For Tesco (TSCDY) and its shareholders, its U.S. subsidiary Fresh & Easy has been a tumultuous issue. Tesco management has been adamant in giving the new venture more time, but shareholders have been doubtful about the unit’s ability to thrive in a competitive U.S. grocery market. Warren Buffett, who is normally quiet about managerial action, came out against the operation and described the move as “foolhardy.”
Fresh & Easy suffered a first half loss this year of 74 million pounds ($118 million dollars), though the subsidiary’s losses has narrowed over the years. Management expects to breakeven by 2014 if not sooner. Recently Tesco announced it would sell Fresh & Easy products at its Tesco stores in the UK. This raised many questions as it appeared a move to shelter losses and create a false sense of brand equity with Fresh & Easy.
The U.S. Market
It’s obvious why shareholders don’t like the subsidiary. The U.S. grocery market is highly competitive with large players such as Wal-Mart and Costco making up a substantial part of the market. This article in Supermarket News conveys just how competitive the grocery market is in markets like Sacramento, Calif. Fresh & Easy carves out its niche alongside Whole Foods and Trader Joe’s in marketing to the more health-oriented consumer. While Trader Joe’s is privately held, Whole Foods is publicly traded and we can see from its financials that its margins and asset turnover is not that far off from that of Wal-Mart. The key difference is that Whole Foods’ cash flows have not been as steady as Wal-Mart’s and the grocer has significantly less debt bringing down its overall return on equity relative to Wal-Mart.
How Are Consumers Receiving Fresh & Easy?
Though sales are slowly picking up at Fresh & Easy, is it necessarily becoming a hit with consumers? I looked up the reviews of Fresh & Easy, Sprouts, Trader Joe’s, Whole Foods & Safeway/Von’s on Yelp.com and came up with following table. It wasn’t the most thorough statistical analysis as I simply picked the first four stores for each respective grocer in each respective region with at least 30 reviews. Nevertheless, it does give a fair idea of how well received each of the stores is.
Fresh & Easy was one of the better reviewed, but Trader Joe’s was clearly in a league of its own as can be seen. Interestingly, Fresh & Easy came ahead of Whole Foods. Should this be the case in other markets it would bode well for Fresh & Easy’s sales growth as it is still a relatively unknown grocer compared to Whole Foods.
The Architect of the Subsidiary
Sir Terry Leahy, Tesco’s CEO for the greater part of the last two decades, is credited with building the grocer to its current heights. Leahy conceived the “Clubcard” in the 1990s and pushed Tesco into foreign lands with great results. As he notes in his recent book Tesco was studying the US market since the late 90’s. At the time the market was very much fragmented and Wal-Mart had not yet made a serious incursion into grocery. Leahy said it was a better decision to start their own franchise rather than say paying $10 billion for one (as Wal-Mart had with Asda) as they could employ their world class competencies and international experience. Leahy doesn’t note in the book, but his attitude toward the U.S. would likely have been different had Wal-Mart been soaking up more than 30% of the grocery market.
Tesco's rollout of Fresh & Easy in 2007 worked against it from the start. Leahy said the timing couldn’t be worse as consumers generally hunker down in recessions and are averse to trying new brands. The real estate collapse was particularly painful as many of the Fresh & Easy stores were located in suburban parts of Southern California that completely emptied out. Leahy has not yet backed off the Fresh & Easy brand and remains optimistic it will perform in time.
Shareholders such as Warren Buffett are right that Tesco should have avoided the U.S. market. As the legendary investor said in an annual shareholder letter, “I don’t try to jump over seven-foot bars: I look around for one-foot bars that I can step over.” With Fresh & Easy and the U.S. market Tesco tackled the seven-foot bar. The U.S. market is nothing like that of the Eastern European, Thai or South Korean markets of the late 1990s that Tesco conquered so easily. The U.S. market is crowded with some of the best competition so profits and market share won’t come easy.
Tesco is certainly a world-class grocer, but as Fresh & Easy continues to struggle, it also consumes the precious time of management. Wasteful capital allocation can dent shareholder returns, but misallocating human capital could very well be more punishing for a company that has the best talent. Had Tesco not invested so much time and personnel in Fresh & Easy would its domestic UK operation still be mired in the problems it has today? Maybe it wouldn’t have, but there’s no point dwelling on the past. In economics there is a concept known as the “sunk-cost fallacy.” Loosely speaking, it describes the wrongful rationale in continuing with a project even if there are more valuable opportunities elsewhere only because so much time/money had been invested in the initial project (the sunk cost).
Hopefully Tesco does not see Fresh & Easy this way. A great deal has been invested in the venture, but that doesn’t mean the project has to be a capital sinkhole. Quite simply, if there are better opportunities elsewhere, Tesco should steer the ship in this direction and away from the U.S. market.
Disclosure: Long Tesco