January 22, 2010

Tesco CFO Laurie McIlwee talks money

Tesco CFO Laurie McIlwee (photo: Tesco)
Laurie McIlwee: "Aldi and Lidl were our greatest threat" (photo: Tesco)
Laurie McIlwee, Group Finance Director at UK grocer Tesco since February 2009, is a rare breed among CFOs. This down-to-earth Northerner can actually discuss financial strategy without talking Persian.

Despite his unfazed attitude, 2009 must have been something of a baptism of fire for McIlwee (47), the youngest member on the Tesco board.

After all, it was nearly the year of global financial meltdown and the worst recession on many national markets, including Tesco's core UK one, since 1945.

Admittedly, the former distribution director and ex-PepsiCo man is steering a pretty big ship to ride out the heavy seas. As per the business year to the end of February 2009, Tesco posted group sales, including VAT, of £59.4bn.

This makes the British market leader the world's third-largest food retailer. With a pre-tax margin of 5.5 per cent, Tesco is also one of the most profitable mass market retailers.

Probably, Tesco today is the most exciting kid on the block.

Now in 13 foreign markets

The company has not only grown its portfolio of store formats in an innovative way. Tesco is also aggressively expanding its online shopping and customer services, including financial services.

Since 1994, the Brits have moved into 13 foreign markets (Ireland, Central & Eastern Europe, South East Asia, USA), including cash & carry stores in India.

Still, Tesco faces teething problems in the recession-hit US and lacklustre like-for-like growth in the UK, which still accounts for more than two-thirds of group profits and sales.

How then does McIlwee intend to continue generating an excess return on capital across an increasing range of geographies and business areas in the current credit crisis?

"Customers have no reason to shop anywhere else" 

Mr McIlwee, Tesco Christmas 2009 sales topped forecasts, but on a stores-open-at-least-a-year basis, your UK sales grew at a slower rate last year than Morrisons, Sainsbury or Asda. Why is the market leader having such a tough time?
Many of our competitors are only recovering to where they were two or three years ago through buying stores from the Coop, Somerfield etc., but this growth has not been at our expense. We have a very loyal customer base and have grown like-for-like sales more consistently than anyone else, i.e., by roughly 3 to 4 per cent p.a. over the last decade.

But why were you hit harder than most others in 2009?
Customers at Tesco spend more per shop than any other retailer in the country. So, when times are hard, it’s going to impact Tesco proportionally more than anybody else. We also sell more non-food than any other retailer, so anything which is a discretionary purchase in a very tough time is again going to affect Tesco more than others.

Who has been your greatest threat over the last year?
Aldi and Lidl.

Why, when they are both so very much smaller in the UK than your major Highstreet competitors?
All our main competitors run a very similar operation to our own. So, if we work more efficiently than the other major multiples, we’ll win. But, when you come up against somebody like Aldi and Lidl with a very different operating model, you have to ask yourself whether you need to do something differently.

And what conclusion did you come to?
In an environment where there was a lot of inflation driven by food commodity prices, our customers were trading down, so 14 months ago we launched a range of discount brand products which is bigger than Aldi’s and which gives Tesco customers the opportunity to down-trade.

Why create inward deflation within your own portfolio?
Our research revealed that Tesco shoppers were doing part of their shop elsewhere. So, now we have the “Discount Brand” range, our customers have no reason to do part of their shop anywhere else.

What is the difference between your “Discount Brand” range and the “Value” range you have had for the last ten years?
The main difference to “Value” is that all the “Discount Brand” lines have brand-type names. Although “Discount Brand” is printed as an umbrella label on both the packet and shelf, the range is only opaquely registered by the customer as a Tesco house brand.

So you don’t even put the Tesco name on them?
You wouldn’t recognise our discount brand lines as brand names, but they are very similar to the shopping experience at Aldi, where you will have a “Fairy” liquid-type detergent called “Daisy”, or something similar.

