Analysis & Commentary: Fresh & Easy Neighborhood Market and Tesco's Lowered Expectations

Tesco plc CEO Sir Terry Leahy outside one of the global retailer's United Kingdom stores. Sir Terry -- 'A Pence for your thoughts?'

As we reported and wrote about here on November 12 and again here on November 19, Tesco Fresh & Easy Neighborhood Market USA CEO Tim Mason announced on November 12 that the grocery chain was scaling back its heretofore rapid new store opening program, which has had the retailer opening a new small-format, convenience-oriented Fresh & Easy grocery and fresh foods market about every three days in the Southern California, Metropolitan Las Vegas, Nevada and Metro Phoenix, Arizona market regions since November, 2007.

This retrenchment includes postponing Tesco's entry into Northern California, which the grocer plans to be its fourth and newest market region.

The first stores in Northern California's San Francisco Bay Area and in the Sacramento-Vacaville Metropolitan market region were originally supposed to be open in mid-2008, according to Tesco's first announcement about the new market launch in late 2007. During the first quarter of this year Tesco revised that target, saying the first Northern California Fresh & Easy markets would start opening by the end of 2008, which would be right about now. Then once again earlier this year the grocer revised the target again, saying plans called for the Northern California stores to begin opening in early 2009.

Based on information from our sources, it's now doubtful any of Tesco's Fresh & Easy stores will open in Northern California in the first quarter of 2009. Rather, we see the first stores most likely not opening any sooner than the middle of next year.

300 stores by end of 2009: Fact or fallacy

For many months now Fresh & Easy Buzz has been saying Tesco's goal of having 300 Fresh & Easy stores open by the end of 2009, which is the number most of the mainstream press has been reporting over and over since late 2007, was unrealistic for a variety of reasons. Chief among these reasons being the fact, as we've reported, the grocery chain is way behind in building its Northern California distribution center in Stockton, California, along with the simple fact the grocer's rapid new store opening pace isn't sustainable, considering the existing Fresh & Easy stores remain below Tesco's sales targets for this time in the chain's development, along with a few other reasons.

The sustainability issue also is why Fresh & Easy took a three month new store opening pause from early April until July 2 this year. Beginning on July 2, when it opened it Manhattan Beach, California Fresh & Easy market at 1700 Rosecrans, the grocery chain started up its rapid new store opening pace again, opening a new store about every three days or so in its three Western U.S. regional markets.

Instead of towing the 300 stores by the end of 2009 party line, we've suggested having about 175-200 Fresh & Easy stores open by the end of 2009 is a more likely realistic figure.

It appears we're spot on. Tesco Fresh & Easy Neighborhood Market CEO Tim Mason is now using that same number -- about 200 stores open and operating by the end of 2009 -- publicly and to the press. For example, in a brief report on November 12 in the Financial Times, staff writer Elizabeth Rigby writes: 'Mr. Mason now hopes to hit the 200 target by November next year, some 10 months later than planned.' He also used the 200 store estimate in his November 12 interview with The Times (United Kingdom) newspaper.

Additionally, Tesco's Fresh & Easy's Neigborhood Market's corporate spokesperson is now using the about 200 stores open by the end of 2009 figure as well when speaking to the press.

We talked to a source at Tesco's Fresh & Easy Neighborhood Market who told us on the condition we wouldn't mention the source's name that the 200 store number by the end of 2009 isn't even a sure thing. Rather, that the grocery chain could easily fall short of that number. This fits with what the Financial Times' Elizabeth Rigby wrote in her brief report on November 19: 'Mr Mason now hopes to hit the 200 target by November next year, some 10 months later than planned.' Notice the word HOPES in the sentence.

Since Fresh & Easy's original strategy called for the grocer to have 200 stores open by early 2009 (like by the end of February or March of next year), and then open about a hundred more in the remaining 10 months of 2009 to get near that 300 total number of units by the end of next year's original target, having around 100 less stores than projected by the end of next year will have a major impact on Tesco's Fresh & Easy model -- and sales and profit/loss target.

Among the impact includes taking longer to break even financially with Fresh & Easy. The Fresh & Easy Neighborhood Market business plan and related financials is based on having those 300 stores, or close to that number, (and the added volume they would bring) open by the end of 2009. Therefore, with fewer stores open the grocer is going to have to obtain significantly increased sales and substantially improved profit performance out of its existing stores (and the new stores it does open between now and the end of 2009) in order to keep its losses close to plan. Same stores sales and profits must increase in order to minimize losses.

