Tesco's Still California Dreamin'

After conquering the U.K. grocery market, Britain's Tesco in 2007 set its sights on the U.S., opening a smattering of small outlets called Fresh & Easy on the West Coast. One recession and about £555 million ($894.9 million) in losses later, Tesco is modifying a strategy that confused shoppers and drew criticism from investor Warren Buffett, whose conglomerate Berkshire Hathaway owns about 3 percent of Tesco.

"They've had a real problem in California," Buffett said during Berkshire's annual investor weekend in early May. Berkshire Vice-Chairman Charlie Munger went even further: "Tesco is God Almighty in England," he told London's Telegraph recently. "But you come into Southern California, and you have Trader Joe's and Costco. That's tough competition. It's a different world."

Philip Clarke, who became Tesco's chief executive officer in March, is hoping to convince his fourth-largest investor that he can turn around Fresh & Easy. On top of the estimated $2.4 billion the company has already sunk into the unit, Clark is opening more U.S. stores. He's also launching Fresh & Easy's first TV ad campaign and testing in-store bakeries at some of the 175 outlets. Clarke has pledged to stop the losses by 2013—three years later than the company initially hoped.

The U.S. has been a tricky market for U.K. merchants. U.S. stores owned by J Sainsbury and Marks & Spencer both failed to catch on with American consumers. None of this stopped former Tesco CEO Terry Leahy from tackling the world's largest economy. It was the first time Tesco entered a market with a new format, creating small, neighborhood stores focused on selling fresh foods and ready-made meals.

Tesco didn't fully understand the preference for frozen food in the U.S. and is now adding more. It also doesn't accept manufacturers' coupons, a staple of U.S. retailing. For the last 18 months it's been adding coupons of its own for, say, $3 off a $30 bill, to its weekly flyer to attract shoppers. Some consumers were also confused by the predominance of the chain's own house brands rather than widely advertised national labels. "They were unlucky; they went out to the U.S. at a very bad time," says William Hobbs, who helps manage $264 billion in assets at Barclays Wealth. "But really they didn't get their offer right. It's a very difficult, competitive market."

Tesco has expanded Fresh & Easy's offerings to 5,000 products, from 3,500, says Simon Uwins, the chain's chief marketing officer. He added low-sodium and low-fat Eatwell prepared meals to compete with Nestlé's Lean Cuisine dinners. Stores have been repainted to include brighter colors. "We're very confident that we've got Fresh & Easy in a place that customers like it. We've just got to get more customers into it," Uwins says.

There are signs of life: Same-store sales in the U.S. rose 9.4 percent in 2010, the fastest pace of any Tesco division. To keep it up, Uwins has to lure customers from rivals including Aldi Group's Trader Joe's, which also specializes in selling its own products, and larger supermarkets such as Wal-Mart Stores (WMT), and Safeway, which offer a wider array of brands.

"Trader Joe's is very well-established. They too have very local customers who love their stores," says George Whalin at Retail Management Consultants, a retail and supplier advisory firm in California. Whalin thinks it may be easier for Fresh & Easy to lure customers from the big-box stores, hyping the time saved by shopping in its smaller outlets.

Some 30 percent of Fresh & Easy sales come from goods that originate at a huge campus in Riverside, Calif., where it produces freshly prepared meats and chilled prepared foods. Yet some customers remain cool to Tesco's reliance on private-label items. More than half of Fresh & Easy products are house brands, such as a 12-pack of Taurino beer for $7.99. "I like quality, [so] I'll pay the extra buck or two" for a brand, says Justin Pommer, 32, who lives across the street from a Fresh & Easy store in Hollywood but rarely shops there.

Such reactions from shoppers aren't encouraging. Explains Mike Dennis, an analyst at MF Global: "Realistically, even if we do get near break-even, [the U.S.] doesn't sum up as the second engine of growth for Tesco even after another few hundreds of millions."

The bottom line: The world's second-largest retailer after Wal-Mart, Tesco has lost almost $900 million trying to expand in the western U.S.

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