Cheerio then, Sir Terry – you're a hard act to follow

Leahy made Tesco Britain's biggest grocer, but his successor may have to shrink it. And the group's new bank could be first for demerger, says Richard Northedge

Sir Terry Leahy spent his career building Tesco into Britain's biggest grocer. However, it may be the task of his successor, Philip Clarke, to break up the company. Shrinking Tesco might satisfy the critics who believe it has become too large, but the pressure to split the company could come from investors who fear the group's breadth will damage its value.

The retailer that once piled it high and sold it cheap now has a product range that extends from food to furniture and from mortgages to motor scooters. Its outlets stretch from its Cheshunt headquarters to China, and its customer base ranges from buyers of its low-cost Value goods to purchasers of high-quality Finest items.

Its 4,811 stores range from corner shops to mighty megastores. The 480,000 staff rang up sales of £63bn in the year to January, giving Tesco 31 per cent of the UK grocery market and £1 in every £7 spent by British shoppers.

If Clarke proposed to hive off part of the group, he might look at the 2,329 international stores that he currently runs and which provide a third of turnover, or split off non-food products. But if the group is to be divided, the part to stand alone could be the new bank Tesco is soon to roll out.

Tesco has offered financial services since Leahy's predecessor, Ian MacLaurin, set up a joint venture with Royal Bank of Scotland in the 1990s. The section has grown steadily, offering insurance, credit cards and loans. But when the credit crunch hit RBS, the bank was eager to sell its half share in the venture to Tesco for £950m and to degear its balance sheet.

Tesco Personal Finance, now wholly owned and renamed Tesco Bank, is being primed to become a major competitor to the high-street banks. Already, six million customers buy Tesco financial products and have deposited £4.4bn with the company, but later this year the group intends to launch a savings account and a range of mortgages; then in the second half of 2011 it will launch a current account.

The group hopes to capitalise on customers' discontent with their current banks, and their lost trust in traditional financial organisations. If Tesco can capture just a fraction of the market share it already has in groceries, it will become a major bank. Liz Hartley, principal consultant at Datamonitor, forecasts that despite the British inertia in changing banks, Tesco will be one of the top 10 banks within three to five years.

However, the bigger the bank grows, the more it changes the company. Selling fridges or fashion was diversification, but these are still goods bought and quickly resold at a profit, just like food. Banking is different. It involves stacking the Tesco balance sheet with liabilities – the savings taken in, and interest paid on them – and loading it with loans. And banks are valued very differently from retailers.

Tesco's shares are priced by investors at more than 15 times its profits, for instance – a premium to rivals such as Morrisons, Marks & Spencer or Sainsbury's that have price-earnings ratios of 10 to 12. Banks, however, are valued by net assets and their profit ratios are almost meaningless, with HSBC on 36 while loss-making RBS and Lloyds have no ratio.

Combining a retailer with a bank risks damaging the group's £32bn valuation: investors who want a supermarket undervalue the financial side and would-be bank shareholders fail to appreciate the trading operation. It is because one business could drag down the value of the group that most diversified conglomerates – from Hanson to Great Universal Stores – have demerged. BAT tried to combine financial services with retailing by owning Allied Dunbar and Argos, but realised they were worth more independently.

Sam Hart, a retail analyst at stockbrokers Charles Stanley, says: "For the time being, the bank revenues are relatively small in the scale of things, so they'll continue to value it as a retailer. But if the bank accounts for 20 or 25 per cent of profits, that would start to raise issues."

But Clarke and Leahy are already thinking on that scale. They reckon service businesses will contribute £1bn a year profit, probably within five years. That includes Tesco's phone and internet services too, but the bank could account for £600m. And, after tax, profit from the whole group last year was £2.3bn.

Banks also tie up capital – with regulators demanding even higher reserves following the crash. Tesco Bank's £5.7bn balance sheet gives it a healthy tier-one capital ratio of 13 per cent, but as the business booms the group will have to back up savers' deposits with even more capital. The bank also has over £200m of cash lying in its vaults just to provide liquidity, but investors may see that and the reserves as dead money which could be better used to finance store expansion. And while Tesco is currently reducing the debt financing of its core business, it will increasingly take on borrowings at its bank.

Tesco plans to be a conservative banker, however. It lifted the bank's trading profits to £250m last year, despite lower interest rates cutting revenues. It deliberately shunned high-risk drivers, even though that hit motor premiums and it boasts a dedicated risk team that uses credit-scoring and affordability criteria to decide on loans. Even so, bad debts rose 32 per cent to £177m.

And bad debts are not something shareholders in supermarkets expect to see – strengthening the case for splitting the bank from the core business. As a separately listed company, Tesco Bank could jump straight into the FTSE 100 alongside its parent.

Demerger is not something Clarke is planning as soon as he becomes chief executive next spring. "It's business as usual," he says. "I've got an extremely big responsibility when I take over in March to support the 480,000 people that every day have to be there, and make sure customers get what they want." Rolling out the banking concept abroad is higher up his agenda than a demerger.

Darren Shirley, of the stockbroker Shore Capital, says: "You can never say never, but I think it would be some way away".

There would be problems to overcome in hiving off Tesco's bank. Unlike some other groups, Tesco offers all its products and services under a single name – indeed, it uses the strength of its brand to move into new markets. And whereas firms such as Virgin or Metro are seeking branches to build banking empires, Tesco will use its existing stores. The bank will also exploit the data from customers' Clubcards. So even if the bank's finances are always kept separate from the retail business, the two would need an agreement to use premises and names.

"The banks are going to be situated in-store and open Monday to Saturday, so they are going to be integrated," says Shirley.

Hart concedes that demerging the bank is possible in the long term, but says: "Part of the reason customers trust Tesco Bank is the financial backing that the core part of the business gives them. But once it gets to a significant size, it's going to raise certain issues and investors will struggle to analyse the part of the business that is not directly related to their area of expertise."

And if Clarke matches his predecessor's 13 years in the chief executive's chair, some think he will have to decide if Tesco is too mammoth to manage and too diverse to digest.

"Sure, there are going to be changes in the future, but I don't know what they are. I'm just getting over the shock of knowing I'm going to be chief executive," he says.

"But if we can do in the next 10 years what Terry has done in the past 10 years, we're going to be an awesome business. And that's what I hope we become – awesome."

Trading's tough on the high street

Tesco will be back in the spotlight this week, when it announces its latest trading update. Rival Sainsbury's will be doing the same in a busy week for the City.

Investors will be keen to see how well the supermarkets are coping with slowing food price inflation, as consumers get more careful with their spending.

Tesco could be helped out by the weakness of the pound, as the chain continues to expand abroad. Fresh & Easy, above, the supermarket's well-publicised push into the US, had 145 stores at the end of the 2009/10 financial year, with sales of £354m.

Sainsbury's chief executive, Justin King, warned last month that he expected "the environment will remain challenging and consumer spending will be under pressure". However, the balance sheet was still strong enough for £900m to be used on capital expenditure last year.

Majestic Wines will announce its 12-month results tomorrow, though these will not be in time for what is expected to be a strong bounce during the football World Cup in South Africa.

Tesco shares closed at 394.2p on Friday, down 1.83 per cent on the start of the day's trading. Sainsbury's slipped 0.52 per cent to 321.4p, while Majestic increased 4.5p to 275p.