Tech Industry

Taking Tesco global

The U.K. retailer has succeeded in areas where others have foundered--especially in selling goods online. McKinsey spoke with Tesco's vice chairman, David Reid, to learn his recipe for success.

Many retailers have tried and failed to establish themselves outside their home markets. Likewise, some retailers have gone astray trying to exploit Internet shopping. As a result, Tesco, the United Kingdom's biggest grocer, has attracted considerable attention because of its ambitious overseas strategy and its successful online home delivery service.

Tesco also happens to be the undisputed world leader in Internet grocery sales (www.tesco.com). Its online home delivery service is now profitable, Tesco says, and it has struck a deal in the United States with Safeway, which will use Tesco's system for a home-shopping service.

In this Quarterly interview, conducted by Peter Child, a director in McKinsey's Paris office, Tesco deputy chairman David Reid discusses the role of international expansion, Internet shopping and nonfood sales in the company's ongoing quest for growth.

Q: Let's talk about your e-commerce strategy. Why do you think Tesco succeeded where others failed?
A: It's probably not as black-and-white as that. Part of our success was due to the fact that we got in early--it was like working with a system made of sealing wax and string. We started off with a few stores and were surprised how attractive they proved to be to customers. So we spent two or three years perfecting the system. The key thing was that we developed a system based on our practical experience.

Since demand was low, albeit rising, the decision not to invest millions of pounds in building new warehouses but to use existing stores and get staff to pick orders from the shelves turned out to be excellent. It's satisfying to prove all the experts wrong!

We restricted capital to the minimum. Instead of spending lots of it, we put a lot of effort into getting the system and processes right: how to manage vehicle loading, for example. You can't be sending out half-empty vehicles if you want any financial returns. But this is exactly what some supermarkets ended up doing--and taking hours to make trips to and from the warehouse. Most of them have had to stop.

The degree to which we came under attack for choosing this model rather than the classic warehouse one was incredible. The criticism from some analysts was almost vitriolic. They couldn't understand how we could be so stupid. Obviously, we've been through a steep learning curve. But the point is that while other people were talking about it, we were getting down to the hard strokes.

We didn't know all the answers, but if you follow the customer and keep going, you'll actually find out how big the opportunity is before anybody else does. We ended up with a system that worked and was popular with our customers. And because we didn't need to invest megamillions of pounds, we were able to expand the service rapidly and soon had 90 percent or more coverage of the market in the United Kingdom. We are still learning and continually improving the system.

What's more, home shopping is now part of the Tesco toolkit that we can put into our businesses elsewhere. It's in Ireland, and it's being launched in South Korea, which has very high Internet penetration, and others will follow. Other companies are also interested in our system, as the Safeway deal shows.

It's not difficult to see why other retailers opted for warehouses. Big warehouses can be fully automated and offer scale advantages. And this may well turn out to be the right model eventually. But it's certainly not the right way to start. I remember somebody asking our chief executive, Terry Leahy, "When will you have to put in warehouses?" He replied, "I don't know, but we'll be the first to find out."

So Tesco may move toward the warehouse model?
I'd be surprised if we didn't test it out at some stage, but only on the back of significant scale and in a region where we can get the warehouse close enough to the customers to give a good standard of service. At some stage, if we don't have warehouses the turnover might become a burden on stores. Internet shopping now accounts for 5 to 8 percent of turnover in some lead stores. The occasional one might reach 10 or 12 percent. But if you remember that during the Christmas period, stores cope with 50 percent more volume, there's obviously some way to go before we reach the point where the stores can't cope without warehouses.

Your Internet shopping site sells nonfood items, and you chose to expand abroad using the hypermarket format even though nonfood hasn't traditionally been part of Tesco's offering. How important is nonfood in your growth strategy?
Currently nonfood, excluding gasoline, is in the low teens as a percentage of turnover. In some stores, it can be as high as 25 or 30 percent. And in our hypermarkets in emerging markets, we are capable of selling up to 45 to 55 percent nonfood because they don't have the formats specifically for consumer goods that we have in the West. We're trying to increase our nonfood business in the U.K. at twice the rate that the Tesco business as a whole is growing. So if we were increasing 5 percent a year on food, we'd be looking to do 10 percent on nonfood.