Northern California here we come, later than we started from

In terms of postponing it Northern California market launch, we've identified thus far 46 Fresh & Easy store locations in the region -- 25 in the San Francisco Bay Area and 21 in the Sacramento-Vacaville region. Fresh & Easy has confirmed 37 of these locations -- 18 in the Bay Area and 19 in the Sacramento-Vacaville market region.

Most of these 46 Bay Area locations are vacant, former retail store buildings the grocer is currently or plans on remodeling into Fresh & Easy stores. As a result, the company holds leases on the majority of these locations. Therefore, even though Tesco is postponing opening the stores it still has to pay the monthly rent on those buildings. Commercial landlords seldom give retail tenants a rent vacation because they've changed their plans on when they plan to open their stores.

For example, if Fresh & Easy postpones opening the first stores in Northern California for six months -- from early 2009 -to- mid 2009. The company still has to pay the monthly rent on all those non-open stores. And if the first batch of the stores don't start opening until six months later than originally planned that means the second and third batch of stores won't open until more than six months later than originally planned, which means paying rent on those (second and third phase opening stores) unopened stores for an even longer period of time.

This is going to have an impact on the expense side of Tesco's balance sheet since empty stores don't generate income. In fact it could add hundreds of thousands of dollars in expenses to the company's balance sheet.

It's our analysis actually that it's wise for Fresh & Easy to postpone opening its Northern California stores. But we aren't sure the grocer should even go into Northern California with the current Fresh & Easy format, so that's little comfort overall.

What isn't wise though, and indications that something is wrong, is to keep putting off the dates which the first stores will open.

In his November 12 interview with The Times CEO Tim Mason said the reason for postponing the grocer's Northern California launch is due almost completely to the current financial crisis and recession. However, in the interview he also mentioned essentially being behind in constructing the retailer's Northern California distribution center in Stockton, which is about 35 miles from Sacramento and about 50 miles from San Francisco.

Fresh & Easy Buzz has know since early this year, as have others who follow Fresh & Easy closely such as Piper Jaffray-UK senior research analyst Mike Dennis, who's been writing in his regular notes to Tesco plc investors about the construction delay of the Northern California DC and how in his analysis it would cause Tesco's Fresh & Easy to postpone its entry into Northern California and therefore will result in his view in Tesco's failing to meet its sales and profit targets for Fresh & Easy. Dennis follows Tesco plc closely. He's also been one of the closest observers and analysts of Tesco's Fresh & Easy since it set up shop in Southern California.

Therefore, since Tesco's Fresh & Easy has known since earlier this year it was behind schedule (either on purpose or not) with its Northern California distribution center, why did it wait until November, 2008 to announce it wouldn't be entering Northern California on schedule? Some might say: "It's the economy stupid!" In other words, is the recessionary economy the real reason for postponing the launch, or is it because there's no way the Northern California distribution center is or will be ready anytime soon to service Fresh & Easy stores in Northern California? You be the judge.

However, even if the economy was booming, the retailer couldn't open stores in Northern California without its distribution center being open, which is one of the two reasons CEO TIm mason has given for postponing the launch. Perhaps Fresh & Easy saw the financial meltdown and recession coming in the first quarter of this year -- something the U.S. Treasury Department , Federal Reserve and nearly every independent economist missed -- and decided to delay construction on the Stockton DC just in case?

We don't doubt the financial crisis and recession has something to do with Tesco's plans to postpone its Northern California launch. However, without a distribution center the bad economy is a moot point. Therefore there's more to the decision than just the external factor of the financial crisis and recession, obviously.

Interestingly, the interviewer for The Times didn't ask Tim Mason the simple question: 'Why is it taking so much longer than planned to construct and open the Northern California distribution center in Stockton.' Since Mr. Mason mentioned this himself, that the DC is behin schedule, it certainly would have been a logical follow-up question for the interviewer to ask. Perhaps the interviewer did ask that important journalistic question but either it wasn't answered or if asked and answered the answer didn't appear in the November 12 profile piece in The Times?

Setting the bar too high with PR hype

Having roughly 100 fewer Fresh & Easy stores opened by the end of 2009 -- the 300 store number was used by the company right up until a couple weeks ago after all -- will also have a negative perceptual effect on Tesco's U.S. small-format, convenience-oriented food and grocery retailing venture.

