Loyalty card key to Tesco bank ambitions

 

A huge store network and client base coupled with a popular customer loyalty scheme are set to help Britain's biggest retailer Tesco surmount big challenges to its plan to break into banking.

Growing enthusiasm for Tesco's banking ambitions could also help to trigger a rerating of the supermarket group's shares, which trade at a discount to many European peers, mainly due to its recent underperformance in its main British grocery market.

"The current 20 percent (price to earnings ratio) discount to the market looks harsh to us" ING analyst Peter Brockwell said in a recent research note, arguing the financial services business in particular was "not fully valued by the market."

Tesco, the world's No.3 retailer behind France's Carrefour and U.S. industry leader Wal-Mart, announced a big push into banking in July 2008, when it agreed to buy Royal Bank of Scotland out of a financial joint venture.

But the group gave few details of its ambitions, saying only it planned to make annual profits of 1 billion pounds from retail services - which include telecoms, online and home shopping as well as banking - within a few years.

It has since made progress, setting up a bank headquarters in Scotland, unveiling plans to open 30 in-store branches this year and signing an insurance deal with Fortis, and investors will be hoping for more details from a series of presentations on the retail services business on November 19-20.

Tesco shares have risen nearly 8 percent this year, underperforming both the FTSE 100 bluechip index and the DJ Stoxx European retail index

While some analysts say the discount is higher, Reuters data pegs the price-earnings multiple for Tesco at 13.1 times forecast earnings compared with 14.9 for the European sector index, still a significant 12 percent lag. 

CHALLENGES

The challenges Tesco faces in banking are considerable.

No organisation has successfully built a big British retail bank from scratch within the last 100 years and recent new entrants, mostly building societies and internet banks, have tended to founder on two traits among customers.

One is a reluctance to go through the hassle of switching their main current account, through which they usually receive their income and conduct their main monthly payments. Britain's consumer affairs watchdog, the Office of Fair Trading, estimates just 6 percent of Britons switch current accounts each year.

The other is a growing readiness to move savings to get the best interest rate. Internet bank ING Direct, for example, grew rapidly when it offered industry-leading rates, only to see much of that reverse when it moved back in line with the market.

The result is new entrants have struggled to build a big, stable deposit base, which they need to fund more profitable areas of banking, such as mortgages and personal loans.

Morgan Stanley analysts calculate that in order to fund a 5 percent market share in consumer lending Tesco would need a deposit base of about 70 billion pounds - unless it relies on wholesale markets, which they say would be unlikely as that is the model which led to the failure of Northern Rock.

"We struggle to see how it (Tesco) will be able to build a sustainable (as opposed to 'hot money') deposit base to fund lending on this scale" they said in a recent research note.

RISE TO PROMINENCE 

Tesco, however, has a powerful set of tools which could help it to create a low-cost bank, allowing it to offer competitive interest rates while preserving profit margins, as well as to attract and retain customers.

One is its network of over 2,200 UK stores, which allows it to add banking services at little extra cost and offer customers the convenience of banking at the same time as grocery shopping.

A second is that it serves over 20 million Britons a week - a captive market to which it can advertise its banking wares.

Thirdly, Tesco is generally a trusted brand with a reputation for value, in stark contrast to the public perception of traditional banks after the recent financial crisis.

Fourthly, the group runs one of the most successful customer loyalty schemes. Its Clubcard has about 15 million active users and its coupons have a redemption rate of around 90 percent, suggesting a strong attraction for shoppers.

Some analysts believe this could be the key to breaking down inertia on current accounts and retaining the loyalty of savers.

"Having a well-understood, powerful auxiliary benefit to offer (new and existing) customers gives Tesco a competitive tool unavailable to incumbent operators," Cazenove analysts said. They see Tesco capturing about 3 percent of the UK mortgage market, funded by a deposit base of 40 billion pounds.

One short-cut to building market share would be for Tesco to make an acquisition, and no doubt the UK government would welcome interest in the nationalised Northern Rock or parts of the Lloyds Banking Group, in which it owns a big stake.

But many analysts think that, with nearly 10 billion pounds of debt and a focus on reducing this, Tesco will steer clear of deals, and that it wants to build up its own business, without the troubles of integration or closing unwanted branches. 

That could mean a long, gradual rise to prominence, according to Barclays Capital, which expects financial services to add about one percentage point to Tesco's earnings growth in the short-to-medium term.

"(That) may not sound especially exciting but, within a relatively low growth sector, an extra percentage point of growth is certainly worth pursuing" they said.