Where do you position the “Discount Brand” lines on the shelves?
During the launch we put them in the power aisle, which is the first aisle that customers encounter when they enter our stores and where everyone looks to see what is on offer. We then place them on the main gondola.

Do you put these discount brand lines on the lowest shelf, i.e., at ankle-level, as most German retailers do with their price fighter ranges?
They won’t always be at floor level; they can be at eye level, depending on what range they’re in and the internal merchandising logic of the range in question.

How successful have they been?
They have been tremendously successful and have created a lot of customer loyalty.

What type of customer tends to buy your discount brand lines? Presumably, those with low socio-demographic status?
No, there are as many up-market customers as people on challenged budgets who buy them.

Customer loyalty is one thing, but have these discount brands had any effect on Aldi’s and Lidl’s hitherto dynamic growth in the UK?
Prior to the launch of the discount brand, Aldi and Lidl were among the fastest-growing retailers in the UK and were certainly stealing market share off Tesco. That’s not the case anymore.

Can you really equate the introduction of your discount brand to a decrease in the dynamism of hard discounter growth?
You can almost see a decline in their growth charts from day one of our launch. Remember that we have learned a lot from competing with Aldi and Lidl around Europe. We have also exported the “Discount Brand” range to our stores in Eastern Europe where it has been equally successful in competing with them.

You may have stabilised market share via discount brands, but surely they dilute your margins?
They are the lesser of two evils. It is better to have a pound of sales on a lower margin than not have a pound at all. Aldi, Lidl & Co. have taught us as broad-range discounters that, if you tailor your products to be very efficient through the supply chain, what you might lose in gross margin against other retailers, you gain back in operating margin.

This presupposes that you can be more efficient than Aldi, which most German retailers have failed to achieve…
That’s exactly it. We already achieve a 6 per cent operating margin, which is one of the best in the world. We then piggy-back a very efficient product range on an already very efficient model, and let the synergies work for us.

Why do you call your discount brands “a very efficient product range”?
All the products have been designed specific to shelf, i.e., they are very supply chain-friendly and always in shelf-ready packaging. The pack sizes always fit on our shelves, which increases rotation.

You never get a situation with a discount brand where you’ve got to put two-and-a-half cases on the shelf and have to take the remaining half back to your warehouse. So, they are accretive both in terms of cash margin and percentage margin at operating level.

One of Aldi’s competitive advantages in Germany is that, as one of the largest commercial real estate owners in the country, its rental costs are extremely low. How does Tesco manage its property portfolio?
About 75 per cent of our store space is freehold. So balancing property ownership with managing the cash-flow is a key priority for me. We like to own our own property, but it is expensive and capital-intensive.

So does that mean more opco/propco deals?
No, not for Tesco because, when you get an opco/propco deal, you don’t control your own property, someone else does. Internally, however, we structure that way in some of our markets. For instance, in China we have a property company and an operating company. However, we do this under our own umbrella in order to keep the benefits to ourselves.

Could you give an example of what you just meant by “balancing property ownership”?
Just before Christmas, we sold one of our shops near Manchester. It’s a great store of around 50,000 ft² (4,645 m²) which we’ve had for about 15 years. It cost us around £18m to build, but we sold it for it for £50m, so we had a really good appreciation in capital value. Then we invested the money to buy a 500,000 ft² (46,450 m²) store in China.

So in only 15 years we’ve gone from a 50,000 ft² shop in England to one ten times as large in the world’s fastest growing major economy. So we are a good property investor.

You may get more bang for your buck in terms of sales space in China, but presumably you won’t always be able to value Chinese property so highly for depreciation purposes on your balance sheet?
Here we could talk a lot about valuation, but we are good property developers. Right at the bottom of the recession at the end of last year, the market value of Tesco property was around £28bn while the market cap of the company was about £24bn.

So we were at a premium to our market cap in terms of the property which we own.

Interesting. The new investors at Carrefour seem to think that they can simply order management to capitalise on the company’s property portfolio at the press of a button. From what you have just been saying, it would seem to take a considerable amount of time to mature expertise as a property developer?
You are absolutely right. It can take over 20 to 30 years to build a good pipeline of new stores and land coming into one’s portfolio every year in a way that appreciates international investment.

Presumably, however, you are dependent on international real estate trends?
One has to parcel together lots of different bits of property, and it is a probability game. Not all the things come through in the year that you want them to. So you have to have a kind of 80:20 strategy. Some property deals are going to come through, and some aren’t, but will in the next year.

In an interview with UK daily newspaper “The Telegraph” in October 2009, your CEO Sir Terry Leahy is quoted as saying: “We will be more international and in more countries.” In view of recent moves into China, Turkey, Japan, the USA and India, doesn’t Tesco risk overextending itself by entering still more countries?
I don’t think that Terry meant more countries, he was probably referring to the fact that we want to expand in our existing markets. Our international operations currently represent a third of our profitability, but they will be two-thirds as time goes forward.

But wasn’t Sir Terry hinting to the City of London that Tesco intends entering Russia etc.?
Currently, there is no plan to expand into Russia, Brazil, or wherever. However, whether in E. Europe or Asia, we have never excluded entering new countries adjacent to the ones we are already in.

We have quite a few formats which we can bring to any market. We can do big box, medium-sized, or small, and we can add retail services to the businesses we have around the world. Therefore, we have a broad stable of potential growth opportunities.

How long must your shareholders wait to achieve UK-type returns (ebitda: capex; like-for-like growth) in E. and S.E. Asia?
It would be wrong to think that you could take one investment scenario such as the UK, a small island where we’ve built up the business for 90 years, and compare it with the rest of the world.

On average, you are always going to have various countries at a seed corn, development or a maturing stage. So, you can’t bundle up international operations and ask why it is not the same as the UK.

But are you convinced that you have the ability to enter a foreign country and replicate the success you have had in the UK on a country by country basis?
Yes we can! If you take somewhere like Korea, it is approaching the same kind of returns, profit margins, and sales per square foot as the UK. This has given us the confidence to move to huge economies such as India, the US and China. Ten years ago we had access to about 1 per cent of the world’s consumer basis, now we have access to 50 per cent.

There has been market speculation in the past about Tesco/Ahold. Could this combination make strategic sense?
You can never say never, but we are not really a big acquisitions company. Our preference and our best returns have always come either from buying small companies in-country to add on to our current business or from growing organically.

Would Tesco ever consider entering Germany with its 80 million consumers and high GDP per head in central Europe?
Again, one can never say never, but, imagine that you were sitting at the strategic table at Tesco head-office, what would you think? You would ask: “If we go into a new market, what’s going to make us win? What competitive advantage are we going to have versus others who have been in that country for a long time?”

But I’m not sitting at Tesco head-office in Cheshunt. I’m a trade journalist wondering if Tesco would ever follow Carrefour, Marks & Spencer, Walmart etc. and try its luck in Europe’s largest economy?
The marginal returns you are likely to get from going into any western European country will be a lot lower than in some developing countries where everybody is trying to build a business from the same starting line.

Going to Germany, Spain or France is therefore not particularly high on the strategic agenda because we feel there are better returns in the developing markets.

And eastern Europe?
If you take Eastern Europe post-1989, everyone went to land grab, and there were lots of companies who went into the region where nobody had a competitive advantage at that point.

But isn’t, for instance, the Czech Republic all too rapidly becoming over-stored towards western European levels? In a country hardly larger than Bavaria, a dozen or so international retailers continue to expand there. Isn’t the market becoming over-stored too quickly?
At first blush, that many major retailers chasing only around 10 million potential customers doesn’t sound like a very good business proposition. However, of course, over time two or three retailers will emerge as market leaders. They will be the ones who stay the full journey and build a scale business. Obviously, we believe that we will be one of these.

But, at the end of the day, has the game been worth the candle?
I wouldn’t look at the Czech Republic in isolation. As it is contiguous to Slovakia, Poland, Hungary etc., I would see it as part of a regional business model. In Eastern Europe we have a broad business where we can leverage scale in terms of staff, supply chain, property, financing, currency etc.

What was the strategic reason for entering the US, where you most certainly are competing with entrenched competition?
As regards countries like Germany, we currently don’t have a competitive advantage to go into those markets and win. As a company with the ambition to become a global retailer we regarded this as a challenge. So we have developed a concept which will allow us to enter first-world economies, but one which clearly has to be different to a standard Tesco shop.

In other words, your “Fresh & Easy Neighborhood Store”. How would you define the concept?
After conducting detailed consumer research for a long time in the US we have come up with what we believe is something very different to what American consumers are accustomed to. “Fresh & Easy” is a small box with very good value in terms of price which predominantly offers fresh produce in a neighbourhood location.

Fresh & Easy customers are incredibly loyal. Once we’ve had a customer come into our shop, they rarely go elsewhere.

Yet some research points to a lack of US consumer acceptance. After an investment of around $1.46bn in Fresh & Easy to date and a brief pause, you have now resumed your rollout. Are you really sure that you have the right model for US customers?
What we are not getting yet is a big enough share of their potential basket. Therefore, we are enhancing our range so that customers feel they can make a material part of their purchases at our neighbourhood shop while appreciating the great value.

Sounds like a cultural problem?
Customers find it hard to believe that they can get big-box prices in a small box because in the US they have been conditioned to believe that you only get value when you go to a 200,000 ft² (18,581 m²) shop. Suddenly, they are going into something which is 7,000 ft² (650 m²) and getting better value.

So, that will be a long burn. People’s shopping habits in the US are very entrenched, but we know that, as people convert, they then like it.

Doesn’t the need to grow the customer basket ultimately mean that you will have to build larger stores?
No, think about Aldi. Fresh & Easy is not that much smaller than an Aldi store. Admittedly, they approach the customer offer in a completely different way, but Aldi has built a very good business around shops of a similar size.

So size is not the constraint, given that there are no real options for a US customer to go to a small shop. Admittedly, you can’t do all of your shopping there, but you can do a significant portion, and it is a winning formula.

Are you really convinced that you are onto a winner in the US?
Yes, that is proved by the customer loyalty of those customers who shop with us. We are very confident that we shall have a very successful business once the economy starts to recover in California, Nevada and Arizona, where our business is currently based.

I can already see the seeds of future success in some of the 135 stores we already have, especially in the LA coastal area. So, if we can do it in some stores, where the local economy is more prosperous, then we will have a very successful overall business as soon as prosperity returns.

Also, don’t forget that we already achieve good like-for-like figures and are growing strongly. In fact, there isn’t any other US retailer which can show such positive growth and like-for-like figures in the current recession.

How do you view China?
I think we’ve earned our spurs in places like Thailand, Malaysia and Korea where we are already the no. 1 or no. 2. So being in the world’s fastest-growing major economy, and probably, one day, the largest one, is a major priority for us, and we will push very hard there over the next five years.

In view of your need to build scale aggressively in China, Turkey, India etc., shouldn’t you be tightening up your international portfolio and diverting resources from the US into Asia?
We just don’t need to. We have the resources to do both. It is of long-term strategic importance to have a model which also works in a first-world market. And, if we have one which can thrive in the largest consumer market in the world, it will work pretty much anywhere.

With Tesco.com and Tesco Direct you have also developed one of the few successful online shopping business models in international retailing. Why did you choose a store-based picking model rather than work through centralised warehouses?
When we began our dot.com business, everyone told us that a central picking facility was the most efficient model. However, when we did our own detailed analysis, we found that all the cost is in the transport. So you need to have your picking locations as close to customers as possible, which benefits both costs and service.

