Problem child back with retail's big boys: Tesco has realised that shoppers want value, not more stores. Heather Connon reports

AFTER months of concern that food retailers were about to be sucked into a spiral of price wars and market saturation, Tesco yesterday signalled to investors that the sector has pulled back from the brink.

As harbingers go, the company's trading statement looks at first glance an unlikely bearer of glad tidings. A decision to depreciate its store portfolio will cost more than 10 per cent of profits; an pounds 85m write-down on surplus land was a bolt from the blue; and even the promise that this year's result would be 'slightly higher' than last year's looked distinctly unexciting after five years of annual compound growth of more than 20 per cent.

But while all this may have been bad news for profits in the short term, it has made the long-term profitability of the sector look far more secure for two reasons.

First, the group has hinted that last year's skirmish on price is over and a full-scale price war, similar to the bruising battle of the late 1970s, has been avoided. Second, Tesco has accepted what has long seemed inevitable: there is a limit to the number of superstores Britain can stand. Continued expansion at the rate seen over the past few years is likely to harm, not help, profits.

Tesco is not the first to say these things. Archie Norman has made warnings about saturation his stock- in-trade since he took the helm at Asda. Sir Alistair Grant, chairman of Safeway's owner, Argyll, has conceded that future returns on superstores will be lower by cutting back his expansion plans.

But Tesco was the sector's problem child. In its desperation to catch up with Sainsbury's, long the doyen of the sector, it embarked on an ambitious expansion programme, paying up to pounds 40m for some sites. In doing so, it lost touch with its customers and failed to take notice when price, rather than the elegance of the aisles, became shoppers' key priority.

Its results were the first among the big three to show cracks. Its like-for-like volume growth stalled more than a year ago and it was struggling to receive the returns on investment achieved by Sainsbury's, the market leader, or Safeway, which paid far less for its stores.

Yesterday's statement shows it has learned from its mistakes. 'Its management has always been seen as among the best in the industry,' said Bill Currie, food retail analyst with Barclays de Zoete Wedd.

'These actions confirm that. They have shown that they were not just sitting around tearing their hair out last year; they were taking corrective action.'

The first correction came on pricing. Cash-strapped consumers wanted low prices and they were increasingly turning to the discounters, and Mr Norman's new price- conscious Asda, to find them. Tesco hit back with the launch of Tesco Value - a range of basic foods like baked beans and yoghurt at rock- bottom cost. That was seen as high- risk. It could have undermined the reputation for quality which it had worked so hard to build up, and it could have added to the - already severe - pressure on margins.

But the gamble appears to have succeeded in attracting customers back. Sales in the 20 weeks to 1 January were 11 per cent ahead of the previous year, better than the 10 per cent reported at the interim stage. More encouragingly, like-for-like sales volumes were increasing again, by 2.5 per cent, for the first time in 18 months. And best of all, the pressure on margins seemed to be receding.

'We had the best Christmas ever,' said Sir Ian MacLaurin, chairman. 'One of the most gratifying things is that the customer count and the customer spend are both moving ahead.'

While pressure on gross margins, which fell 0.2 percentage points in the six months to 14 August, continued, the low point appeared to be in November and there are now some signs of a recovery - although David Reid, finance director, said it could take a few months to get back to the level of the first half.

That suggests the initiatives launched by the big supermarket groups last year - Sainsbury's has cut the price of about 200 of its lines permanently, while Safeway has re- emphasised its everyday low prices - have re-established their value for money credentials in shoppers' minds.

Safeway and Sainsbury's have yet to make trading statements, so it is impossible to judge if Tesco's success has been at their expense. But the fact that none have launched the hitherto traditional January price-cuts initiative suggests that they are also happy with their trading.

The losers are likely to have been the discounters and the smaller chains. With price no longer an issue, shoppers are once again choosing the comfort and range of the big chains.

That does not mean margins will continue on the smooth upward path of the 1980s, but it should stop them falling too sharply.

The second piece of corrective action by Tesco will take longer to show through. Capital expenditure will be cut from pounds 750m this year - and forecasts of pounds 1bn when it launched its pounds 572m rights issue in 1991 - to between pounds 400m and pounds 450m in the year to February 1996.

While the number of stores may not be significantly lower, at about 20 compared with 28 this year, their average size will drop sharply as the group focuses more of its resources on smaller, market towns and on its Metro chain of city centre shops.

That is good news for shareholders. Tesco will find it easier to finance the lower level of capital expenditure from its own resources and cash flow should be neutral by February 1996, at least a year earlier than its previous predictions.

That means more of its earnings for shareholders. It is forecasting a 9 per cent dividend rise this year, more than double the increase in earnings.

Paradoxically, though, this is also good news for its rivals. With both Safeway and Tesco curtailing expansion, the threat of saturation has receded. While Sainsbury's has yet to comment on its plans, analysts point to the superior returns it earns on new investment and say that it is unlikely to scale back its expansion programme.

'Their rights issue in 1991 was to fund their existing programme, not expand it like the others,' said Bill Myers of Yamaichi.

With Tesco spending less than half what was once expected, Sainsbury's would find it far easier and cheaper to find sites, he added.

But there will be casualties elsewhere. Now that the majors have demonstrated their determination to fight on price, the discounters will find it far harder to woo new customers. Meanwhile, companies such as Gateway, Waitrose and the Co-op, whose relatively small size means there are fewer opportunities to fund price cuts through economies in distribution and buying, will find it even harder to compete.

(Photograph and graph omitted)