Great businesses can sustain great Returns On Capital.
I have just searched my blog database (which you can find online here…) for “Tesco” and found 12 articles in the past few years, the latest in February 2014 (here…), which repeatedly decried Tesco’s mistaken focus on price rather than any other meaningful differentiation in this now very mature marketplace. I lead business reviews with companies and find myself harping on a lot about ROC (return on capital) and how good returns are fundamentally driven by a differentiated proposition. It doesn’t matter awfully where that differentiation comes from but it does matter that it is both meaningful to a big enough audience and that customers are prepared to pay a premium over competing products because of it.
If you fail to maintain a differentiated brand, which Tesco arguable had in the early days of its Clubcard, when relationship marketing in retail was relatively novel and they were early-movers in this space, then you end up competing almost exclusively on price. Whilst it has surprised me a little just how quickly Tesco’s underlying return on capital has come down, from 19% a decade ago to probably less than 10% now, it was the inevitable consequence of not staying different enough. I guess the recession didn’t help much but it was the heavy discounters (Lidl & Aldi) entering the market that sounded the death knell for high-margin volume food retailing in this country and they openned the first stores in the UK over 20 years ago now. So, no excuses, this has been coming for a long while.
With some notable exceptions, rather than trying to be different the biggest of our food retailers just added more and more stores, products and business streams, and burnt their fingers overseas; carrying on regardless, in the hope that scale and cash flow momentum alone would see them through. No wonder then that the old guard business leaders, who have built or transformed both Tesco and Sainsbury, have moved on. Did they see all this coming? I was somewhat surprised when Warren Buffett invested in Tesco a little while back: I assumed at the time he knew something I didn’t but it now seems I was wrong.
Is it just a coincidence that the current revelations come just one month after a new “outsider” CEO has been appointed for the first time? Until now Tesco have appointed its leaders from within. Although I am loath to compare my experience with his I do remember being appointed more than once to be the boss of much smaller businesses to find out in my first few weeks that things were not at all what I was expecting, or what I had been told during my interviews. The most dramatic was many years ago when I took over a retail business in the telecoms sector turning over some £10m where I soon found out that a third of turnover was fraudulent. When I revealed this to the shareholders I was castigated for trying to weald my new broom too briskly. I wouldn’t be surprised at all that what Tesco had seen internally as being “best practice” with the management of its trading accounts with its biggest suppliers is now seen rather differently and that wishful thinking and internal pressures, rather than prudent accounting, has lead to this sorry mess.
On the bright side, it is a perfect opportunity to deal with the fundamental problems that Tesco, and the other big guys in this space, now face. I predict a much leaner business with greater focus, less business streams and lower prices. Hopefully, it will also surprise me and be different too, so that we continue to shop there as the heavy discounters continue to grow. You need to do more than build a big business to preserve great margins – let that be a lesson to us all.