Can Tesco beat Britain's banks?

Supermarket giant Tesco looks set to follow up its conquest of the retail sector with an aggressive move into banking. Tim Bennett looks at the secrets of Tesco's success, and examines how the retailer aims to beat the banks at their own game.

Tesco looks set to follow up its conquest of the retail sector with an aggressive move into banking. HSBC and Barclays, be afraid be very afraid, says Tim Bennett.

How successful is Tesco?

The supermarket chain is Britain's biggest retailer by far. Group sales for the last financial year rose 15.1% to £59.4bn, meaning Tesco shifts more than £1bn of stock every week and accounts for around a third of all UK supermarket sales. Underlying pre-tax profit hit £3.1bn roughly three times the highest profit ever achieved by British bellwether Marks & Spencer, back in 1998 (ignoring inflation). Tesco now employs 440,000 staff worldwide and plans to add 11,000 to its UK payroll, even as the economy struggles.

All that just from selling food?

Tesco isn't just about food these days. As the BBC's Robert Peston notes, two figures buried behind the headline numbers reveal just how far beyond its roots as a simple grocer Tesco has gone. The contribution of non-food sales (everything from DVDs to sofas) to total turnover is a staggering £8.7bn. That's twice the clothing and general merchandise sales of even M&S. But it's the other figure that should now have every British bank worried.

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"Fat returns" an operating profit of £244m on "loans and other assets" of £6.2bn mean that its financial services unit, Tesco Personal Finance (TPF), is "already a player" in the sector. And remember that Tesco made that kind of money at a time when "many of the world's biggest banks were struggling to make any profit at all".

So is Tesco becoming a bank?

No, but it will own one soon. TPF is already a wholly-owned subsidiary since the Tesco Group bought out a 50% stake previously held by Royal Bank of Scotland in December 2008 for £950m. It isn't a fully-fledged bank, but does sell 28 products, ranging from credit cards to travel insurance, to a customer base of around five million.

Currently, it mostly acts as an agent for other firms. Buy Tesco dental insurance, for example, and you are actually buying a plan backed by AXA PPP. However, CEO Terry Leahy has declared he intends to have "Tesco Bank" branches in 30 stores by the year's end.

How big a threat is Tesco?

Massive. As Alan O'Sullivan notes on, Tesco will soon be the first British retailer to offer current accounts. These are the key weapons needed to take on the banks, as "they are the vehicles through which those banks cross-sell other (more lucrative) products".

And although bank customers tend to stay with their current-account provider for years, making it tough for a newcomer to build a business, Tesco has a big advantage a captive customer base. It can market new banking products either online where many shoppers already order groceries or in store.

Finally, Tesco could even link its new current accounts to its loyalty points scheme and perhaps even offer incentives (e.g. lower account fees) linked to a customer's spending.

Isn't this a bad time to start a bank?

No. In fact the timing could be perfect. The UK's existing banks (First Direct and the Co-operative Bank excepted) were already drawing scorn for their poor customer service before the credit crunch struck.

Having now lost billions in the subprime mortgage fallout, in many cases (e.g. Lloyds TSB and RBS) requiring direct help from taxpayers or being taken over by them (Northern Rock), the market is ripe for the emergence of a "good" British bank.

"Tesco appears ideally positioned to benefit from the demise of the more traditional high-street lenders," says the FT's Alphaville blog, noting that TPF grew its deposit base from £2.5bn to £4.5bn between October 2008 and February 2009 alone. What's more, finance firm Cazenove notes that TPF's bad debts are running "significantly below" the banking industry average and that the division boasts a tier-one capital of 12%.

Given that (according to Forbes) