Tesco Bets Small–and Wins Big

John Browett, CEO of British on-line grocer Tesco.com, isn’t smug enough to

amble around the company’s headquarters singing the old Gershwin tune. But few

would begrudge him if he did.

Assailed by analysts during the peak of the dot-com boom for its go-slow

approach to selling groceries over the Internet, Britain’s No 1 supermarket

chain has watched one rival after another put up the white flag. Now, Tesco.com

has assumed the mantle of the world’s largest and most successful on-line

grocer. "We’ve been a bit lucky," says Browett, "but we’ve

also been right."

Tesco’s big bet was to bet small. In 1996, when the Web was exploding and

on-line groceries seemed like a brilliant idea, Tesco PLC dipped its toe

ever-so-gently into the water, outfitting a single store in Osterley, England,

to accept orders by phone, fax, and a crude website. The idea was to test

whether customers would buy groceries without shopping in conventional

supermarkets. Equally important, Tesco had to figure out whether it made more

sense to pick those groceries off the shelves of its stores or build separate

warehouses to fill on-line orders.

By March, 1998, the company had proved there was sufficient demand and that

picking from stores worked. But it had to keep tweaking the process to get the

economics right. It wasn’t until September, 1999, that it rolled service out

to 100 stores.

"They get it"

Now, Tesco.com is firing on all cylinders. It has expanded to 250 outlets–more

than a third of the chain’s 690 British stores–enabling it to deliver to 91%

of Britain’s population. The business is on track to turn in revenues this

year of more than $450 million and boasts a respectable net operating margin

from groceries of around 5%, or more than $22 million, analysts estimate. Last

year, the dot-com unit lost $13 million due to the cost of expanding into new

businesses such as CDs and videos, but it was profitable on groceries.

"They were the only company in the world to really get it," says a

retail analyst at Schroder Salomon Smith Barney.

What Tesco got was that selling groceries over the Net was going to be small

potatoes for the foreseeable future. After all, the chain is expected to book

sales this year of $30 billion, making its on-line operation a mere 1.5% of

revenues. So instead of spending a fortune to build distribution warehouses

outfitted with fancy technology, Tesco chose a decidedly low-tech approach.

Fewer than two dozen employees are needed to pull products off the shelves in

each store and schlep them in vans to customers in the neighborhood. It’s kind

of like an electronic version of the 1950s delivery boy.

Today, Tesco.com handles more than 3.7 million orders per year–and half of

its on-line customers weren’t previous Tesco patrons. Now, the company is

building on that foundation to expand into other businesses, such as baby

products and wine by the case. "We’ve got a chance to become the leading

‘last mile’ delivery service in Britain, because we’re taking it very

incrementally," Browett says.

"Out on a limb"

That’s a lesson that failed dot-coms likely wish they had learned. Many Net

startups were undone by focusing so much energy on growth that they never knew

whether their business models worked until they hit the wall. Says Browett, who

at 37 could easily be mistaken for the head of a Web upstart: "You can’t

make a run for revenues and then work out the cost structure later."

Despite that timeless logic, e-commerce gurus from McKinsey and Andersen

Consulting (now Accenture) questioned Tesco in 1999 for not building warehouses,

prompting the company to recheck its math to make sure it wasn’t heading down

the wrong path.

Staying the course proved even sweeter for Tesco after the ignominious

failure of Webvan Group. The Foster City (California) startup, one of the most

richly funded in history, went bankrupt in July. It burned through $1.2 billion

in two years trying to establish a purely Web-based grocer in the US. Webvan’s

strategy was vintage dot-com: It shot for the moon, aiming to build two dozen

automated warehouses around the country, costing up to $35 million apiece, that

were supposed to cut 40% off the labor expense of handling groceries. Each was

meant to serve a 60-mile radius encompassing millions of potential customers.

But after building only three warehouses–in Oakland, California, Atlanta, and

Chicago–the numbers got worse and worse.

Webvan’s Waterloo: Customer demand wasn’t high enough to operate the

facilities at anywhere near their capacity, so fixed costs swamped revenues.

Growing competition

By contrast, Tesco’s decision to pick groceries out of existing

supermarkets kept startup costs low. The company spent just $58 million over

four years to launch its on-line grocery operation, and has since laid out $29

million more to expand into nonfood items. The wisdom of that tortoise-vs-hare

approach has been validated by a host of other companies.

The prime example: In June, Safeway, the No 3 supermarket chain in the US,

said that it would partner with Tesco to deliver groceries to on-line customers.

"We liked Tesco’s track record," says Safeway spokeswoman Debra

Lambert. "They understand how to combine technology with bricks and

mortar."

That’s not to say there aren’t drawbacks to Tesco’s approach. Orders

are automatically routed from a data-processing facility in Dundee, Scotland, to

the nearest store, so customers are limited to buying only what’s available

there. If it happens to be one of Tesco’s smaller outlets, they may have only

20,000 items to choose from, vs 40,000 at larger stores. Analysts worry, too,

that the Tesco.com model won’t "scale up" when the business gets

bigger. Although its fixed costs are low, Tesco.com has relatively high variable

costs because more orders require more labor for picking and delivery. As a

result, Tesco.com won’t likely be able to reap the economies of scale that

Webvan expected from its warehouses–meaning it may never become much more

profitable than it is today.

On top of that, Tesco will face growing competition. Despite Browett’s

claim that the secret of Tesco’s success lies in painstakingly tested and

refined processes, some analysts think competitors can fairly easily copy or

improve upon them.

Hybrid approach

None of this worries Browett. He thinks Tesco.com can hit $4.35 billion in

sales–about 10 times today’s levels–before running out of headroom in its

stores.

What really riles Browett, though, is the notion that rivals will have an

easy time catching up. "This looks simple on the surface, but the detail

underlying it has turned out to be very, very hard," he says. That’s

where Tesco’s by-the-numbers management has proven to be an invaluable asset.

Founded in the 1920s by immigrant businessman Jack Cohen, for decades the

company played scrappy second fiddle to Sainsbury’s. The turning point came

seven years ago, when Tesco marketing executives won an internal power struggle

with the traditionally dominant purchasing managers. That resulted in the

elevation of then-marketing head Terry Leahy to his current role as CEO of Tesco.

From that point Tesco has obsessively focused on satisfying customer demand.

By the late 1990s, it surged past Sainsbury’s in sales and market share,

despite its less upscale image.

Slow start

But the dot-com operation may be Tesco’s most unlikely triumph. Launched as

a skunk-works project with six mid-level managers reporting directly to Leahy,

Tesco.com got off to an inauspicious start. For two-and-a-half years–an

eternity in Internet time–the unit’s managers tinkered with the formula.

"We went down some blind alleys and back," admits Tesco.com Chief

Operating Officer Carolyn Bradley.

After rejecting phone and fax orders as too expensive and error-prone, Tesco

settled three years ago on a system that lets customers place orders only over

the Web. But the process of picking products off the shelf was punishingly

inefficient. In the supermarket business, where margins are thin, a few pennies

per item can make the difference between profit and loss. And the one thing

Tesco wasn’t willing to do, Bradley says, was to lose money on its dot-com

operation.

When the company retrenched in 1998, it came up with a nifty solution. Rather

than having pickers traverse the entire store filling orders for individual

customers, each supermarket is divided into six zones–groceries, produce,

bakery, chilled foods, frozen foods, and "secure" products such as

liquor and cigarettes. Each picker, outfitted with a rolling cart, scours a

single zone retrieving products for six customers at a time. Then, customer

shipments are assembled in the back room and stacked in vans for delivery.

Tesco.com typically fills two to three waves of orders per day, which allows

customers to buy as late as noon and receive a delivery by 10 that night.

Delivering the goods

There’s another surprising factor that has spelled the difference between

success and failure for Tesco. When the company rolled out Web shopping, it

bucked conventional wisdom and imposed a 5 ($7.25) delivery fee per order, an

amount it figured the market could bear. By contrast, Webvan offered free

delivery for orders over $50, which ended up costing it millions in unrecovered

expenses. Charging for delivery proved to be a masterstroke. First, it largely

covers the cost of the vans and drivers who blanket the country. Tesco.com takes

in about $27 million per year from the fees, close to the estimated $34 million

cost of deliveries, figures a Booz, Allen & Hamilton analyst. Imposing a fee

also boosts the likelihood that customers will be at home during the two-hour

window for their deliveries, since they have to pay again for redelivery. That’s

a big win for Tesco, given that returning merchandise to the store and

restocking it could savage margins.

Even more important, the delivery fee has helped raise the typical order size

because customers want to get their money’s worth. So the average purchase

from Tesco.com is three times a typical $35 supermarket transaction, a vital

contributor to the on-line operation’s solid gross margins. Eliminating the

fee in an effort to stoke demand would take away the incentive to spend up. And

indeed, Tesco.com has no interest in boosting sales if the result is a loss on

operations.

Instant legitimacy

Truth be told, Tesco.com also enjoys advantages Webvan never could have

recreated even with another $1 billion in funding. By being a part of the Tesco

empire, it can piggyback on the parent company’s advertising, branding, and

customer database. As one of the best-known and most trusted names in Britain,

Tesco confers instant legitimacy on its dot-com unit. Plus, the on-line

operation gets free ads in Tesco’s quarterly mailing to its 10 million

affinity-card holders and has linked its Website to store databases so customers

can easily reorder products they’ve previously purchased on-line or in a

supermarket. On top of that, having pickers in Tesco stores provides constant

publicity for the Web service–a benefit Webvan could never enjoy because it

had no retail presence.

Tangible and intangible advantages such as these have prompted some analysts

to question whether Tesco.com would turn a profit if it were a stand-alone

business. ABN Amro’s Mark Wasilewski, for one, thinks the parent may not be

charging its dot-com unit enough in-store costs–depreciation, utilities,

marketing, and so on–as a way of making Tesco.com’s books look better.

Browett dismisses the charge. "There’s no point in fooling

yourself," he says. Every unit, whether Tesco’s financial-services arm or

its dot-com operation, has to carry its own weight, he insists.

Besides, he adds, the criticism entirely misses the point: Tesco isn’t

trying to create a stand-alone business. Tesco.com is merely an additional sales

channel that lets the company boost revenues and push more products through its

system. As long as it’s not leaking red ink, it’s a net gain.

By Andy Reinhardt in BusinessWeek. Copyright 2001 by The McGraw-Hill Companies, Inc