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Tesco Shifts US Strategy…
Starts Buying Real Estate

Jim Prevor’s Perishable Pundit, September 15, 2009

We’ve written quite a bit about Tesco and its journey to America as Fresh & Easy. We’ve been quiet lately because Fresh & Easy also has been quiet lately. The company has been doing some fill-in store openings in its initial marketing area and holding off on opening any stores in Northern California, where it had already leased a number of locations.

Now a piece by Jonathan Birchall in the Financial Times has reported that Tesco, though not opening stores in Northern California, is working on its Stockton distribution center, still acquiring store sites and, in fact, is now seeking to buy real estate rather than lease stores:

Tesco is continuing to invest in the future growth of its US Fresh & Easy stores, in spite of the UK supermarket group saying earlier this year that it had put the second stage of its US expansion in northern California “on hold”.…

In April it said it was slowing the pace of store openings in its existing areas and that it would delay its move into northern California, originally planned for this year, because of the economy. It did not give a new date for the expansion.

But the retailer has continued to add to almost 50 store sites already acquired in communities including San Francisco, Sacramento and San Jose as well as Reno, Nevada. This month it reportedly paid $3.75m (£2.3m) for two plots in the East Bay area, while it has also acquired a third site in San Francisco this summer.

Property brokers say Fresh & Easy has been increasingly interested in buying rather than leasing sites, given the current slump in commercial real estate prices in the region.

Fresh & Easy has also completed work on the structure of a distribution depot in an industrial park in Stockton that it will use to service new northern California stores when they open, supplementing a similarly large facility, east of Los Angeles, that serves its existing locations.

While Tesco has cited the state of the economy as the main reason for slowing growth in the US, it has also faced a tough battle to establish itself, with stores that include concepts — such as pre-packing its fresh fruit and vegetables — that US shoppers are not used to.

Tesco said it was “being prudent in our expansion and our plans for northern California remain on hold”.

City officials in San Jose in Silicon Valley say the company has indicated it was now looking at opening stores there next summer.

Before the Financial Times piece, George Avalos at the Contra Costa Times reported that Fresh & Easy Buys East Bay Land:

Fresh & Easy’s start-and-stop expansion in the Bay Area could be getting ready to start again, now that the grocer has bought two key retail sites in the East Bay for an estimated $3.6 million.

The grocer, a unit of England-based supermarket giant Tesco, has gobbled up vacant parcels in Brentwood and Oakley. Fresh & Easy paid an estimated $1.95 million for the Oakley site and $1.65 million for the Brentwood property.

“It’s great to see that retailers remain somewhat active despite the tough times,” said Henry Englehardt, a Colliers International real estate broker.

Fresh & Easy remains cagey about the timing of its expansion in the Bay Area. But at the very least, the grocer is seizing buying opportunities in a California commercial real estate market that has nose-dived.

“Economically, there are certain advantages to buying right now,” said Brendan Wonnacott, a Fresh & Easy spokesman. “Our actions are dictated by the economic conditions on the ground.”

Still, these land purchases might signal a new approach for Fresh & Easy, whose existing 125 stores are in Southern California, Arizona and Nevada. The company’s stores usually range from 10,000 to 15,000 square feet.

Until the recent transactions in the East Bay, Fresh & Easy had chosen to use leases of land or buildings for its fledgling expansion program, a search of property records in several Bay Area counties shows.

A unit of England-based supermarket giant Tesco, Fresh & Easy has been poised to jump into the Bay Area market since 2007. But those efforts have gyrated between heating up and cooling off.

In late 2007, Fresh & Easy confirmed it was eyeing several East Bay sites for an expansion. In early 2008, Fresh & Easy said it was committed to opening stores in Walnut Creek, Antioch, Concord, Danville, Fairfield, Mountain View, Napa, Oakland, Oakley, Sunnyvale, Vallejo, San Jose, Hayward and San Francisco.

Delays ensued. In late 2008, the grocer said it had slowed its expansion to Northern California due to a lousy economy. Yet in the spring of 2009, Fresh & Easy signed a lease for a Pleasanton site. The grocer has yet to open a store in the Bay Area.

In mid-June, Fresh & Easy bought a Brentwood parcel in The Shops at Fairview retail center from Brentwood Balfour Investors. That was followed in mid-July by a Fresh & Easy purchase from Ohara Properties of a chunk of land in Oakley, site of a future shopping center called Laurel Plaza. Colliers arranged the deals.

“The fact that Fresh & Easy bought the land signals a pretty strong commitment by them to the area and the marketplace,” said Matt Beinke, project developer for Laurel Plaza.

That’s because it’s a lot tougher to walk away from a property one owns than from a lease where payments can simply halt….

For now, though, Fresh & Easy won’t disclose any precise expansion plans in the Bay Area. Some industry insiders believe stores will start opening locally in 2010, including at least one of the recently purchased East Bay sites.

“We are committed to the area, absolutely, Wonnacott said. “We just don’t have an announced date at this point. But we will be opening in Northern California.”

Actually if the company is guaranteeing the lease, Tesco can’t walk away from a 30-year lease either, so we don’t think the key issue is commitment to retail.

The decision to invest in real estate is a double edged sword. On the one hand, it will make Fresh & Easy a tougher competitor as it switches the dynamic on the financial statement, so if results are poor, instead of showing a loss or a larger loss due to rent payments, it instead shows an inadequate return on invested capital.

On the other hand when it launched Fresh & Easy Tesco was quick to point out that by leasing stores the division would minimize its requirement for capital.

As we pointed out here, though often lauded as a great operator, Tesco actually makes very low returns if you back out its real estate holdings.

For retailers, real estate is an opportunity to cover a multitude of sins. Well used by retailers, investment in real estate is a short term strategy to acquire key locations that would not otherwise be available. Then they quickly sell the real estate and lease it back.

If Tesco intends to hold this real estate it might one day make money on it, but it could buy real estate and lease it to others and make money on it as well. The key issue here is whether the retail concept is profitable.

If Tesco is going to tie up an average of $1.8 million of its shareholders dollars just to buy the land for a store, by the time it builds and outfits the store, plus pays to inventory the store, it will have close to $5 million tied up, in some locations more. We wish them well but the concept has just shown no track record of being able to make money, much less to earn a return adequate to justify that kind of investment.

We have heard some rumblings from the real estate community that Tesco is inquiring about much smaller stores, perhaps half the size of a typical Fresh & Easy. Whether this is for a convenience store concept or a refinement of the Fresh & Easy concept, or even whether it will actually come to pass, we can’t say.

Many have interpreted our critique of Fresh & Easy as a doubt that Tesco will survive in America. Yet we don’t think the two issues are closely related.

Tesco is a large and wealthy company, and if it has made the strategic decision to stay in America — regardless of cost — it will stay in America, presumably trying new formats and revamping Fresh & Easy until it stops hemorrhaging money.

In that sense, Tesco’s future in America has little to do with the success or failure of the current Fresh & Easy concept and more to do with its ability to pump cash in other operations.

That is why if Wal-Mart really wants to lay down the gauntlet and tell Tesco it better leave Wal-Mart’s American turf alone, the place to send that message is not in Phoenix but in London.

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