On an ebit basis, your online business makes better margins than your stores, but is this not a case of marginal cost allocation?
The dot.com P&L picks up every single cost that any store does with the exception of rent. It picks up an allocation of depreciation, distribution to the store, security, printing, stationery, electricity etc. as well as anything which is specific to the dot.com business, i.e., pickers, systems, vans, fuel, refunds, etc.

So it’s a fully-costed P&L with the exception of rent, where the store is rented. You could say, Tesco.com should allocate a bit of rent, but we already have those shops, so it would be wooden dollars to start moving the cost around.

Aren’t your current stores subsidising your online business?
Our online business is incremental. The important starting point with an internet business is that you have to have a successful retail business first. The internet is just another channel to reach your customers.

Why do you think so many retailers have failed to make a success of their online businesses to date?
If you start with the premise, that you want an internet business and you try to think what kind of retail model to put in to it, that’s where people have come unstuck. We have developed a successful food and non-food business, and now we are accessing our customers through the internet, but we treat it purely as another channel to market.

Another way to reach your customers is through financial services. Currently you are building a bank, but isn’t this both expensive and time-consuming?
Not in relation to the real and potential gain. We’ve been in banking for ten years via a joint-venture with Royal Bank of Scotland, but have since bought them out. All that we now have to do is build a system, and we regard ourselves as good systems builders.

Your bank competitors have well-established systems; doesn’t this put you at a disadvantage?
Many of the banks are sitting on legacy systems which are 15 or 20 years-old, so it is quite an advantage to come at it with a 21st century approach and a white piece of paper. So we don’t feel disadvantaged when we have to build a system.

In fact, most of what we are buying is off the shelf anyway, so in terms of cost and service, ease of use, and simplicity for customers to understand, we have an advantage. Remember also that we already have a lot of products in our financial services stable.

When will you become a full-service retail bank by moving into current accounts and mortgages?
It’s either going to be the end of 2010 or early 2011. It’s a fantastic opportunity for us. Twenty million customers come through our shops every week, not including our online customers.

Where do you see your competitive advantage over the high street banks?
It is quite a challenge to go to the bank in the UK where banks are normally only open from 10 a.m. to 3 p.m. If you work, you are usually obliged to go to the bank at lunch time.

Often, there is a massive queue because most of the people serving on the counters have gone to lunch. Most banks are situated in town centres where parking is very difficult. So, by the time you’ve found a parking space, you’ve run out of time.

Now compare all this inconvenience with our model. We offer bank services in the store where our customers are going to be anyway. We have big free car parks, and, thanks to our experience with staff rostering, we are open 24 hours a day, seven days a week.

Of course, we also run a big internet business which provides a very convenient service. So our customers enjoy a very superior proposition.

But, if you also start offering mortgages, inevitably, you will also have to repossess people’s homes; won’t that hurt the Tesco image?
Well, we don’t allow our customers to push a trolley through the tills for free, so that’s theoretically negative for our image as well! However, we seem to manage to achieve a balance on that, as we will with other things.

To what extent has the banking crisis in the UK benefited your plans to expand your financial services offer?
Well, Tesco is a trusted organisation and we have very loyal customers, but you can’t be complacent about this; so when we offer new financial services we will try to compound the strength of the brand rather than merely piggy-back on it.

Do you think that customers now trust Tesco more than their bank?
Our own research would imply that they do, yes.

How profitable is your financial services business?
Currently, our financial services contribute about £240m in profit, shared roughly equally between insurance and banking services.

Lebensmittel Zeitung with its online sisters (photo: LZ)
Lebensmittel Zeitung with its online sisters
Read in German: 'Druck von Aldi' by international editor Mike Dawson on page 29 of Lebensmittel Zeitung, no. 3, 21.01.2010

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