Tesco

This report relates strategy concepts developed by Michael Porter to the supermarket chain Tesco. It will argue that although developed 30 years ago, Porters analysis is still useful in assessing the competitive environment of firms these days. However, because there have been many developments in technology, such analysis can prove to be static, simplistic and only partial. The second part of this report will look at management moves within Tesco in the past 5 years and attempt to evaluate to what extent they have contributed to achieving additional profits. The analysis will be based on product market and financial information.

Relevance of Porter’s concepts

Porter’s concepts can be applied to many organisations. His five forces analysis involves examining the external environment and focusing on the structure of the industry. The aim of this type of analysis is to devise a strategy that will enable firms to develop opportunities and protect them from threats. By doing so, firms can achieve possible competitive positioning or, in other words, differential advantage over the products or services of their competitors.

The five forces comprise barriers to entry, the threat of substitutes, consumer power, supplier power and the degree of rivalry. In supermarket grocery retailing, barriers to entry are extremely high. Most obviously, the capital requirement of entry is going to be the primary factor to overcome for potential new firms. High initial investment and fixed costs are likely to deter many potential newcomers. Another barrier to entry is economies of scale. Tesco and other large supermarket chains are able to purchase large volumes of goods for a reduced price. In contrast, smaller start-up companies are more likely to buy smaller volumes at higher prices. New firms also have to be aware that customers have developed loyalty to existing firms. This reality can be seen in the example of discount stores such as Lidl or Aldi who have struggled and failed to establish themselves as major players in the grocery retail market. Another of Porter’s five forces is the threat of substitutes. Firms should analyse to what extent it is possible for customers to switch to the substitute. It is also important to keep up with competition if there is a threat of obsolescence. In such cases, firms should make sure that customers find their products or services more attractive. Alternatively, companies in the same industry may choose to compete on price, which will reduce profit margins. This can clearly be seen in the example of major grocery retailers who are engaged in a price war. For example, Tesco offers price check on its website.

Power of consumers is closely linked to the availability of substitutes. Geographically, most people have a choice between different supermarket chains, who compete on price and various promotions. Suppliers can be in a particularly strong position when they demand a price premium for their products and when the final product can be affected by their suppliers’ delivery schedules and quality. However, Tesco is controlling the situation by not relying on one big supplier but by having a number of smaller ones. This way, the bargaining power of Tesco is increased. If a particular supplier is charging too much, Tesco is in a position to demand a lower price. Should the supplier not be willing to do so, Tesco can switch to another supplier.

Lynch argues that the extent of competitive rivalry depends on how competitive the market is. All four of the major players are trying to increase their market share. Consequently, the grocery market is particularly competitive.
Porter's five forces is a "bottom line" way of analysing a company, from the perspective of the company. In the true spirit of capitalism, it looks at economic rivalry as being of central importance, and suggests that you should look only at factors affecting the company's profit in a systemic model defined by that rivalry.
If it is difficult to differentiate products or services, then competition is essentially price-based and it is difficult to ensure customer loyalty.

Porter also talks about generic strategies. There are 3 generic strategies- cost leadership, differentiation, and market segmentation. Porter argues that in order to be successful, a company needs to pursue one of the strategies and must not be ‘stuck in the middle’. There are essentially only two sources of competitive advantage, differentiation and low prices. He also suggests that firms with high market share are profitable because they pursue a cost leadership strategy whereas firms with low market share are profitable because they pursue differentiation or a market segmentation strategy. However, Tesco does not seem to fall in any single category. It has more than 30 per cent of the market share in grocery retailing in the UK. However, at the same time, it does not offer discount shopping and is not even the cheapest among the main supermarkets. It offers Tesco basic foodstuffs as well as Tesco Finest. Indeed, Lynch argues that there is empirical evidence suggesting that some companies do pursue both differentiation and low-cost strategies at the same time. Tesco, being one such company, uses low costs to provide greater differentiation and then reinvests the profits to lower their costs even further. Another part of Tesco’s strategy that could be seen as differentiating is its building of community. As far as Tesco’s customers are concerned, again, they cannot be ranked as belonging to a certain social group. By providing both cheap and expensive groceries, it offers products for people with limited budgets as well as those who are more well off. Although this contradicts Porter’s view of a successful strategy, it appears to be working in Tesco’s favour.

A company’s value chain consists of all the activities it performs to design, produce, market, deliver, and support its product. The value chains of companies that supply and buy from one another collectively make up an industry’s value chain, its particular configuration of competitors, suppliers, distribution channels, and customers. The value chain also includes the information that flows within a company and between a company and its existing or potential customers. Supplier relationships, brand identity, process coordination, customer loyalty, employee loyalty and switching costs all depend on various kinds of information.

