WASHINGTON, June 30, 2011 /PRNewswire/ --
The CtW Investment Group is calling on incoming Tesco (LSE:TSCO) Chairman Richard Broadbent to address investor concerns about mounting losses at Tesco's Fresh & Easy subsidiary by conducting an objective and independent strategic review of the U.S. business and to publicly articulate a strategy for profitability.
In its 29 June letter, the CtW Investment Group also notes that under the new remuneration policy, U.S. CEO Tim Mason's incentive pay will be substantially de-linked from Fresh & Easy's performance, raising questions about executive accountability for continuing losses in the U.S. The CtW Investment Group also points out that all executive directors will continue to have their incentive pay linked to profits from the sale and leaseback of property, which may potentially allow executives to "pick their number" in order to hit performance targets.
The CtW Investment Group's 29 June letter to the Tesco Chairman-elect is below and can be found at http://www.ctwinvestmentgroup.com:
June 29, 2011
c/o Barclays PLC
1 Churchill Place
London UK E14 5HP
Dear Mr. Broadbent,
We call on you, as the incoming Chairman of Tesco's board of directors, to lead the board in an objective and independent review of Tesco's Fresh & Easy operations in the U.S., and to publicly articulate a strategy to deliver on the company's repeated promise that Fresh & Easy will "break even" by 2013 (and presumably be profitable thereafter).
We believe that the board must undertake this strategic review not only because Tesco's existing approach to the U.S. market has been notably unsuccessful, but also because, with the changes made to the Tesco executive remuneration policy by the Remuneration Committee, the Fresh & Easy CEO, Tim Mason, no longer has his remuneration tied directly to the performance of U.S. operations or to the achievement of expansion milestones.(1) The original purpose, as stated in 2007, of adding U.S. award objectives to Mr. Mason's pay package was to incentivize the U.S. CEO to deliver a strong and profitable U.S. business in a challenging retail environment. Given that Fresh & Easy remains unprofitable and that the U.S. retail environment remains challenging, it appears Tesco has simply dropped the idea of linking executive performance pay to the performance of the U.S. business in any meaningful way.
Since Mr. Mason has been responsible for leading Tesco's efforts in the U.S. market since their inception, delinking his pay from Fresh & Easy eliminates the primary mechanism through which Tesco executives were in any transparent way held accountable for poor U.S. performance. Of course, as we have pointed out in letters to your predecessor and current Chairman David Reid, in practice it appears that Tesco did not meaningfully hold Mr. Mason - or any other Tesco executive - accountable for Fresh & Easy's substantial and ongoing losses, and instead "moved the goal posts" to enable Mr. Mason to enjoy handsome remuneration despite Fresh & Easy's evident struggles. This year, for example, the Remuneration Committee awarded Mr. Mason a bonus worth 80% of his salary even as the U.S. results disappointed and trading losses increased for the third consecutive year.
Additionally, our communications to Mr. Reid argue that overall executive remuneration at Tesco appears to have been inflated by the inclusion of property profits from sale-leaseback transactions in the performance measures (particularly EPS) used in Tesco's past executive pay plans. In our most recent letter, we noted that even a shift to Return on Capital Employed (ROCE) as a performance measure would not ameliorate our concern that executives can "pick their number" and undertake more or fewer sale-leaseback transactions in order to hit their targets.
The CtW Investment Group works with pension funds sponsored by unions affiliated with Change to Win, a coalition of U.S. unions representing nearly five million members. These funds have over $200 billion in assets and are substantial long-term Tesco shareholders.
We outline our concerns below.
Fresh & Easy's Continued Struggles
"I look at the plans and the plans are persuasive. But…there is a big shift required if we are not to get to your doomsday scenario and a billion [pounds] of accumulated losses. Now, the plan doesn't say that, so deliver the plan."(2) Philip Clarke, Tesco CEO
Ever since Tesco's first stores opened in the U.S. in November 2007, the company has claimed that the reception by U.S. consumers has been very positive, and that profitability was just over the horizon. Despite these claims, as Figure 1 shows, Fresh & Easy's trading losses have increased every year, even as sales have grown.
These losses raise questions about the Fresh & Easy business plan and its implementation. The U.S. business has consistently failed to meet expectations: In fiscal 2008/2009 losses from U.S. operations were 142 million pounds Sterling, or 42 million pounds higher than projected. The following year U.S. losses climbed to 165 million pounds even though the company had expected a "similar loss" to what was experienced in the prior year. In 2010 Tesco said it believed that Fresh & Easy losses had peaked; however in 2011, the company once again reported higher than expected losses of 186 million pounds. The number of store openings has also fallen considerably behind the Company's projections.
Tesco has frequently suggested that Fresh & Easy's losses should be attributed to the considerable start-up costs associated with Tesco's first major commercial venture in the U.S. For instance, in its 2009 Annual Report, the company asserted that it would achieve profitability after opening 300 U.S. stores. However, not only has the pace of expansion in the U.S. slowed sharply, but the increases in scale that have been achieved do not seem to be delivering improvements in profitability.
