has are exceptionally busy, it has developed a tesco.com-only store. Tesco.com also offers a digital download which gives customers access to almost 60,000 DVD titles and games. Anticipating the even larger opportunity in online non-food markets, the group launched Tesco Direct for catering to non food segment in August 2006 and this was made online through tesco.com. Tesco has also placed its online non-food ranges like electrical goods, books, wine, music and movies under one virtual roof - Tesco Extra. Online shopping has steadily grown in popularity in the UK. In 2006, online spending grew by 33.4% to 10.9 billion. The online retail sales are forecasted to from 10.9 billion in 2006 to 28 billion in 2011. The online retail sales as a percentage of total retail sales are expected to increase from 4% in 2006 to 8.9% in 2011. With a strong foothold in online services, Tesco is well placed to benefit from growing online spending. A strong online presence enables the group to serve new customer segments, avoid investments in physical infrastructure and earn better margins. Strong brand image Tesco has an impressive brand image. It is associated with good quality, trustworthy goods that represent excellent value. Tesco's innovative ways of improving the customer shopping experience, as well as its efforts to add value through financial services have resulted in strong brand equity. A strong brand image, besides enhancing customer retention rates, enables the group to launch more products under its own labels and allows it to enter new markets and product lines relatively quickly, as was the case with its entry into the personal finance market.

Weaknesses
High dependence on the UK and Europe Tesco is heavily dependent on the UK market. In fiscal 2007, it derived 76.6% of its total revenues from the UK, 13% from the rest of Europe and 10.4% from Asia. One of its competitors, Wal Mart derived 22.1% of its revenues from its international operations. Another competitor, Carrefour, derives over 52% of its revenues from its international operations. Concentration of operations in the UK and Europe makes it vulnerable to market conditions in this region and puts it at a competitive disadvantage relative to rivals with a larger presence in fast-growing Asian markets.

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Weak returns Tesco has recorded weak returns in the last few years. Its return on assets, return on investments and return on equity during 2005-2007were 7.1%, 8.3% and 16.8%, respectively. Whereas, one of its competitors Marks and Spencer recorded return on assets, return on investments and return on equity of 11.4%, 15.2% and 49.3% for the same period. Weak returns reflect the inability of the management to deploy assets in profitable avenues, and this could result in decreasing investor confidence Weak inventory turnover Tesco has recorded weak inventory turnover in the fiscal year 2007. Its inventory turnover ratio for fiscal 2007 was 25.1. One of its competitors J Sainsbury recorded an inventory turnover of 29.4 for the same period. Another competitor, WM Morrisons, recorded an inventory turnover of 32.5 for the same period. Low inventory turnover ratio indicates that the group is not able to rotate its inventory faster and does not have an effective inventory management system in place. Low inventory management could increase the sale of goods on discount. This would affect the group's revenue growth in the coming years.

Opportunities
Retail environment in the Eurozone The Eurozone retailing has been showing growth in 2007. In February 2007, Eurozone retail sales experienced a 1.1% growth compared to February 2006 figures. Again, Eurozone retail sales were stronger than expected in March 2007, rising 2.2% relative to the same month previous year. In April 2007, they had a 1.6% year on year growth. In April 2007, the food, beverage and tobacco sector (FB&T) posted a 0.5% rise in sales from March, and non-food sales grew by 2.3% in the Euro area. FB&T sales in April 2007 increases 0.7% year on year. In 2006 Eurozone recorded a real GDP growth of 2.8%, the steepest increase since 2000 and is forecast to continue to grow in 2007. This could improve the profits of large retailers like Tesco, for whom Europe is the primary market. Opportunities in private label and non-food markets The private label market in the UK is witnessing a strong growth in sales. In 2006, out of total consumer packaged goods (food, beverage and personal care) sold in the UK, 36.7% were private label products, amounting to 42 billion. Private label market penetration is forecasted to grow to 40.2% by 2011 to an amount of 52 billion. Private label brands provide higher margins than branded products. Besides retailing branded products, the group sells 400 Value products and more than 1,000 standard own-brands, including Cherokee, Florence + Fred and Healthy Living. The group's own brand sales are approximately 50% of its total sales. Tesco could leverage its strong portfolio of own brands to increase its margins. Tesco's UK non-food sales are still small, but hold significant growth potential. Tesco's non-food sales in UK, totaling approximately 7.6 billion in 2007, rose by 11.6% over 2006 levels. The non-food segment includes several integrated non-food categories such as tobacco, household and traditional non-food categories such as white goods, clothing and entertainment products. Tesco has a market share of only 8% in UK's non-food market. With skills in sourcing, supply chain management and merchandising, Tesco has the strengths to improve its market position in this segment.

