Is there no stopping the Tesco success story?

As Tesco reports a surge in sales and profits, the imminent Safeway takeover could spell trouble for the UK's favourite grocer

Another day, another chocolate-frosted performance from Tesco. The supermarket chain smashed City expectations yesterday to report another strong surge in sales and profits, further extending its lead over the rest of the UK food retail sector and its influence over our lives.

As the group's insatiable appetite for more places to unfurl its red, white and blue banner gathers pace, it is hard to recall a time when that familiar trio of colours represented anything other than the country's number one grocer. That fact was underlined by the 6.3 per cent leap in the company's comparable second-quarter sales and the 21 per cent jump in underlying pre-tax profit to £661m for the first half. Not to mention the 17 per cent rise in group sales to £14.9bn.

Yet as Andrew Higginson, the group's finance director, says: "It's easy to forget that 10 years ago the two failing food retailers in the UK were Tesco and Asda....And 20 years ago, before the market consolidated, you never would have picked Tesco as a winner". Back then, the group's image was distinctly downmarket. Tatty shops stuck in dreary town centres like Uxbridge were the order of the day, not state-of-the art new superstores such as that opened in Hove earlier this week.

Despite the company's recent stellar track record - it has dished up 26 per compound like-for-like sales growth over the past five years - Mr Higginson is cautious. "The thing about our industry is that things can change pretty quickly," he warns. Just how quickly could became clear sooner than even Mr Higginson may imagine, once the Government publishes its impending verdict on the competition probe into the five-way £3.5bn bid battle for Safeway.

Mark Hughes, a food retail analyst at Numis Securities, says: "Structurally, something very important is happening to the sector over the next six months. There are risks around the corner for Tesco that it hasn't really faced for the past three or four years".

Sir Terry Leahy, the group's chief executive, may dismiss the impact of a negative outcome for Tesco's own takeover offer, claiming: "We love competition. It makes us a better business," but others aren't so easily convinced. "Despite their platitudes, they must be very concerned about it," Paul Smiddy, at Robert W Baird Securities, said.

Meanwhile, Mr Hughes reckons Tesco has most to lose from the Safeway takeover, which will remove a weak number four from the market. Although Tesco was quick to join the bidding frenzy that was sparked at the start of the year when William Morrison's unveiled plans to merge with Safeway, no one ever thought Tesco was in with a chance. "Tesco may have 27 per cent market share but if Safeway's 10 per cent is taken up by Morrison and Wal-Mart's Asda, then Tesco will be up against much tougher competition than previously," Mr Hughes said.

Luckily, the group is not exactly being complacent. Its four-pronged strategy for producing double-digit profit increases is well ingrained, with growth coming from its core UK business (thanks to its new store-opening programme and the march it stole on the convenience store market with last year's acquisition of T&S); its move into selling non-food products; its provision of services such as banking and telecoms; and its overseas expansion.

Of the four, it is perhaps the growth of the non-food side of the business that is most exciting, especially against the backdrop of a weak international economy, which is still affecting several of the 10 countries it has stores in outside the UK.

Although the group doesn't split out exactly how it is faring in each of its non-food markets, Sir Terry was offering tantalising teasers yesterday. He said sales growth of its three clothing lines - Cherokee, Florence and Fred, and Tesco - outstripped the rest of the clothing market by a rate of six times during the past six months, giving it a market share of 4.4 per cent. Meanwhile, the supermarket group sold more volume of medicines and toiletries than Boots and Superdrug combined and more chart CDs than Woolworths or Virgin. And it grabbed a quarter of the market for sales of the latest Harry Potter book, beating specialist retailer WH Smith and forcing it to issue a profit warning just last week.

With just a 5 per cent share of the non-food market and a 12.3 per cent share of the total UK retail market, the group is confident it still has plenty to play for, although Sir Terry ruled out mimicking Asda's recent launch of stand-alone clothing stores under its George label, saying Tesco could make "better use" of its space.

Mr Higginson says there isn't a secret to Tesco's success. "This isn't a monopoly business, no one is forcing people to shop at Tesco". He puts the group's transformation down to two simple factors: listening to its customers and acting on their recommendations (the group's customers apparently designed the 400 stores to enjoy a makeover recently); and its staff.

Treating its employees well - its has 320,000 worldwide - pays off in spades in terms of their dedication to the company. Sir Terry, 47, who took over as chief executive six years ago, joined as a graduate aged 22, while David Potts, the company's retail director, started out stacking shelves aged just 16. And while management continuity is important - helping Tesco to avoid the "crisis hires" of most of its competitors, in the words of one analyst - Tesco isn't afraid to bring in fresh talent. It hired John Hoerner, the former Burton group boss last year, to help advise it how to boost clothing sales.

Although Tesco has managed to attract a broad church of shoppers by stacking its shelves with a product range that uniquely appeals to all social classes, it is perhaps price that is the biggest driver of footfall. It has already invested £150m to cut prices this year and pledges more where this came from. Who knows, if Asda scoops Safeway, Tesco's pricing may have to get keener still.

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