Table 1: Fresh & Easy Growth Not On Target (Pounds Millions)
Change in Trading
Change Change Change in Sales per Profit per
in in Trading Marginal Marginal
Stores Sales Profit Store Store
2009/2010 30 pounds pounds 4.87 pounds -0.77 pounds
2010/2011 19 pounds pounds 7.79 pounds -1.11 pounds
--------- --- ------- ------- ----------- ------------
As Table 1 illustrates, while Tesco's newly opened stores over the past year have been associated with an overall increase in sales per store, they have also been associated with increasing losses per store. Tesco is projecting that Fresh & Easy will "break even" sometime in the 2012/2013 fiscal year, without any clear indication of why shareholders should have confidence that this goal will be met. Given that increases in scale so far seem to have done little to improve profitability, we are skeptical that the current strategic approach can achieve even its relatively modest goals in two years time.
This skepticism about Fresh & Easy's prospects finds support in the published views of many analysts following Tesco, who point to the substantial challenges Fresh & Easy faces in winning over U.S. consumers and generating a return on investment commensurate with the Tesco's large U.S. investment.
More specifically, analysts have questioned whether like-for-like growth at Fresh & Easy is driven mainly through extensive use of discounts and promotions, such as $5 off coupons, which represent a substantial percentage of average customer purchases at small format stores such as Fresh & Easy. Mike Dennis of MF Global questioned the wisdom of opening stores in Northern California that are supplied by daily deliveries from the company's distribution center in Riverside, located hundreds of miles away. Others have questioned the heavy reliance on in-house brands in a supermarket culture where the private label offer is widely considered to be inferior in quality.
Crucially, while Tesco has clearly made its share of mistakes entering the highly competitive U.S. retail market, it has compounded its errors by alienating some stakeholders, including vendors and their trade groups, community organizations, Fresh & Easy employees and trade unions. For example, the respected "Perishable Pundit" blogger Jim Prevor has written, "Tesco elected to alienate many suppliers when it broke the produce trade's cultural pattern by refusing to join trade associations…" (3) Prevor has also published extensive commentary from industry members highly critical of Tesco, such as:
"…one reason everyone is so interested in Tesco's adventures is because of the way they treated the potential U.S. suppliers and the market place. When suppliers were interviewed, there was a level of arrogance and bullying that most of us hadn't seen since we were on the playground in grammar school."(4)
Rather than spend two further years on a strategic trajectory that does not appear promising for numerous reasons, we believe that the board must undertake an objective review of U.S. operations, and determine what changes in strategic direction are necessary to turn Fresh & Easy around.
As part of this review, we urge the board to meet with key stakeholders - including consumers, vendor associations, community leaders, elected leaders and representatives of organized labor - in the areas where Fresh & Easy has established operations, in order to ensure that it is fully informed of the public perception of Fresh & Easy, and any obstacles this perception may present for future growth. While Fresh & Easy is currently only a small portion of Tesco's overall operations, the U.S. market clearly presents enormous growth potential for Tesco if it can adopt a viable strategy going forward.
Property Profits and Executive Remuneration
As we explained in our May 16, 2011 letter to Mr. Reid, we are concerned that over the past several years, but especially following the 2008 financial crisis, a disproportionate and growing share of Tesco's profit before tax has been generated by sale-leaseback transactions. Since profit before tax is a key determinant of overall earnings and earnings per share, it appears to us that even with Tesco's adoption of a new remuneration plan focusing on group-wide ROCE, executives could have the ability to "pick their number" and undertake a higher quantity of sale-leaseback transactions in years when core retail operations have not generated the earnings necessary to hit remuneration plan targets.
Other analysts have questioned the use of property profits in determining executive pay levels. For example, in its recent analysis of remuneration at Tesco, PIRC asserted that mature property sales are not "indicative of sustainable operational group performance," and that including property sales in metrics to determine bonus pay outs under the long term performance scheme "is not appropriate." (5)
As we have stated in the past, we continue to urge the board to clearly distinguish retail profits from real estate profits, and to base remuneration solely on the former. Since transmitting our May letter, we have noted that Tesco has committed to keeping property profits within a range of 250M pounds to 350M pounds (i.e., below the level of the past two fiscal years). However, as far as we are aware, Tesco has not disclosed any change in practice with respect to counting such real estate profits toward executive remuneration targets, and so our concerns remain. We enclose a copy of our May 16, 2011 letter to Mr. Reid for your review.
We understand that as a newly incoming director and Chairman, you may feel chary of immediately challenging the strategic decisions taken by incumbent managers and your fellow board members. Nevertheless, we urge you to do so in order to ensure that Tesco shareholders fully support the company's executive remuneration arrangements and have confidence in the best position possible to realize the potential of U.S. expansion. If instead Fresh & Easy continues to stagger along with mounting losses, we fear that Tesco may abandon the U.S. market and leave its considerable potential untapped. In our view, that outcome may be avoided by a timely assertion of your role as Chairman in providing much needed strategic advice to management on a critical but troubled long-term investment.
cc: Tesco PLC Board of Directors
** Note: For additional information or comment please contact Ed Keyser at email@example.com or at +1-202-721-6063. **
CONTACT: Ed Keyser (US), 00-1-202-721-6063
(1) Tim Mason is not a member of the Tesco PLC Remuneration Committee. The company states that "no member of the [Remuneration] Committee has any personal financial interest in the matters being decided…nor any day-to-day involvement in running the business of Tesco." Tesco 2011 Annual Report p. 75. Tim Mason was recently appointed Deputy CEO and Chief Marketing Officer of Tesco in addition to his continuing role as President and CEO of Fresh & Easy.
(2) Financial Times, "Leahy planned for 10,000 Tesco stores in US," 9-19-2010.
(5) PIRC Alerts, 6-21-2011, p.1.
SOURCE CtW Investment Group