A retail revolution?

Yesterday Tesco, the UK retailer, announced that its full-year pre-tax profit dropped by more than 50%, recording the worst performance in the company’s history. This is a result of a L2.4bn writedown. When you have to write down investments, you better do it all in one go so your reporting basis is nicely reduced and next quarter (or year) you can show both “healthy” growth and positive result. So Tesco took all its dirty laundry out and simultaneously wrote down its US venture, Fresh & Easy, to the tune of L1bn, took a surprise L804m property writedown in the UK for projects it will no longer pursue, and rounded it with a L495m writedown in CEE and a L115m provision for mis-selling of a financial product. Altogether, this sent full year pretax profits down from L4bn in 2011 to L1.96bn in 2012, on sales of L72.4bn worldwide. Margins peaked at 6.2% in 2010; yesterday Tesco reported 5.2%.

There were times when Tesco could do no wrong. The previous CEO, Terry Leahy, was revered by investors and peers alike, so much so that he was knighted in 2002. Under Sir Leahy’s watch, the retailer grew relentlessly both at home and internationally, becoming the third largest global retailer, building up a bank, a mobile telecoms operator, a L1?billion-a-year clothing business, the UK’s biggest e-commerce and one of the top five retailers for books, toys, electrical equipment and home products. It expanded with shops in Asia, Australasia, Europe and America and grew into a giant with a market capitalization of L35 billion. When Sir Terry left Tesco in 2011, Paul McCartney appeared in his farewell video, telling him to come and join his band.

Well, that seems to be a thing of the past. Commentators today say that Sir Leahy took Tesco on a path of too aggressive international expansion. One of the larger bets of that time was to roll out a new supermarket chain, Fresh & Easy, in the USA. The Fresh & Easy chain employs about 5,000 people and has about 200 stories in Arizona, California and Nevada but failed to ever make money as Tesco seems to not have figured how Americans want to shop or what they want to buy. Tesco launched it in 2007 and after about L1bn of accumulated trading losses and a L1bn writedown, the company now finally acknowledged that it could not afford to keep trying anymore. The new CEO Philip Clarke pulled the plug. The rest of Tesco’s international businesses are a mix of the good, the mediocre and the ugly. The good ones are Korea, Thailand and Malaysia, where Tesco achieves about 15% of return on capital, close to UK levels. Central & Eastern Europe, hit by recession and fiery competition from discounters, has fallen below 7%. Turkey, China and India, the main development markets, are still recording losses. Chinese expansion in particular was sharply reined in as Tesco complains that too much capital is chasing too few customers in China.

But there is more to worry about. In the UK, the home market where Tesco still generates 60% of its sales, Tesco issued a profit warning and says that it is quitting a race to build more large stores. A strategic decision has been adopted to move away from the real estate expansion and rather to focus on online presence and on convenience shops. It means that some 100 sites for new Tesco hypermarkets, which the retailer bought in the UK some 5-10 years ago, will no longer be developed. Tesco has simply concluded we are now moving into a new, multi-channel retail world. When commenting on the failure of its US business, Mr Clarke said that despite extensive research undertaken into the US shopping habits before entering that market, this research was done in 2004-2005. The world of retailing is so different now, he said. Who was shopping on a smartphone back then?

Indeed. So if there is no real estate expansion to eye, what will the retailing giant do? Tesco has just spent L49m buying a family-friendly restaurant chain called Giraffe as it strives to revive its UK business. The chain of more than 40 restaurants, pretty and popular as they are, seems a bit too little to move the dial and not entirely consistent with one’s idea of retailing. But Tesco aims to bring the restaurant chain inside its stores, to make them a more attractive place for families to spend time in, shopping mall style, and potentially to use up some of the space in its big stores as demand for more and more non-food items migrates online. Tesco has realized that food court offering is actually not an afterthought but rather it is central to the business proposition and a customer appeal of a mall. It sees no reason why supermarkets shouldn’t try to emulate it. Prior to Giraffe, Tesco invested in an upscale coffee chain Harris + Hoole and a chain of premium bakeries called Euphorium Bakery. Analysts believe that Tesco is accumulating a portfolio of propositions that can be selectively incorporated into and around its larger stores. They expect to see a combination of a realignment of space to food, the stores shrinking and more space being given to both online shopping pick up points (called Click & Collect in Tesco) and to service formats.

Evolving Tesco's biggest hypermarkets by installing restaurants and cafes is one part of the new strategy. The other one is expanding the retailer's business online. Tesco’s digital strategy includes further growing Tesco Direct and Tesco Marketplace, a third party online trading platform. Tesco Direct is the only UK online food retailer (though they do huge amounts of general merchandise as well) which is profitable and has been so since 2006. It is planning to increase its product range from 75,000 to an unbelievable 200,000 products. Tesco is no longer just a supermarket either, it is also a media and data company. Its recent acquisitions include Lovefilm, internet-based DVD rental service, Blinkbox, online movie streaming service, and We 7, a music download platform. Tesco is now busy building music and movie catalogues in the cloud. Tesco is striving hard to become the first true multi-channel retailer, that is to achieve an endless shelf, a fully integrated product offering seamlessly available both in brick-and-mortar stores and online. In its UK stores it experiments with using augmented reality which is allowing customers to browse the entire clothing range available in a particular store as well as the online catalogue, using magical mirrors in special dressing rooms which project the clothes on the customer or on digital mannequins. It has developed a very popular interactive app, partnered with Apple to deliver Tesco Clubcard holders their loyalty vouchers redeemable in i-pads and i-phones. It works hard on social media integration and social games. BBC Good Food website, the most popular cooking site in the UK, has linked Tesco Ingredients into a shopping basket so when you are browsing recipes to cook, it will come up with a complete Tesco shopping list, which you can then order online and have delivered.

“Apps are the new high street”, says Mr. Clarke. You better take his words seriously as Mr Clarke isn’t a 19-year old hood-wearing Silicon Valley protégé who wants to believe his own hype. Mr Clarke has started his career stacking shelves in his local Tesco and has been working his way up the company ladder since 1981. So grab your smart phone and go for it…