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Opportunities in India and other international markets India is the second fastest growing economy in the world. The real GDP growth for India is forecasted to be around 8.5% in the fiscal year 2007-2008 and 8% in fiscal 2008-2009. The strong economic growth of India has led to higher personal incomes, which are fueling demand for consumer goods. The Indian retail industry is expected to grow 14.6% annually during 2005-2010, to reach $517.6 billion by 2010. The Indian food and grocery retail industry was estimated around $221.1 billion in 2006. It is expected to grow at an average rate of 11.5% during 2005-2010, to reach $336.7 billion in 2010. Several leading Indian and international groups have already entered the retailing industry to exploit growing demand for consumer goods from 150-million strong Indian middle class. Tesco is reportedly planning to enter the Indian market through a joint venture with Hero Group, a leading Indian automobile sector group. Tesco already operates in other Asian countries such as South Korea and is, therefore, ideally placed to enter the Indian market. Tesco is, therefore, well poised to benefit from the growing consumerism and retail industry in India. Tesco is expanding its operations in other international markets also. In January 2006, the group acquired eight large Makro stores in Malaysia. In May 2006, the group acquired 11 Carrefour stores in Czech Republic. It also acquired 27 small stores from Edeka in April 2006. It acquired 146 Leader Price stores in Poland in December 2006. The group plans to open additional stores in Thailand and South Korea. In Thailand, Tesco is rolling-out 'Value' hypermarkets, supermarkets and Express stores alongside its standard hypermarkets. In addition to about four standard hypermarkets per year, the group plans to open 30 Value stores, 60 supermarkets and up to 500 Express convenience stores in Thailand by 2008. As a result, the group's operating profit is expected to double in both South Korea and Thailand between 2006 and 2009. Furthermore, the group entered the lucrative US market in 2007, starting on the west coast under the Fresh & Easy Neighborhood Market banner. Growth in international markets would enable the group to reduce its heavy dependence upon the UK market and allow it to benefit from the faster growth of other markets.

Threats
Rising labor wages in UK Labor costs are rising in the UK. The UK government announced that the adult minimum wage rate would rise from 5.05 to 5.35 per hour in October 2006. The national minimum wage is expected to further rise to 5.52 an hour from October 2007 in the UK. The rate for those aged 18 to 21 years would be increased from 4.45 to 4.60 per hour and the rate for workers aged 16-17 years would increase from 3.30 to 3.40 per hour. The group employs about 318,283 full time equivalent employees on an average in 13 countries around the world in the fiscal year 2007. Out of this 58% of employees are located in the UK. An increase in labor costs would adversely impact the group's margins.

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High interest rates in the UK Though the UK retail market is poised to grow by about 15% during 2006-2011, a slight decline is expected in 2007. Growth in 2007 at 2.8% will be slightly lower than 2006's 2.9%. Although the Bank of England cut interest rates in August 2005, they still remain at high levels. Interest rates in the UK stood at a high of 4.5% at the end of January 2006. This was further raised to 5.25% in January 2007, 5.5% in May 2007 and was proposed to be raised further by 25 basis points to 5.75% in July 2007. The high cost of credit will act as a brake on consumer expenditure encouraging households to limit non-essential expenditure, particularly on deferrable big ticket purchases and this could adversely affect Tesco's performance. Intense competition The UK retail industry is highly consolidated with Tesco, Asda, Sainsbury's and Morrisons dominating the sector. Tesco is facing intense competition in the retailing business from other supermarkets and discount stores. Its main competitors include Sainsbury and Asda, in addition to numerous small and local store operators. Tesco faces intense competition from Asda, which has the second largest retail market share in the UK. Competitive pressure in this sector is rising up further with Marks and Spencer's (M&S) and Waitrose coming up with expansion plans in the UK. In addition, M&S is also expanding in emerging economies like India and China. For instance, Marks and Spencer, the UK-based, leading international department store retail chain, operates a retail chain of 469 owned stores in the UK, Ireland and Hong Kong, as well as 248 franchisee stores in 30 countries of the world, services over 16 million customers each week. The group plans to expand internationally by opening 100 new 'simply food' stores in fiscal 2007 compared to 63 'simply food' stores in fiscal 2006. In addition, Marks and Spencer intends to renovate 70% of its stores by Christmas 2007 and increase its floor space by 15% to 20% in fiscal 2007. Increased competition could lead to pricing pressures, which would reduce the group's profits. Difficult conditions in the international markets Demand for the group's products and services in part depend on the general economic and political conditions affecting the countries in which the group operates. Changes in demand for its products and services can magnify the impact of economic cycles on the group's businesses. For instance, in 2006, an improvement in Tesco's performance in most of Central Europe, Ireland and Turkey was offset by the effects of continuing weak economy in Hungary. This was a consequence of the strong economic measures taken by the Hungarian government which reduced consumer spending. As a result, the group's non food category was particularly affected. Political uncertainty in Thailand resulted in difficult business conditions for the group in the second half of 2006. Though, the group was able to overcome it due to its strong market position but continuance of the situation may affect the group's performance.

Food MarketWatch
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Published 12/2007 Page 47