Philip Clarke's Early Welcome to America: Tesco Logs $151 Million Half-Year Loss For Fresh & Easy Neighborhood Market

Analysis

Tesco today reported a first-half fiscal year 2010/11 loss of £95 million (British pounds) - $151 million U.S. - for its U.S. Fresh & Easy Neighborhood Market fresh food and grocery chain, despite reporting first-half revenue (ex-Vat) of £244 million - $388 million - which is a 47% increase over the same period last year.
[Despite its big loss with Fresh & Easy, Tesco today reported an overall first-half pre-tax profit of £1.6 billion - $2.54 billion - which is a period-over-period increase of 12.5%, on sales of £29.8 billion - $47.35 billion - a 7.1% increase over the same period last fiscal year. (The revenue and earnings figures exclude value added tax, or VAT.) Prospects were considerably improved in its Asian operations. Tesco's group earnings exceeded most analysts estimates and were met well overall, with the retailer's stock rising slightly at the close of the markets today. You can read Tesco's half-year report here.]

The £95 million - $151 million - loss at Fresh & Easy Neighborhood Market is an increase of £10 million - $16 million -over the FY 2009/10 half-year loss of £85 million - $135 million.

Tesco said a "significant" amount of the higher loss was do to its buyout earlier this year of Wild Rocket Foods, Fresh & Easy's former in-house produce supplier, and 2 Sisters Food Group, it's former in-house meat supplier.

Tesco said today it bought the trade and certain assets and liabilities of 2 Sisters Food Group,
Inc. for £52 million ($82.9 million) on June 18, 2010, and on July 19, 2010 it acquired 100% of the ordinary share capital of Wild Rocket Foods, LLC for £64 million ($102 million). The two acquisitions though were combination cash and other consideration deals. Tesco paid out £45 million ($72 million) in cash in the combined deals. The remaining £71 million ($113 million) was in other considerations. See here.

Riding in the danger zone

As we noted in our piece yesterday - October 4, 2010: Tuesday's Tesco Interim Report Offers A Road Map of Sorts For the Future of Fresh & Easy Neighborhood Market - its our analysis that if Tesco reported a loss today for Fresh & Easy of $115 million or higher, it would be in what we term the extremely severe danger zone. It did - to the tune of $151 million - and it is.

Were it not for the $72 million in cash spent to buy Wild Rocket Foods and 2 Sisters Food Group, Tesco's first-half loss for Fresh & Easy would have been closer to or even below our $115 million baseline. But we, and Tesco, live in the real world. Therefore, playing numbers games by not including the $72 million would be mere foolery.

Speaking of foolery, it was a foolish move in the first place, as we said long before Tesco bought out Wild Rocket and 2 Sisters, to bring a produce and a meat company from the UK to California and create these two in-house suppliers for Fresh & Easy, since California is the fresh produce supplier mecca of the U.S. and has premier fresh meat suppliers like Coalinga-based Harris Ranch and others. And it's a move Tesco is paying for today with its half-year loss number.

Plenty of hat but not much cattle

Tesco CEO Terry Leahy, who is retiring in early March 2011 and will be replaced by Tesco veteran Philip Clarke, currently the head of the retailer's European and Asian divisions, today put a polished face on the out-sized loss fat Fresh & Easy USA.

For example, he said Tesco plans to have 400 Fresh & Easy stores open and operating by the end of its 2012/13 fiscal year, which ends in February 2013. That means Tesco would have to open 232 new stores - there are currently 168 units - between today and mid-February 2013, which is a pace considerably more aggressive than its done in the last three years. It amounts to Tesco opening 64 more stores, in a less than two-and-one-half-year period, than it has opened in a nearly three-year (next month will be three years) period, from November 2007 -to- November 2010. The first batch of Fresh & Easy stores opened in the last week of November 2007.

We can't help but noting how this rhetoric sounds familiar. Tesco originally said, and continued saying so until about late 2008, it would have at least 200 Fresh & Easy stores opened by the end of 2009, with a total store count of at least 300 units by the end of 2010. As mentioned, there are currently 168 Fresh & Easy stores. Based on our reporting Fresh & Easy won't hit the 200 store mark by the end of this year.

Tesco also said today it plans to break-even with Fresh & Easy by the end of its 2012/13 fiscal year, using the 400-stores opened marker as what's needed to break even. In our analysis that's one predication piled on top of another.

However, incoming CEO (March 2011) Philip Clarke said only recently he plans to look at Fresh & Easy USA from top-to-bottom, including visiting numerous stores and spending time at the chain's headquarters in El Segundo, California, shortly after he takes over the leadership of Tesco.

But it appears that was then. He now seems on board, indicating such a full review won't be done. "There's no need to carry out some big strategic review," he said today. "It's clear that continuing, and moving toward profitability, is the right thing."

