Monday, October 4, 2010

Tuesday's Tesco Interim Report Offers A Road Map of Sorts For the Future of Fresh & Easy Neighborhood Market


We'll get a good indication of where United Kingdom-based Tesco stands mid-year with its Fresh & Easy Neighborhood Market chain when the retailer reports its interim fiscal 2010/11 corporate sales and earnings on Tuesday, October 5. The earnings report, which will include half-year sales and the loss amount for Fresh & Easy, can serve as a road map of sorts for Tesco's now nearly three year-old U.S. fresh food and grocery chain venture, if we view it in the right way.
In its most recent fiscal year, 2009/10, which ended February 27, 2010, Tesco reported a full-year loss of $253 million, on sales of $544 million, for Fresh & Easy Neighborhood Market USA.

The previous fiscal year, 2008/09, Tesco lost $208 million, on sales of $308 million, at Fresh & Easy.

What's most troubling, and should be of most concern for Tesco, is that its 2009/10 fiscal year loss was $48 million more than in the previous year, despite growing sales by $236 million year-over-year, largely through opening new stores rather than same-store-sales.

The key reason this development is troubling is because central to Tesco's strategy with Fresh & Easy Neighborhood Market is its strategic plan is predicated on reducing its losses and breaking even with Fresh & Easy, something it wanted to do by the end of this (2010/11) fiscal year but won't, by significantly growing sales (top line) rapidly, thereby creating a critical mass on the revenue side of the ledger.

On Fresh & Easy's cost-side, its top-heavy senior management structure and team could be streamlined to reduce some expense, and some cost-saving efficiencies can also be gained in distribution and logistics, but the chain's labor and related costs are already relatively low and even cutting to the bone can't solve the Fresh & Easy Neighborhood Market loss problem.

In June when Tesco reported its first quarter sales and earnings it said overall sales at Fresh & Easy USA were up 37.8% (40.6% at constant exchange rates). Much if not most of that sales growth was due to the opening of several new stores early in 2010 rather than do to organic, same-store sales growth, according to our analysis.

However, a nearly 38% growth in sales in Q1 is significant. And assuming Q2 sales growth is similar (or even half the percentage amount), we should see strong half-year sales growth at Fresh & Easy, over fiscal year 2009/10.

In October 2009 Tesco reported a half-year loss of $135 million (85 million pounds) for Fresh & Easy, on sales of $267 million (168 million pounds). Sales grew over the half-year period by 115.4%. There were 126 stores at the time. There are 168 stores presently.

Lets do a little back-of-the-envelope estimating and discussion.

Fiscal year 2009/10 sales for Fresh & Easy was $544 million. Let's assume conservative first half 2010/11 fiscal year sales growth at Fresh & Easy of 58% (the 38% reported in Q1 and an additional 20% in Q2, mostly attributed to new stores opened during the period.) Even though we're being conservative, that's ample first-half sales growth to, under Tesco's "grow sales and reduce losses to break-even" scenario, expect a significantly smaller loss than last year's half-year loss of $135 million. And if the half-year sales growth is greater than 58%, then the expectation of lower losses should be even higher. If not, once again we'll be seeing substantial sales growth without any downward movement in the loss column.

So, let's use last year's $135 million reported half-year loss as our baseline for discussion about what Tesco will and should report for Fresh & Easy on Tuesday.

Our analysis is on Tuesday Tesco needs to report an interim (half-year) loss for Fresh & Easy of $88 million (best case scenario), at the lowest end, and a loss for the first half of the year of $115 million, at the highest end of our range. $115 million doesn't mean things are rosy, by the way.

If the number is $115 million or higher, it's our analysis Tesco is in the extremely severe danger zone with Fresh & Easy; it will once again have grown sales significantly without any reduction in losses.

If the number comes in on Tuesday at $88 million or below, we'll view that as decent but solid progress for Tesco with Fresh & Easy.

Anything between $88 million and $115 million should be viewed on a relative sliding scale (the closer to $88 million the better).

The analysis above is our own, based on extensive research and reporting on Tesco and its Fresh & Easy USA chain, rather than anything Tesco or Fresh & Easy Neighborhood Market has said or announced. In April of this year Tesco projected its fiscal 2010/11 full-year loss for Fresh & Easy would be about the same as in 2009/10, saying it would be in that $253 million range. [See - April 20, 2010: Strong Group Revenue & Profit For Tesco... But $253 Million Loss at Fresh & Easy.]

Unfortunately, especially for shareholders, Tesco won't breakout key industry statistics for Fresh & Easy when it reports its half-year sales and earnings on October 5. For example, the retailer won't breakout same-store (like-for-like) sales growth within its overall sales growth number. Doing so would be extremely valuable - and telling - because it would show what true percentage of sales growth can be attributed to new stores, compared to an increase in sales at the Fresh & Easy stores open for at least one year.

Additionally, Tesco won't offer any actual sales-per-square-foot figure for Fresh & Easy Neighborhood Market. Sales-per-square-foot is a key indicator of how a grocery chain is performing. The retailer doesn't break this figure out for any of its international operations, so it should come as no surprise it doesn't do so for Fresh & Easy. However, since we've been figuring Fresh & Easy's sales per-square foot for nearly three years as part of our research and coverage, let's just say if Tesco were to report that statistic that it would be at about 50% of where the grocer needs it to be at this point in time.

Lastly, not only won't Tesco report what its average gross margin is at Fresh & Easy, which is understandable, it won't even likely say in meaningful terms where it stands compared to the U.S. food and grocery retailing industry average.

Significantly improved gross margins are key to Tesco's breaking-even with Fresh & Easy. And while we don't know the exact blended average gross margin percentage for Fresh & Easy, we've been able to obtain enough information over time, including recently, to be able to say its far too low at present - primarily because of strong competition and heavy discounting, such as the continued chronic use of the 20% off store coupons, combined with less than planned volume for its private brand products (original plans called for at least 300 stores by now rather than the current 168, along with much higher sales at those stores open), which comprise about 60% of the approximately 5,000 SKUs sold in the Fresh & Easy stores.

In our analysis, the key variable to look for - the Canary in the coal mine if you will - on Tuesday regarding Tesco's Fresh & Easy Neighborhood Market, is how much of a loss there is relative to how much sales growth there is for the first half of fiscal year 2010/11. Remember, the trend is growing sales but increasing or static losses.

We don't believe Tesco can merely grow (via sales) itself to break-even and then on to profitability with Fresh & Easy USA - remember same-store-sales, sales-per-square-foot and gross margins, for example. But unless as job one it begins to reverse the trend of growing sales but increasing or static losses, it will, to borrow a phrase from former President George Bush Sr., continue to remain in "deep do-do" with Fresh & Easy USA.

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