In February, Tesco (the British supermarket) announced that it would finally enter the U.S. It hesitated for some time with is decision because of stiff competition in the U.S. market. It now looks about ready to open its first set of stores (see the interesting background article in this week’s issue of the Economist).

From a business strategy perspective, Tesco has decided to sandwich itself in size somewhere between convenience stores like 7-Eleven and the local supermarket chains like Kroger, Safeway, Albertson’s, etc. It will occupy larger square footage than typical convenience stores, but smaller square footage than the local supermarket. All of this is meant to offer a greater selection than convenience stores (so that the customer can actually find a greater selection of staples that they want) and greater convenience than the supermarkets (so that the customer can get in and out more quickly, …especially during rush hours). Insofar as market segment is concerned, it will likewise sandwich itself between upscale stores like Whole Foods and mass market stores like Wal-Mart. It will attempt to appeal to the middle market, a market that it views as under-served in the U.S.

I have my reservations about this strategy. First, I think that Tesco will have a difficult time convincing customers to come to stores that offer more convenience simply because they are smaller. They are banking on people who stop in on their way home from work to stop in and pick up something quickly, …perhaps even for dinner that evening. Frankly, I believe, and studies show, that American consumers cherish variety. Although they are creatures of habit and tend to buy the same things over and over, they perceive value in the "opportunity" for choice. They like to know that there are many things on a menu even though they often choose the same thing. For this reason, I’m not so sure that the  convenience offered by Tesco will trump the variety available at the "traditional" supermarkets. With respect to market segment strategy, there is the potential for Tesco to find itself in a classic "stuck in the middle" dilemma. This would occur if, for instance, the top portion of the middle market prefers to shop at the upscale chain, and the bottom portion of the middle market prefers the downscale, mass market outlets. Therefore, in trying to broadly appeal to the middle market, they don’t satisfy any niche adequately. For this reason, Tesco may find itself squeezed on both sides by Whole Foods and Wal-Mart.

But even if this strategy turns out to be a good one, and even if the strategy is well executed (something that Tesco is actually good at), there is a third factor that should not go overlooked. That is, it is just incredibly difficult for firms to compete in foreign markets!! This is what is referred to in the academic literature as the liability of foreignness. That is, before you even start competing in the foreign environment, you’re already behind. You don’t speak the language, you don’t know the culture, you lack local operational experience and infrastructure, and you don’t know how to navigate the legal and regulatory environment. All of this results in increased costs for foreign firms, and places them at a competitive disadvantage vis-a-vis their domestic counterparts.

Research suggests that in order to overcome the liability of foreignness, foreign firms should be orders of magnitude better than their local competitors - to offset their cost disadvantage. It’s unclear to me that Tesco is that much better than its seasoned U.S. competitors. And although you look at Tesco’s entry and think that their cost disadvantage shouldn’t be that great - after all, they’re British, so language shouldn’t be an issue; the cultures are also relatively similar; and not only that, but the legal and regulatory environments are close enough. This would presage a successful entry in the U.S. But that would be a misguided conclusion. Even though it’s generally easier for British firms to enter the U.S., and vice versa, this does not make it costless. Moreover, given their lack of operational experience here, and their underdeveloped supply chain, entry will not be easy. And to top it off, they’re operating in a market (retail supermarkets) in which margins are generally paper thin.

So welcome to the U.S. Tesco. You may have a great strategy and you may be able to execute it well, but you are still foreign to this market. There is no margin for error, especially here - where retail competition is incredibly fierce. I wish you well, …but the deck is stacked against you. 

The FTC recently sent a letter to Whole Foods Market, Inc. vigorously opposing its proposed acquisition of Wild Oats Markets, Inc. and seeking a temporary restraining order in U.S. District Court (see article for background). The FTC sees this deal as anticompetitive, one that would allow Wild Oats to dominate the market for natural and organic foods. I am not sure I necessarily agree with that assessment, or the FTC’s decision to oppose the deal. Certainly a thorough analysis of the implications of the deal for competitiveness is required. However, what struck me was the possible implications that such a maneuver by the FTC holds for the Sirius Satellite and XM deal.

I discussed the Sirius-XM deal at length in a previous post (see post). What jumped out to me about the whole situation is that Sirius seems to be making similar arguments in its justification for the XM deal that Whole Foods is making in its bid to acquire Wild Oats. Specifically, Whole Foods suggested that they were being squeezed by competition from traditional supermarkets like Safeway, and from supercenters like WalMart and Costco. They maintain that both sets of stores have been increasing their natural and organic offerings - at once creating separate store-within-a-store formats that carry natural/organic foods, and at the same time integrating natural/organic product offerings on shelves among more traditional product offerings. Likewise, Sirius’ position was that they face substantial competition in the form of HD radio, traditional radio, iPod connectivity, and internet
streaming. Both Sirius and Whole Foods therefore believe competition from substitutes will put a ceiling on their
ex post pricing power.

