By James Davey
LONDON (Reuters) - After a decade pushing its non-food business, Tesco <TSCO.L>, Britain's biggest retailer is changing, and a conspicuous focus on fresh produce greets shoppers at its newly styled superstores.
"Customers were saying they felt we didn't have the right products in our shop," said Kiran Sudan, store manager at the recently refurbished Kensington superstore in west London, whose catchment area is a multi-cultural mishmash of affluent dwellings and social housing.
Floor space for general merchandise, such as electrical items, has been cut by over two thirds at her store, part of Tesco's fresh food drive, which has introduced an additional 2,000 grocery lines and a recognition that the future of non-food retail is largely online.
So far around 400 of Tesco's 3,000-plus British stores have been refreshed, with wider aisles, warmer natural colours and wood cladding, and an array of fresh food counters.
In her 30 years at Tesco, Sudan has witnessed phenomenal success under Terry Leahy, chief executive from 1997 to 2011, when double digit yearly profit growth was the norm, and the recent stumble under his successor Phil Clarke.
Founded by Jack Cohen in 1919 as a group of east London market stalls, Tesco, which now turns over 65 billion pounds and employs more than half a million people worldwide, was one of Britain's most consistent companies in terms of earnings growth, until it issued its first profit warning in over 20 years in January last year.
The breakneck expansion model couldn't keep delivering.
"We've run too hot for too long," Clarke acknowledged.
For Mark Pooley, store manager at the Tesco Metro convenience store on Tooley Street, near London Bridge, Clarke's words were a turning point.
"Someone saying, 'We realise this needs to change, and we will do something about it' created a positive feeling in the business," he said.
Last April, Clarke, who began his Tesco career aged 14, stacking shelves in a store managed by his father, launched a billion pound plan to reverse years of underinvestment in existing British stores and stem a steady loss of market share to rivals like Wal-Mart's <WMT.N> Asda and J Sainsbury <SBRY.L>.
Tesco, the world's third-largest retailer after Wal-Mart and Carrefour <CARR.PA>, remains the market leader in Britain, which accounts for over 60 percent of group revenue and profit, but its grocery share has slipped to 29 percent from a peak of over 31 percent in 2007.
Its 3.6 million square metres (39 million square feet) of floor space still accounts for one in every 10 pounds spent in British shops, but it is switching from a space-hungry, expansionary business to one focused on making the most of existing stores, improving returns on investment and better cash generation.
In January, Clarke said Tesco was "back on form" in Britain, with underlying sales growth of 1.8 percent for the six weeks to January 5, its highest in three years.
Though it has stepped up investment in existing British stores and online, overall group capital expenditure is falling, coming down from 3.8 billion pounds in 2011-12 to 3.3 billion in 2012-13. The key driver of this is 38 percent less space opening in Britain in 2012-13 than in 2011-12.
For a decade its average capital expenditure was about 6.5 percent of sales, but now it is targeting less than 5 percent and an increase in return on capital employed (ROCE) from 13.3 percent in 2011-12 to 14.6 percent by 2014-15.
All this means Tesco will have more free cash, which could mean higher dividends and share buybacks a few years down the track. Analysts at Deutsche Bank reckon Tesco could return 1.6 billion pounds per annum from 2016.
"This business is generating huge amounts of capital still. If they are not using that, it's much better in our hands than in theirs," said Charles Heenan, investment director at Tesco shareholder Kennox.
ONE YEAR ON
With the turnaround a year old next week, about 8,000 new staff have been recruited and trained, and existing staff re-trained. Own-brand food products have been re-launched, promotions have become more personalised and a new price-comparison initiative has been introduced.
Clarke has also accelerated investment online, rolling out Click & Collect services to about 1,400 stores, where customers can use their PCs, tablets and smartphones to order from a range of 200,000 non-food product lines for pick-up in store.
At Tooley Street, Pooley is seeing an impact.
"Last week, outside of an Olympics week last year, was my best sales week ever," he said.
The refit of his Metro convenience store shrank the size of the checkout area but provided a bigger salad bar popular with city workers and extra space for health and beauty products.
Bahar Maulod, a teacher shopping in the Kensington superstore, said it looked more organised.
Housewife and mother of three Susan Hakme also liked the new look, though, demonstrating that no change is without pitfalls, she said she found the cafe too expensive and complained that "they should have done clothing" and had got rid of children's books.
Though there are encouraging signs, a better trend is by no means settled, with analysts forecasting flattish underlying UK sales growth for Tesco's entire fourth quarter, with trading possibly hit by a Europe-wide horsemeat scandal, which found that some beef products sold by Tesco and other grocers, including Asda, contained horse.
"Christmas trading was acceptable, certainly not a disaster, but it's not like they're hitting any home runs yet," said Kennox's Heenan.
Though Tesco's shares have increased 18 percent over the last six months, they trade on 12 times forecast earnings, below Sainsbury's 12.6, Wal-Mart's 14.3 times and Carrefour's 14.7, according to Reuters data.
Clarke's plan will take time to boost profitability.
The group made underlying pretax profit of 3.92 billion pounds in its 2011-12 year, up 1.6 percent. According to a consensus of analysts' forecasts that will fall 10.7 percent to 3.5 billion pounds in 2012-13, reflecting the cost of the turnaround plan, the impact of the euro zone debt crisis on eastern European markets, regulatory issues in South Korea and losses in the United States, which Tesco is expected to exit.
But with analysts forecasting that Tesco will see profit rises of 3.7 percent and 7.7 percent in the following two years, Clarke may yet win the affection of investors.
"You should never count them out," said the boss of one of Tesco's British rivals.
($1 = 0.6496 British pounds)
(Additional reporting by Sinead Cruise and Neil Maidment; Editing by Will Waterman)