This effect in part is by the global retailer's own creation. Beginning at least two years before it opened its first Fresh & Easy grocery and fresh foods market Tesco started building up the public relations hype in terms of what a major food retailing venture Fresh & Easy Neighborhood Market would be. British and U.S. newspapers ran bold headlines, with the urging of the retailer's PR staff, touting the "British Food Retailing Invasion." Story after story talked about how Tesco planned to open as many as 500 stores in three years. How it would begin in the Western U.S., move to the Midwest, then on to the east coast, concurring America.'

In effect, what Tesco did through its public relations program was to set the bar for Fresh & Easy so high, even if the grocery chain exceeded all expectations in its first year of operations, which it hasn't, doing so still likely would not have been good enough based on all the pre-store opening hype the company generated in the media.

Tesco couldn't control what the mainstream media wrote, and the press loves drama, but the company intentialy created much of this hype and fed it to the press. Much of the mainsteam media loves canned stories after all, especially press releases. Tesco's PR staff did their jobs and gave it to them. It wasn't the Pr folks' fault. Rather it was the fault of the corporate executives who encouraged the hype strategy.

As most entrepreneurs and good politicians know, a company or individual must walk a fine line when playing the expectations game. It's always far easier and much more popular to go beyond expectations than it is to not meet them. Tesco set the expectations so high for Fresh & Easy that it shouldn't be any wonder to the company's executives that their performance to date has been frequently criticized. Creating excessive PR hype can be a double-edged sword. If you live up to the hype you are a hero. If not you are a goat. But nobody else is to blame -- after all it's your hype. Nobody forced the company to create and communicate it.

In Tesco's case it set the bar so high for itself with all of its publicity generation about revolutionizing American food and grocery retailing and building a empire in a scant couple years that now each time it announces a cut-back, major change or postponement, it makes the retailer look like its failing.

Perception can be reality after all. But in Fresh & Easy Neigborhood Market's case the problems go beyond mere perception -- the grocery chain has real merchandising, marketing and operations problems.

Need for major change and new strategy

As we've argued in Fresh & Easy Buzz, it's our analysis these performance problems are based largely on a single faulty premise and strategy, that the retailer has tried to use a British model of food and grocery retailing in the Western United States. That instead of bringing in key executives with extensive experience in the market the retailer has relied almost completely on executives with experience primarily in the United Kingdom. From this faulty strategy a myriad of operational, merchandising and marketing problems have then been created.

Coupled with this change, Fresh & Easy Neighborhood Market then needs to fine tune its value propostion through merchandising. Once achieved it needs to create an integrated strategic merchandising and marketing program designed to coomunicate its value proposition on a consistant and regular basis -- tout if frequnetly and hammer it home.

For example, based on its no frills model and overall low everyday prices, consumers should be flocking to Fresh & Easy stores like they are to discounters like Wal-Mart and Aldi in the current severe economic recession. That isn't happening. Why? It's our analysis the reasons are the two we outlined above -- the faulty use of a British food and grocery retailing model and a failure to properly create and communicate a strong value proposition.

What would Sir Terry do?

Tesco is a great global retailer. But in terms of approaching the Western U.S. market in a smart, regional and local way, the way all successful grocers do, it's failed miserably in that regard. Why this is so, in our analysis, we find very hard to understand.

But two other British retailer's, Sainsbury's and Marks & Spencer, both did essentially the same thing when they entered the U.S. some years ago; both acquiring existing U.S. retailers, operating for some years -- and both failing.

Tesco however still has a strong chance to be a success with Fresh & Easy in the U.S.. But it's our analysis that unless major changes are made, and its use of the British food retailing model is dumped and replaced by an American regional, sub regional and localized strategy, those chances for success are at best slim.

Tesco plc CEO Sir Terry Leahy has been largely silent for most of the year about Fresh & Easy Neighborhood Market USA. That's mainly because he made Fresh & Easy Tim Mason's (the grocery chain's CEO) baby, so to speak.

But we can't help being curious about what Sir Terry thinks about the developments over the last year at Fresh & Easy's corporate headquarters: the fact seven category managers and buyers have left corporate headquarters since February, 2008 (and another four or five left in 2007 before the first store even opened); the sudden departure of co-vice president of operations Brain Pugh and the conditions leading up to that sudden departure; the need for Fresh & Easy to spend a significant chunk of change to create a new interior design package for the Fresh & Easy stores just a few months after the first stores opened, and now the postponement of the Northern California launch; along with a few other things.

Perhaps we will hear from Sir Terry soon?