Business Week: Tesco Defies Gravity

Europe: April 15, 2008
Business Week

Tesco Defies Gravity

Even in parlous times, the British supermarket chain is posting robust sales and profits, especially in emerging markets
by Mark Scott

All eyes are on retail sales these days as a measure of consumer sentiment in shaky economic times. On Apr. 15, British-based supermarket chain Tesco (TSCO.L), the world's third-largest general retailer after Wal-Mart Stores (WMT) and Carrefour (CARR.PA), offered investors a welcome dollop of good news, reporting pretax profits up 5.7% for the year ended Feb. 23, to $5.6 billion, on a revenue gain of 11.1%, to $101.7 billion.

The strong results, which met analyst expectations, underscore two vital points. First, Tesco did well despite weakening consumer confidence—or perhaps because of it. As an aggressive discounter, it is thriving as customers shy away from pricier fare. Second, although growth is slowing in developed economies chilled by the global credit crunch, Tesco continues to rack up huge gains in emerging markets from Hungary to Malaysia.

The proof is in the numbers. Tesco's revenues in Britain climbed 6.7% for the year, to $74.5 billion—roughly twice the growth rate of the economy as a whole—and its operating profits rose 7.1%. Sales outside of Britain surged 25.4%, to $27.2 billion, and profits jumped nearly as much, by 24.3%. International sales now constitute more than half of Tesco's revenue growth, says Chief Executive Officer Terry Leahy.

Eastern Promise

Investors embraced Tesco's results with gusto Apr. 15, pushing the company's shares up 7.3%, their biggest one-day rise since July, 2002. Analysts were especially impressed with the company's gains in emerging economies. "Central Europe and Asia are in a sweet spot in their evolution because they're becoming mature markets," says Jonathan Pritchard, food retail analyst at Oriel Securities in London. "This hasn't been the best year for the U.K., but those other countries have picked up the slack."

Indeed, Tesco's growth in Eastern European countries such as Poland and the Czech Republic has benefited from aggressive marketing and rollout of new stores, which have kept sales growth in the double digits. After taking over 11 Carrefour outlets in the Czech Republic during 2006, for instance, the British retailer says same-store sales rose 11% year over year.

Tesco's Asian operations also are on a tear, particularly in Korea, where sales at the company's online grocery division have risen 125% since last year. Credit Suisse (CS) analyst Andrew Kasoulis reckons strong economies in Asia (except for Japan) will help keep Tesco's momentum strong this year even if Western countries weaken. The company boosted its stake in China by buying 90% of local supermarket chain Hymall for $353 million in 2006, and Kasoulis believes Tesco can continue to expand there.

Yankee Doldrums

Perhaps the biggest question hanging over the company on Apr. 15 was the fate of its new U.S. push. Tesco has launched a chain of midsize stores in the U.S. called Fresh & Easy, and began opening outlets in California last November (BusinessWeek.com, 10/19/07). But after starting up 60 stores, the company revealed on Apr. 2 that it would halt its rollout for three months to tweak the formula. Brokerage Piper Jaffrey (PJC) estimates that Fresh & Easy revenues in the six months since launch may have totaled only $30 million—some 70% below its original forecast.

Analysts are plainly worried. "The new venture in the U.S. was a major driver [on Tesco's share price] for much of 2007," says Citigroup (C) analyst James Anstead in a note to investors. (The stock rose 18% last year.) "Any negative news on progress in the U.S. business could be taken badly by the market."

Nevertheless, Tesco says it's not pulling out. Startup costs to date of $123 million are running slightly below budget, and the company says it still plans to open around 150 new stores this year. "I'm very encouraged by what I see," Leahy told analysts Apr. 15, conceding that "it's still too early to make definitive judgments." The CEO says he expects losses from Fresh & Easy to hit $200 million this year before the chain turns profitable in the second half of 2009.

Solid Operating Margin at Home

Tesco ought to be able to absorb that expense easily. Despite a slowing economy, Leahy figures revenues in the retailer's home base of Britain will grow 3% to 4% this year. Tesco owns 31% of the market in Britain—more than runners-up J. Sainsbury (SBRY.L) and Wal-Mart unit

Asda combined. And according to Citigroup's Anstead, "Tesco's U.K. operating margin is at record levels." Its low prices "may mean it has more protection than most in a consumer downturn."

That's just the sort of thing investors want to hear in an era of shaky consumer confidence. With its dynamic combination of home-market advantage and international diversification, Tesco looks ready to weather economic uncertainty.