Recession slows the Tesco juggernaut

The grocer has posted some of its worst results in 16 years as its tries to withstand the pressure from its discount rivals and the global downturn. James Thompson reports

Tesco, the UK's biggest retailer, posted its worst underlying UK sales for 16 years yesterday. The admission raised fresh fears that the juggernaut UK growth of Tesco may be grinding to a halt and that its 30 per cent-plus share of the grocery market may be its as good as it gets.

More specifically, Tesco is being buffeted by fierce competition from rivals such as Asda, Morrisons and Aldi, which are perceived to be stronger on price. Some industry experts also contest that the grocer's launch of hundreds of own-label discounter products in autumn was a knee-jerk reaction that confused customers and hit sales. And there are concerns that Tesco could struggle to maintain its international growth amid recessions in countries where it operates.

So how healthy is Tesco; how vulnerable is it to a deep global recession; and what are the threats and opportunities it faces in the UK and abroad?

Despite critics seizing on Tesco's UK figures, many sickly retailers would give their right arm for its overall financial performance. For the 13 weeks ended 22 November, it posted group sales that were up 11.7 per cent, partly driven by buoyant international sales up 14.6 per cent on current exchange rates. Citi, the investment bank, forecasts Tesco's global pre-tax profits will be £2.9bn in 2009.

Lucy Neville-Rolfe, Tesco's corporate and legal affairs director, said: "It [group sales] shows the value of our strategy 11 years ago to broaden the strategy away from the UK."

However, in the UK the picture is not so rosy. Total sales grew by 5.9 per cent over the quarter but the sector focused on like-for-likes sales, excluding fuel, which at 2 per cent represented Tesco's worst performance for 16 years.

The underlying sales figure of 2 per cent is way behind the most recent figures posted by Asda - 6.9 per cent in the third quarter - and Sainsbury's - 3.9 per cent in the first half. Aldi, the discounter, has also hurt Tesco this year.

Jonathan Pritchard, an Oriel Securities analyst, said: "They are haemorrhaging customers to Aldi and Asda. This has become a more sustained trend and it appears that momentum is with others at the moment."

According to TNS Worldpanel data, huge swathes of Tesco customers, based on the value of sales and not volumes, are switching to its rivals.

While Ms Neville-Rolfe said that in a typical downturn Tesco would lose some customers to the likes of Asda and Iceland, "What we have been losing to Aldi we have stopped."

Tesco claims it is taking market share from Morrisons but the Bradford-based grocer's expected underlying sales of more than 7 per cent, to be unveiled tomorrow, will blow Tesco's out of the water. There are several reasons why Tesco is feeling the squeeze and the gloss has come off its underlying sales.

First, the retailer accounts for £1 of every £7 spent in the UK and, as a result, when UK Plc catches a financial cold then Tesco is bound to get the sniffles at the very least.

Mr Pritchard says: "There is no way they can have it both ways. They have to accept that when things go bad for the general retail sector they have to take their medicine, as they have lost the element of defensiveness being a pure food retailer brings."

Tesco said that non-food sales were weak in its third quarter, "showing a small decline on a like-for-like basis", meaning that sales of products such as clothes and TVs had fallen.

Overall, Tesco largely attributes the decline in UK underlying sales to falling food price inflation, fierce price reductions and the launch of its discounter- branded products. Some industry experts believe that Tesco took a gamble by introducing the hundreds of discounter-branded products, such as Trattoria Verdi for pasta and Packers for tea. Tesco did so in September to fight back against the discounter, notably Aldi. The launch was the biggest change to its ranges since its value lines were introduced in 1993.

Tesco said: "By giving our customers more affordable choices, we have deflated our sales during the quarter by between two and three percentage points." Ms Neville-Rolfe said that Tesco had planned for just the decline in underlying sales growth to 2 per cent in the third quarter, as inflation across the sector fell, adding that the discounter brands would attract more customers ahead of what is likely to be a tough trading environment next year. She said: "Given what we face next year we feel this is justified."

Among City analysts, the discounter own-label range divides opinion. Mr Pritchard is not convinced so far.

He said: "The top line [on the discounter products], cash gross profit and the gross margin are less, but at least it is better than them going to Asda. We are not convinced that the "discounter" range is the answer to Tesco's domestic woes."

However, yesterday, Sir Terry Leahy, Tesco's chief executive, said that more than 300,000 extra customers had shopped at its stores each week over the third quarter and that it was starting to see strong improvement in sales.

Darren Shirley, the Shore Capital analyst,says that Tesco's discounter push is nothing new; it launched the products in its stores in central and Eastern Europe years ago to combat the discounter threat in countries such as Poland and the Czech Republic.

"It is not a knee jerk reaction. They took lessons from central Europe while they fought the discounters and the [UK] seems to be buying into it. In the short term, it seems to have stimulated volumes but in the longer term it remains to be seen. But the early signs are encouraging."

Beyond these shores, Tesco faces potentially prolonged recessions at worst and tough trading in a number of the markets where it operates, including the United States, the Republic of Ireland, Japan and Hungary.

Mr Pritchard said: "Things are less rosy in Europe: the Irish economy is struggling – Tesco is thankful that it doesn't sell non-food over there – and the continued woes in Hungary and the Czech Republic have meant that Tesco has been troubled there also. The political and economic uncertainties in Turkey have meant that growth there has been difficult to come by."

While Tesco said it was easing back on the previously rapid expansion of its fledgling US convenience store chain Fresh & Easy, the chain had moved "strongly" into like-for-like sales growth.

Tesco's overall international business continues to power ahead. In particular, it revealed a 28.1 per cent uplift in sales at its South Korean business, boosted by its acquisition of the Homever chain earlier this year.

In 2009, Tesco will find strongunderlying international sales growth more difficult to achieve but, as Mr Shirley says, in the longer term it only needs to make a breakthrough in one of its major markets, such as the US, China or India, for it to be potentially "company changing and pretty exciting".

Overall, while consumers, including Tesco shoppers and bashers, love to focus on slowing UK sales and the new discounter ranges, the real story with Tesco over the next decade will be overseas and in services, such as financial products, as well as releasing shareholder value from its lucrative property portfolio.

Tesco's UK rivals will have enjoyed seeing the grocer's UK business slow yesterday, but the world's third-largest retailer, whose pre-tax profits will come in at just under £3bn again this year, is unlikely to remain on the back foot for long, as it increasingly views the UK business as just another key cog in a global machine.