Like e-commerce, it's still a learning process. We chose to expand abroad using the hypermarket format when we didn't have any hypermarkets of our own in the United Kingdom. And that meant we had to start from a clean sheet. In a way, that was advantageous. We weren't taking U.K.-style stores and dumping them in the middle of Thailand or wherever. Instead, we could say, "OK, what would the customer like to buy here?"--which was an advantage. It means we've been more flexible, more up-to-date.

Quite a lot of the thinking about the layouts, the merchandising, the marketing, and the approach to hypermarkets in the U.K. has been conditioned by our international business. But whatever we decide to do, we need to make sure we do it well; otherwise we could badly weaken our brand. It always comes down to following the customer.

We spend a lot of time trying to understand customers. We take that understanding and translate it into detailed plans to add value for customers--be it better service, better prices, home shopping, or a better range of goods. We have a track record of spotting where customers are moving. Back in the early '90s, we lost track of our customers for 18 months and suffered for it. We lost one or two points of market share, which is huge in retailing. So now we strive to be first in spotting what the customer wants and then get in there and do it well.

How important are loyalty cards in understanding customer trends?
It's very easy to malign loyalty cards. People are always rubbishing them because of the expense. But if you took our loyalty cards away from us, it would be like flying blind. They tell us how to attract customers, how secondary customers behave, how specific customers react to specific promotions, how you can influence competitors' openings, how you can spot new trends, how you can convert customers.

One of the criticisms of loyalty cards is that you get all this data, but you don't know what to do with it all and end up drowning in it. Initially we weren't sure what to do with it. So as with other things, we had to learn. The skill is to know what you want to get out of the system. What you can't have is barrel-loads of paper every day saying, "This is every transaction of every customer." We value data-mining skills so strongly that the company we engaged to do the analytical work is now a subsidiary of Tesco. And we're adapting the system to use in South Korea, which I'm sure will be an eye-opener in terms of what it tells us about the tastes of our South Korean customers.

Tesco is renowned for the speed of its recent international growth. What determines overseas success for a retailer?
First and foremost, cash--which means a strong core business. It's expensive to grow abroad. If you're going to be a serious international player, you have to be one of the top two companies in a number of countries, which has sizable cash implications. Yes, you could grow on a more gradual basis; you don't have to start up in several countries simultaneously. But it still adds up to a huge cash investment, particularly if you choose to grow, as we have done recently, on an organic basis.

If you're spending, you also need the support of shareholders. They need to know what you're doing and why, what the returns might be, what it is you're after. International expansion is a key part of our growth strategy, and it was important for our shareholders to understand that it would take time to show returns.

Indeed, such a strategy inevitably dilutes returns for a while. But it's also an attractive strategy, given the growth rates in many overseas markets and the fact that it's difficult to grow in many Western markets because you can't open stores, or there are union issues, or there are no sites available. We had the support of our shareholders, and our stores in the Republic of Ireland are now cash neutral. Our stores in six of the Central European and Asian markets where we operate are now profitable. In a seventh, Taiwan, we'll be profitable in a couple of years. But initially, it was all driven by our U.K. cash flow.

So you have the cash, and you have the shareholders' confidence. What more do you need for successful international expansion?
You need good research in terms of which countries you choose. You'll need to understand the local market. But the real key is your capabilities. What have you got that will add value abroad? If it's an acquisition, what are you going to add that's going to repay the shareholders? And if you're expanding on an organic basis, what have you got that will give you a leading edge over the current incumbents or will sustain you through the inevitable future competition?

Generally, we rely on our operational skills and operational efficiency. That includes the traditional retailing capabilities--replenishment, own label, innovation. But retailing is a fairly see-through business. People can easily copy what you do, which means it's also a fairly homogeneous industry. If you wander around different stores, you might well be puzzled as to why one has higher revenue than another.

