Tesco's Retrenchment From The U.S. Is Not Such A Bad Thing

| About: Tesco PLC (TSCDF)

Alongside its third quarter interim management statement, Tesco (OTCPK:TSCDF) has announced a strategic review of its 200 unit Fresh & Easy business in the USA on the back of consistently disappointing results.

The Fresh & Easy operation has failed to generate any profit since launch despite being in its roughly fifth year of operation. Tesco has made a cumulative loss of £782m ($1.25bn) since its first store was opened in November 2007, with cumulative capex of £1.2bn ($1.9bn) as of the first half of 2012. The U.S. chain's third-quarter underlying sales growth eased to 1.8 percent from the second quarter's 6.9 percent - a performance deemed unacceptable by Tesco.

The move comes in spite of repeated denials by Tesco that it is considering leaving the USA, while the fact that Tim Mason, the long-time head of Fresh & Easy, has left immediately is a clear signal that a complete exit is a real possibility.

The options under consideration include a straight sale of the whole business, piecemeal disposals or remaining in the USA in some form or other such as through a joint venture.

Tesco confirmed that, in recent months, it has received a number of approaches from parties interested in acquiring either all or part of Fresh & Easy, or in partnering with Tesco to develop the business. Dollar General (NYSE:DG), but, in particular Walmart (NYSE:WMT) is regarded as a potential buyer of some of its West Coast Fresh & Easy stores as it is opening smaller stores, particularly in California where a number of Tesco stores are located.

Interim management statement for Q3 2012/13

The announcement of the strategic review overshadowed Tesco's third-quarter interim management statement, with group sales for the 13 weeks ended 24th November up 2.4 percent, including petrol at constant exchange rates (CER), and rose 2.9% excluding petrol at CER.

In the UK however, total LFL sales excluding both VAT and petrol declined 0.6 percent. In the UK, LFL sales in the food business, the main focus of the company's six-part 'turn-around' plan, rose 1.2 percent. The online grocery business also delivered sales growth of 15 percent. The clothing segment continued to outperform the market with positive LFL sales growth. However, LFL sales in general merchandise segment was lower amid weak consumer demand.

Management highlighted good progress for its six-part £1 billion investment programme to Build a Better Tesco in the UK, which I mentioned in an earlier article. Commenting on the progress made in implementing its six part plan, chief executive Philip Clarke said:

"I am pleased with the performance of our food business in the UK. Our six-part plan is about improving the shopping trip for customers for the long-term and this is a positive early sign. We've now refreshed nearly 300 stores, upgraded or introduced well over 3,000 products and added innovations such as Delivery Saver to our already successful online grocery business - and there is plenty more to come in 2013."

"We have continued to make good progress on our six-part plan to Build a Better Tesco in the UK. As a result, like-for-like sales growth in our food business - the main focus of the plan to date - has improved to +1.2 percent for the quarter, outperforming the market. We are also pleased with the strong performance of our online grocery business, which delivered sales growth of 15 percent."

"Our general merchandise performance overall in the UK was not good enough, and we are renewing our efforts to deliver sustainable, profitable growth in this part of the business."

"I am looking forward to the important seasonal period ahead, and am confident in our plans to deliver further improvements in our shopping trip for customers."

It is good to remind ourselves that currently Tesco makes around two thirds of its sales and three quarters of its profit in Great Britain.

Results from abroad

Total sales in Europe, excluding petrol, grew 1.1 percent at CER, while LFL sales fell 3.6 percent.

Challenging conditions seen in the first half deteriorated in the majority of its markets. Poland, Slovakia and the Czech Republic were particularly affected, with declining economic growth, increasing unemployment and weakening consumer confidence impacting. As in Clarke's own words:

"Consumers in our international businesses faced even more challenging conditions, particularly in Central Europe. We have seen a further weakening in consumer spending in Central Europe, although the effects of this have been partly offset by a better quarter in Asia."

In Asia, total sales, excluding petrol, rose 6.8 percent at CER, amid resurgence in the Thailand market after last year's floods. However, Tesco is suffering in South Korea, Tesco's biggest overseas market, with underlying sales falling by as much as 5.1 percent as legislation allowing local governments to impose shorter trading hours continued to hurt trading.

LFL sales in China also decreased, driven by a continued slowdown in economic growth and lower consumer spending. Commenting on the progress in China, Clarke said:

"In addition to two new stores in China in the quarter, we plan to open a further seven in the next month, in line with our plans to maintain our annual opening programme at a similar level to last year, in this strategically important market for Tesco. "

"Our like-for-like sales in China declined, driven by a continued slowdown in economic growth and lower consumer spending. This was partly due to two key holiday events falling on consecutive dates this year, rather than being celebrated as two separate occasions, as was the case last year."

In conclusion

For a relatively small part of the group's business, Fresh & Easy has taken up a significant amount of capital and management time. The US unit had promised lots but has never delivered and despite all the investment and management attention the US operations generated just 1 percent of group sales last year.

A withdrawal from the USA is not without a precedent. Tesco's main UK competitor J Sainsbury Plc (OTCQX:JSAIY) (OTCQX:JSNSF) sold Shaws' to Albertson's in 2004, for $2.5bn - ironically, in order to turn around its than underperforming UK stores.

A clear cut exit from the USA would remove distractions and would benefit Tesco's financial profile by halting several more years of operating losses. More importantly, it also would allow it to reallocate those resources in order to focus on addressing more pressing issues, in particular in its home market, and elsewhere. Clarke, commented on this, as follows:

"There are clear opportunities to put our people and our resources into other growing, more profitable, better returning businesses in markets where we are already strong and growing."

At this stage, with Tesco posted a return to falling quarterly underlying sales in Britain - raising questions over whether Clarke's 1 billion pound recovery plan is struggling to take effect - it is unclear whether Tesco can reverse the rise of home-grown competitors such as Sainsbury, given the structural changes in the UK market and the overall weak economic environment.

Having exited from France in 1997, Japan earlier this year, and, with the USA potentially to follow next year, Tesco may also be signaling that it no longer is tolerating sub-scale operations in mature markets

If that is the case, and with the UK clearly stagnating, the group's remaining international operations will now have to step up and become an increasingly more important part of the business while at the same time Tesco may decide to clean-out the ship by removing those parts that do not perform, just like Carrefour (OTCPK:CRRFY) did recently, - scaling back its international aspirations, which overall wouldn't be such a bad thing.

Disclosure: I am long OTCPK:TSCDF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Our Dividend Income Portfolio owns a shareholding in Tesco Plc, purchased during 2011 and in early 2012, following the trading profits update. At current levels, Tesco remains historically undervalued as per our valuation methodology.