Trick or Treat: 'Mothballing' 13 stores

Tesco also announced today it's "mothballing" (read closing) 13 stores - six in metropolitan Phoenix, Arizona; six in metro Las Vegas, Nevada; and one in Moreno Valley, in Southern California's Inland Empire region - by November 2. It's currently trying to sublet the stores to other retail tenants. If it can't do so, which it likely won't be able to by November 2, it will board them up and perhaps open them in four or five years, said Clarke, who's already working hand-in-hand with CEO Terry Leahy as part of the succession process.

Incoming Tesco CEO Clarke said today Tesco's reason for closing the 13 Fresh & Easy stores is because the populations in the three regions has shrunk, as well as attributing the "mothballing" of the 13 stores to the high percentage of housing foreclosures and high unemployment rates in the three regions. Inside tip: Most if not all of the 13 Fresh & Easy stores Tesco is closing are C-level stores, meaning they're among the worse performing units in the chain. Fresh & Easy C-level stores are those doing $50,000 or below in weekly sales.

Tesco currently has just 34 stores (28 after November 2) in metro Phoenix and even fewer, 27 units (21 after November 2), in metropolitan Las Vegas, Nevada. In contrast, Walmart, Kroger's Fry's, Safeway Stores, Inc., Albertson's and Bashas' all have 100-plus -to- 200 stores in Arizona, with the majority of their respective units in metro Phoenix, where the vast majority of Arizona's residents live.

Regarding metropolitan Las Vegas, we first said in mid-2009 (and have repeated since) that, based on the performance to date of its Fresh & Easy stores in the region, Tesco shouldn't open any new units in the market in the foreseeable future. It's basically done just that, having opened just one store, at 5639 Centennial Center Boulevard, this year, on March 17.

We don't see much of a problem with closing six stores in the region - after all we've said in the past that Tesco could close a fourth of the 27 Metro Las Vegas stores without experiencing an appreciable drop in sales - except that Tesco is only in four general market regions with Fresh & Easy: Southern California; metro Phoenix, Arizona; Bakersfield and Fresno in California's Central Valley; and metropolitan Las Vegas. If 27 stores is maxing out in Vegas, what does that do for Fresh & Easy's growth potential in the market, as well as overall?

Metropolitan Phoenix, Arizona is much different though. By closing the six stores in the market Tesco is essentially saying it's maxed out in terms of store-count - at the current number of 34 - in the market. That's fewer stores - and much less food and grocery retailing square-footage - than all of the market's leading grocers, as well as far less than second-tier players like Sprouts Farmers Market and a few others.

For example, in terms of overall square-footage, in addition to the store-count numbers for the key metro Phoenix market leaders mentioned above, the Fresh & Easy stores are just 10,000 square-feet each, while the Safeway, Fry's Albertson's and Basha's stores all average 30,000 square-feet (at the low-end) -to about 55,000 square-feet in size. Most of Walmart's stores in Arizona are supercenters. About 40,000-50,000 square-feet is devoted to fresh foods and groceries in the average Arizona supercenter. It also has numerous Neighborhood Market supermarkets in the metro Phoenix regions, which average about 40,000 square-feet. It also has four 'marketside by Walmart' stores, which average about 15,000-18,000 square-feet.

By closing the six stores, Tesco is essentially doing a complete 180 degree turn in its "critical mass" strategy, which calls for having many stores - 34 less six isn't many - located about 2.5 miles from each other in a market region, like Metro Phoenix. It's also stopping short of even coming close to being a player in Metro Phoenix. Walmart (number one in market share), Fry's (2), Safeway (3), Albertsons (4) and Basha's (5) are the top five market share leaders in the region.

Additionally, Trader Joe's, Costco, Whole Foods Market, Sprouts Farmers Market and Sunfllower Farmers Market all have more market share in metro Phoenix than Fresh & Easy does. At present, Fresh & Easy doesn't even register as one of the top 10 market share players in the market. It's not even number 12 or 13, by the way. Niche's can be good for some grocers in metro Phoenix, such as Trader Joe's or Whole Foods, but it's not what Tesco ever planned for Fresh & Easy. And there's already key niche players like Trader Joe's, Whole Foods, Sprouts and Sunflower Farmers Market in the region.

The Arizona situation should give Tesco serious worry, as to a lessor but real degree the metro Las Vegas situation should. However, since the stores are performing so poorly, under $100,00 in average weekly sales, it makes sense to close them.

Will this new dog hunt?

In its report today Tesco attempted to put a polish on the 13-store closing announcement by saying it plans to re-launch its aggressive new store opening schedule by focusing on stores in regions where the economy is doing better. That would be mainly coastal Southern California, a couple inland areas in the Southland like Orange County, and Northern California, where the majority of the new store openings will be.