The answer, I believe, depends to a large extent on how you deal with customers, which in turn depends on how you deal with your own staff. These are the strengths that I believe give Tesco a competitive edge. They allow us to produce a more local offer that appeals to the local customer.

I don't think scale is the key, even though it's much talked about. Global scale doesn't give you the right to go into a country and make money. There's plenty of evidence of that. Capabilities are more important than scale. That's because value comes from serving customers well, which means that most of the added value is added locally. You have to know where to locate your stores, choose the right format, offer the variety of goods that local people want, and offer value for money. And you have to pay attention to how your staff relates to the customers in the stores. All this determines success with customers.

What does scale provide? Sure, suppliers will take more notice of you if you have 20 stores rather than 2. But retailers buy most of their foodstuffs--85 or 90 percent--locally. So for food retailing, it's local scale that's important, not global scale. For nonfood items, there are certain products, such as textiles and durable goods, where scale may allow you to buy on a global basis. But I'd say that while scale advantages are attractive here, they're not overpowering.

Back in 1999, an analyst asked the CEO of our South Korean operation, "How can you possibly compete in nonfood with a retailer that has the global scale of Wal-Mart?" Our CEO didn't understand the question. "What are you talking about?" he replied. "We sell far more nonfood than Wal-Mart per store." So you see, global power isn't everything.

Does that mean you disagree with those who predict that three or four global players will eventually dominate international retailing?
Yes, I disagree. Expanding abroad is a big financial challenge. Inevitably, there's an initial painful period. You might lose heavily in the first year and not break even until the third. There aren't many big players, because not many of them can finance international expansion, but even if there were three or four I don't think they would dominate or exclude other, smaller companies. There'll still be plenty of opportunities for smaller companies that serve customers well.

Nonetheless, once a handful of big companies are established in overseas markets, it must be more difficult for newcomers to compete. How has Tesco, which started its international expansion relatively late, overcome this?
In some ways we were disadvantaged, because other players had established a strong position in certain countries. But we had a very strong cash flow from our U.K. business, which gave us a strong start. I think that until Carrefour bought Promodès, in 1999, Tesco had the number one cash flow in Europe. It was our success in the U.K. that allowed us to go international. If we'd gone international at the same time we were trying to move to the top of the U.K. pile, things might have turned out differently.

We used our financial strength to move quickly. We're probably the fastest-growing international retailer. But at the same time we have remained very focused--careful not to stake too many flags in too many countries. As a result, we've already overtaken a number of retailers in a number of markets. In the nine countries where we operate, we're already the market leader in six of them.

What challenges have been associated with such rapid international expansion?
One of the main hurdles has been human resources. It's been quite difficult orienting our people to work internationally; people didn't join Tesco to get sent off to Thailand, say. We need our best people abroad, people who are good with people and who can translate into the local market Tesco values and the way we work with customers. The trouble is, we need our best people in the U.K. too: it's not as if our business is standing still at home. So this has been a challenge but also a great opportunity to develop wider business managers.

Importantly, we rely on relatively few expatriate employees. What we try to do is have an operating platform that provides the systems and key processes to run the business. These are our steering wheels. They steer us in terms of how we go about doing things, how we manage people, how we motivate people. It's what we bring to the party. We then find local managers who can execute the customer side of that approach to win business. We don't need armies of expatriates.

Some international retailers have 40, 50 expats in any country, which, apart from being expensive, means that there's no room for any of the local people to become anything more than department managers in hypermarkets.

We typically have maybe half-a-dozen expatriates on the operational side in Asian countries. Because we're starting out later than other companies abroad, we've found no shortage of well-educated local people with retail experience in Asia. They obviously understand the local habits and customers much better than an expat who's flown in from the U.K. Employing local managers has been more of a challenge in Central Europe because of the Communist history, so we do have more expatriates there, but that's a temporary measure. We've got some tremendous youngsters being trained and coming through.

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