Only one tool in a toolbox
By looking at competitive positioning and Porter’s five forces analysis, companies can obtain a better understanding of which strategy to undertake. This analysis can be very useful, particularly when looking at the major factors driving the dynamics of the industry. Porter’s model has real value because it raises issues in a logical and structured framework.
Drucker argues that traditional strategy models, such as the one described by Porter, “focus only on the last few hundred yards of what may be a skill-building marathon”. Furthermore, many suggest that building a strategy on a simple concept with long term goals is a mistake. Short-term horizons that are renewed when needed are proving to be more appropriate considering the speed of developments in the economy. This will be discussed in detail below.

While Porter emphasised strategy development based on industry analysis, it is now becoming clear that an analysis of the individual organisation needs to be included. Including financial analysis can be of particular importance. This is supported by a study published by Rumelt where it is suggested that profitability at company level was superior to that of corporate or industry level. Generic strategies enable firms to identify the need for differentiation. However, the real issue is to differentiate a product so that it is attractive to the customer.
According to Lynch, Porter’s framework is static and cannot capture constant changes in the market. Another serious flaw of the model is the assumption that an organisation’s interests come first. In particular it equates buyers with all the other aspects of the micro-environment. Many strategists would argue that customers are the most important aspect of the micro-environment. Geographically, most people have a choice between different supermarket chains, therefore customer loyalty is seen as one of the major challenges for grocery retailers. In this case, industry analysis is not very helpful and it is necessary to consider the core competencies as outlined by Prahalad and Hamel.

Limits of Porter’s concepts include the lack of discussion of broader international context. They also ignore the human resource aspects of strategy, for example cultural factors or management skills. Without a financial analysis of a firm’s performance, these concepts only serve as a starting point in strategic analysis and should by no means be seen as complete solutions.

New Economy

Companies have to adapt to a considerable and fast-paced change in the market. Rifkin argues that many products are being transformed from goods into services. This so called new economy is turning everything upside down, when buildings used to be assets, now they are seen as liabilities. Lynch argues that strategy links the activities of the organisation to the environment in which it operates. This environment is constantly changing due to increases in wealth, international competition and technological changes. Markets have become more complex in economic, cultural and social aspects. Firms have also started to participate in cross-industry operations making Porter’s concepts increasingly out of date. For example, Tesco does not only compete with other grocery retailers, it also competes with firms selling electricals, toys and clothes, and also offers insurance and financial services. Physical assets are becoming increasingly marginal to the economic process. Instead, concepts and ideas are the ones carrying the real value in the new economy. Shortening life cycles, customised production and developments in technology require continuous innovations.

Evans et al. (p71-73) argue that in the era of information revolution the structure of industries has an impact on ways that companies compete. Information is increasingly seen as a basis of competitive advantage. This also has an impact on the five forces analysis. Barriers to entry can be diminished by new businesses choosing to operate through the internet. The change in economics of information can undermine established value chains in many sectors of the economy. This in turn may require a fundamental change in a company’s strategy.
Four pillars and profitability in the UK

As the food market in the UK is becoming saturated and planning restrictions are being imposed, supermarket chains have to look for other ways of making profit. The key to sustaining growth in a seemingly mature market is multiple sources: ‘every little helps’. Tesco’s long-term strategy is based on four key pillars: growth in the UK core, international expansion, increase in strength of the non-food sector to match that of the food sector, and development of retailing services.2

Tesco’s profit margins and turnover in the UK have steadily been increasing since 2000. Table X shows that both sales and profit of Tesco’s operations in the UK contribute by circa 80%. This could be attributed to continuous innovations of existing products and services. Although profit margin and return on capital employed of Morrison’s has been higher than that of Tesco between 2000 and 2003, their recent acqusition of Safeway has put them in a more unfavourable position.

When compared to the industry, Tesco’s profits and turnover have been greater than any of its rivals. This could partly be connected to its market share of 20%. Its closest rivals are ASDA with 11.2% and Sainsbury with 10.6%

Good stock turnover and increased days payable are an indicator of an efficient use of working capital. There has been a steady increase in value added in absolute terms as well as percentage of sales.

Tesco’s strategy and corresponding results

Although Tesco Clubcard was launched in 1995, improvements in technology over the past 10 years have led to improved data collection. It gathers fundamental information such as customers’ lifestage, shopping habits, what they buy, their response to promotions etc.
Based on this information, Tesco is able to exercise ‘reverse strategy’. In this way Tesco can deliver products their customers want rather than trying to find customers for their products. Improved stock taking, shelf stacking and managing of the supply chain can be attributed to a new real-time retail infrastructure. This was adopted in 2001 and later improved in 2003, adding to an ongoing profit. While Tesco is expanding in the number and size of its stores, it is important to be able to exercise and improve control. Accelerating the supply chain and reducing the number of ‘out of stock’ items is thought to lead to improved customer loyalty. This together with minimising of IT management costs and the ability to take a quicker corrective action should a problem occur lead to increase in profits.