The retailer said today it plans to open 19 new stores over the next six months, "with a continued focus on areas where the local economy has been less severely hit and where we are seeing substantially stronger sales performance."

That Tesco is emphasising its new Fresh & Easy Neighborhood Market store openings in California is far from news at Fresh & Easy Buzz. We've been reporting on Fresh & Easy's new store openings in a series of stories all year long. [Read those stories here]

For example, Tesco has opened 39 Fresh & Easy stores so far in the 2010 calendar year - five in January, nine in February, three in March, 11 in April, and 11 in September. Of those 39 new stores, 35 units are in California. Just four of the new stores are in Arizona, with no new stores opened so far this year in Metropolitan Las Vegas.

Focusing its new Fresh & Easy store openings on parts of Southern California and the new market of Northern California, where Tesco plans to open its first batch of stores in early 2011, is far from a sure thing though.

First, in terms of Northern California, as we've been reporting since April in our ongoing 2010 'Northern California Market Region Special Report' series, the region is rapidly becoming one of the most competitive food and grocery retailing markets in the U.S. [Read the stories in our series here.]

For example, as the stories in our series describe, Walmart and Target are expanding significantly in Northern California. New entrants include Sprouts Farmers Market, Henry's Farmers Market and Sunflower Farmers Market. Whole Foods Market and Trader Joe's are growing their respective store-counts in the region in a very serious way.

Additionally, Costco is a major player in Northern California, with plans to be even bigger. Number one Safeway and number two Save Mart-owned Lucky Stores are forces to be dealt with, as is 134-store Raley's. Independents are also a major force in Northern California, including many multi-store operators like Andronico's, Lunardi's, Mollie Stone and others.

Southern California is only getting more competitive as well. As we've previously reported, WinCo Foods is increasing its store-count in the region, as well as building a 1 million-plus square-foot distribution center there. Smart & Final plans to open its first SmartCo Foods store in Southern California by the end of this year or in early 2011, with many more to come. Sprouts and Henry's are growing fast in the region, as is Trader Joe's, which is headquartered in Southern California, where the highest number of its stores are located. Ditto Whole Foods Market - growing fast in the region.

Further, as in Northern California, Walmart, Target and Costco all are focused on the Southland. And we haven't even mentioned Kroger's Ralphs, Safeway's Vons, Albertson's or Stater Brothers, which along with Trader Joe's comprise the five market share leaders in Southern California. Fresh & Easy, which has 93 stores in Southern California, isn't number six, sever or even eight in terms of market share.

Making California dreaming reality

The San Francisco Bay Area and Metropolitan Sacramento region, the two areas of focus for Tesco with Fresh & Easy in Northern California, along with the areas the retailer plans to focus on in Southern California, are all super-competitive, with more competition on the way. The market regions are far from slam dunks.

Additionally, if it wants to be competitive launching in Northern California with Fresh & Easy, it's going to cost Tesco a considerable amount of investment in the form of promotional merchandising and marketing monies. Labor and related costs also are higher in the region than in Southern California, Arizona and Nevada. Tesco has found this out because even though its offering higher salaries for store managers in Northern California than in its other market regions it thus far hasn't had much luck in getting existing managers to transfer north, according to our sources.

In order to make break-even by the end of its 2012/13 fiscal year - the end of February 2013 - as it said it would do today, Tesco has a little over two years to make some serious changes and reverse its fortunes. It's been averaging annual loses of $200-million plus for the last two fiscal years. And today's $151 million half-year loss blows that average up in the northward direction.

On a positive note, Tesco CEO Leahy said today Fresh & Easy's same-store sales (like-for-like) increased by 10% over the period. We're surprised Tesco reported it, since it hasn't in the past. Although since it's a positive number this time, it makes sense it did so.

But on a negative note, Tesco reported a -38.9% trading profit margin for Fresh & Easy, which is very bad news. With a negative margin percentage like that getting to break even is pure pick-and-shovel work at best.

As we've said in Fresh & Easy Buzz for nearly three years - never rule Tesco out. But unless the retailer makes some significant changes in its strategy and operations with Fresh & Easy, that "ruling out" window will soon start closing at a fairly rapid rate, in our analysis.

[Read this related story - October 4, 2010 Tuesday's Tesco Interim Report Offers A Road Map of Sorts For the Future of Fresh & Easy Neighborhood Market- for additional analysis.]

(Editor's Note: Fresh & Easy Buzz used the Google Finance currency converter calculator to make the British pound-to-U.S. dollar conversions. The conversions are as of today's exchange rate. The dollar amounts are rounded to the nearest whole.)