In the case of Whole Foods, testing for anticompetitive effects should be relatively easy and straightforward. It’s not that hard to identify geographic markets in which Whole Foods and Wild Oats do not overlap to see if there is any difference in Whole Foods’ pricing behavior across markets. For Sirius and XM, it’s much more difficult to conduct such an analysis. As digital businesses rather than physical businesses, competition is not as subject to local market forces. The market is anytime, anywhere, and everywhere. I’m not even sure that there are any geographic markets in the US in which XM and Sirius do not overlap. And even if such markets exist, it would be difficult to justify price differences as a satellite radio provider across markets because such practices would almost immediately be viewed as price discrimination. At least in the supermarket space, some variance in prices across retail markets can be expected - justified by differences in local labor market conditions, local rents, and transportation costs.

That analysis aside, Sirius could stand to learn a few things from the government’s initial reaction to the Whole Foods deal, whose case rests on similar justifications. If we can infer anything from the Whole Foods case, it is probably high time for Sirius to give up its pursuit of XM. Given Sirius’ stock price performance since Karmazin’s appearance before the House Judiciary Committee Antitrust Task Force on February 28 (from nearly $3.75 to $2.75), it seems the market already has.

I’m trying my best to stay out of the economic prediction game, especially when it comes to the overall performance of the economy. I’m not a macro guy, so I try to leave predictions and prognostications about the US and global economies to those who are better informed than I. However, I’m having trouble doing that.

It seems that hardly a day goes by that I don’t pick up a paper and see a headline about a deal (whether a private equity deal or a deal involving a corporate buyer) that doesn’t make me scratch my head. As I alluded to in my previous post (see Dumbfounded by the Data), the sheer volume of deals and the premia that firms are paying these days are eye popping. Just to summarize some of the stylized facts about the current market environment:

1. Deal value so far this year has exceeded $2 trillion (on pace to set another record, …and 71% greater than last year at this time)
2. Average acquisition premiums this year have been running about 49.5% (65% greater than the 30% historical average)
3. The use of leverage in these deals is at an all-time high (debt from European firms acquired through buyout, for example, is running at about 6.2 times earnings versus 5.1 times earnings in 2004 and 4.8 times earnings in 2003)

All this is no surprise given the state of liquidity in markets. If you believe the May 2007 report by the OECD, much of this M&A activity has been fueled
by excess foreign exchange reserves in countries such as China, Japan, and
India; recycled petrodollars from countries like Russia and Saudi
Arabia as result of elevated oil prices; and interest rates that have
been at historical lows across the globe over the past six years (see FT article).

But that begs the question, when (and how) will this madness end? As I mentioned in my previous post, I wouldn’t be surprised to see this episode end ugly.

Firms are increasingly debt strapped. In fact, I read a statistic last week that nearly 48% of all bond issues in 2007 have been categorized as below investment grade (junk) compared with 35% just several years ago. The risk spread on these “junk” loans are at an all-time low (about 3.3% over government debt). Moreover, more companies are stretched by the amount of debt that they’re carrying. Given the flood of liquidity in the market, the default rate in the U.S. is hovering at an all-time low of around 1.4%. The historical average for defaults is around 5% 3% according to Ian Altman.

To me, this suggests that it’s just a matter of time before we witness an increase in distressed companies, an increase in default loans, and an increase in insolvency. At some point firms will be unable to service their monstrous debt obligations. For example, I’ll be interested to see how a firm like The Tribune Company, under the leadership of Sam Zell, will be able to pay off its debt - at 10.7 times earnings - in a business (newspapers) where cash flows have been steadily declining.

At the very least, in the near term default rates should rise back to their historical averages of around 3%. But if you believe that money has been too cheap and companies far too overextended, you might plausibly expect 10% default rates, similar to those achieved at the end of the dot com bust. And if you believe that the banks know something that we don’t, what should we infer from the fact that they have been recently building their distressed debt practices (see the interesting Bloomberg article on the subject)? Probably that they expect corporate performance to deteriorate at the very least, and perhaps, some kind of larger systemic market correction.

I have no idea when that market correction will come, and the fortunes of businesses are so intertwined with the fortunes of economies that the catalyst could come from almost anywhere (one quarter of poor corporate performance, central banks turning off the liquidity spigot, a decrease in consumer spending as a result of a housing bust, increased oil prices, increased inflation, war, etc.). Nevertheless, I believe that a correction is coming sooner rather than later. In my opinion, the deals have just gotten out of hand. There is little economic and strategic logic to support them (see my previous post for details). Unfortunately, I also believe such a correction is necessary. We need to bring sanity back to the market (at the very least to the M&A market). My only hope is that the correction, in whatever form it takes, is neither deep, nor prolonged.

As a parting note, I will leave you with some food for thought about the potential timing of an upcoming market correction - a cheeky, though very clever article that appeared in the Times Online entitled “Sell! Twenty Reasons to Panic“. Enjoy!