As mentioned before, Tesco’s strategy is based on customer loyalty. Another way of developing personal relationships between the chain and its customers is the creation of online communities. On its website Tesco.com has numerous clubs including eDiets, the Nutri Centre, Healthy living club and others.

Tesco.com
With coverage of 98%, Tesco are now the most successful online grocer in the world. Recently Tesco introduced shopping list to help customers navigate on the website. First time visitors were offered a suggested shopping list based on their shopping patterns accumulated by clubcard.

Non-food products

In order to stay competitive Tesco have turned to adding many non-food lines. These are currently the main drivers in growth of the UK supermarket chains3. Associated with higher profit margins they can support the decreasing profit margins of food products. It is estimated that the current share of Tesco’s non-food products is only 2.5%.4 As such there is a potential for rapid growth and increased market share in this sector. This is also supported by the fact that only 20% of the population have access to Tesco Extra.

Profitability of the Express format

Following the difficulties in obtaining permission to build out of town superstores, Tesco saw an opportunity in convenience shopping. Its Express format is the equivalent of a corner shop, typically positioned in busy areas of towns. It requires less capital investment and provides higher profit margins and faster returns. Customers are willing to pay higher prices for this convenience. It can be argued that with society becoming fast paced and many people being forced to eat on the go, small stores offering ready-made meals are very profitable.

International expansion

Tesco’s international expansion is based on three principles: finding joint venture partners or a chain suitable for acquisition, being able to locate new sites for further growth and having limited competition in the new market.
In 2002, Tesco had experienced difficulties with expansion in Poland. Expected GDP growth of 5-6% turned out to be too optimistic. The actual growth was only 0.6% which had a significant impact on sales. This was coupled with the acquisition of fifteen HIT stores, two of which were still under construction. Although this move gave Tesco a significantly higher market presence, it was also considered very expensive. In 2000, an attempt was made to penetrate the market in Taiwan. Many questioned the agenda behind such move, as conditions in Taiwan did not adhere to any of the aforementioned three principles. Two years on Tesco still had not found a joint venture partner and was facing competition from the French giant Carrefour. This together with the difficulty of obtaining planning permission led to losses. To this day, there are speculations about Tesco’s withdrawal from Taiwan.

These two slip-ups could be part of the reason why return on capital employed dropped by 11% between 2002 and 2003. In addition, the gearing ratio was almost 92% in 2003, which is a sign of an increased contribution of funds by lenders. This could be perceived as a dangerous move if a firm is not sure about how profitable the investment is. However, it proved to be the right move for Tesco, as return on capital employed increased in subsequent years and gearing ratio was down to 65% by 2005.

It can be argued that Tesco have chosen a very good strategy for international expansion. This is normally done by small acquisition. Once Tesco have familiarised themselves with shopping habits, cultural factors and preferences of the new market, they expand further mostly by organic growth. Customers in different markets have different preferences. Local people are put in charge of newly opened stores, which increases the chances of success because of their know-how. Although this approach has a longer lead time it is also associated with a lower risk. Slovakia, Czech Republic, Hungary, Poland and Republic of Ireland were the first five countries Tesco expanded into internationally. In all of them they have now achieved market leadership. Tesco is currently operating in 12 countries outside the UK and is profitable in 10 of them. The retail industry is considered to be low cash-generating and in this respect it is suited for organic expansion. High capital requirements lead to low return on capital employed. Lead markets such as Korea and Thailand have reached a more profitable phase with high profits and are therefore able to compensate for possible acquisitions in other markets. Expansion in already established markets continues to make profit contributions even more substantial as extra sales can be added at lower incremental capital cost. Capital employed is increasing whilst profits being generated are still catching up so there is the expectation of further improvement in the returns as international expansion continues.

Retailing services
Tesco is currently offering 16 financial products. Their aim is to competitively position their products based on simplicity. Tesco Personal Finance, a joint venture with the Royal Bank of Scotland, was launched in 1997. One of its advantages is the ability of customers to deposit money at any Tesco store. This increased availability makes it more attractive for customers to use Tesco’s services and hence increase their profits. Many transactions can be made when conventional banks are closed. Since launched, Tesco’s Personal Finance services have developed into a business in its own right, making substantial profit.

Changes in the economy and business environment outlined in this report can be closely linked to the operations of Tesco Plc. It has been argued that the lack of international and cultural context of Porter’s concepts limits the extent to which Tesco strategy can be explained by them. Limits of Porter’s concepts include the lack of discussion of broader international context. In today’s world of highly volatile customer preferences, shortened product cycles and innovations, an externally focused orientation does not provide the full picture needed for the formulation of long-term strategy. It has also been shown that management moves in the past 5 years had a significant impact on additional profits made by Tesco. Although the UK grocery market is reaching saturation, Tesco have proved that by expanding in the non-food sector, retailing services and expansion abroad there is potential for long-term growth and profits.