Why Tesco looks frayed at the edges

Clothes sales are down and the US adventure is backfiring. Lauren Mills sets the scene for this week's results

Tesco knows every little helps when it comes to making vast profits. For years, it has been building its clothing and non-food lines to shore up static UK grocery sales. But evidence that it is not bullet-proof will be revealed on Tuesday when it will be the first major retailer to report full-year profits that have been affected by the credit crunch.

Cash-strapped customers are believed to have cooled to its clothing ranges to such an extent that like-for-like sales are expected to have fallen by as much as 3 per cent. "The return on clothing has come down. It has lost its edge," says an industry insider.

Tesco is so concerned that it is looking to trim its UK clothing workforce of around 400 by 10 per cent to cut costs. And that will be an embarrassment for chief executive Sir Terry Leahy, who promised in November 2006 that Tesco would invest millions of pounds in an expanded range of edgier clothing.

The driving force behind the changes would be Terry Green, the UK head of clothing and non-food, who was persuaded to stay at Tesco with a £1m pay rise last April, taking his annual salary to £2.5m. His job is not one of those on the line.

Meanwhile, Fresh & Easy, Tesco's newly launched chain of US convenience stores, has been widely criticised and rumours are rife that the 59 outlets are underperforming Tesco's internal targets by as much as 70 per cent. Mike Dennis, a retail analyst at Piper Jaffray, was the first to come up with the statistic. He now believes Tesco stands to make a loss of more than $100m (£51m) on its American adventure by February 2009, if it sticks to its original plans to open hundreds of stores.

"It made some pretty bold assumptions about what US consumers want," says Dennis. "You would have thought after two years' research and a mock store, it would have known what they want."

Dennis criticises Fresh & Easy's focus on private labels, given that US shoppers are obsessed with brands. Another potential weakness is that Tesco has so far refused to flex Fresh & Easy's 3,500-strong product range to suit local tastes.

News in March of a three-month halt to expansion, announced haphazardly on a company blog, was seized on as evidence that Tesco was on the verge of admitting defeat in the US.

Given how much Sir Terry detests bad press, you would expect him to leap at the chance to set the record straight at Tuesday's results briefing.

But this is unlikely. Tesco will almost certainly remain tight-lipped about its US sales, which will only fuel further adverse speculation.

Tesco will, however, attempt to placate critics in other, more opaque ways. Citigroup analyst James Anstead thinks it will stress "how other, now very successful, parts of Tesco didn't work perfectly on day one".

David Reid, the group's chairman, is expected to announce that the average basket size at Fresh & Easy stores has been growing steadily. He has been briefing investors, tired of the lack of hard sales figures, with this seemingly positive snippet for weeks.

But Dennis is far from convinced: "This is completely misleading. In the last month or so, Fresh & Easy has introduced discounts and promotions. Of course sales will go up."

However, Tesco insiders believe news on Fresh & Easy will be sufficiently positive next week to take the City by surprise. The share price, down 4.25p at 387.5p at Friday's close, suggests it will indeed be surprised.

But if America really is faltering, Tesco will have to work flat-out to ensure that the rest of its international business continues to generate strong returns.

This is more important than ever before because, after years of unparalleled growth, Tesco lost UK market share over the three months to the end of March, according to data from TNS Worldpanel. That figure dropped to 31 per cent from 31.2 per cent a year earlier.

But it is clearly still Britain's premier retailer. Group profits are expected to rise to £2.9bn for the year to 23 February, compared with £2.5bn last year.

So why is it that Tesco gets such a hard time in the press? Evidence that Sir Terry feels increasingly demonised came earlier this month when it emerged that Tesco had launched a libel case against Guardian Media Group (GMG) after The Guardian ran a string of damning articles about Tesco's tax affairs.

Regardless of the rights and wrongs of this case, the issue for Sir Terry is that Tesco does not have many friends in the media. And this has nothing to do with what he would like to believe is a conspiracy against the company. It is because Tesco has acquired a reputation among journalists for being unhelpful.

For Tesco to be looked upon with a little less suspicion, it needs to shed some of its paranoia.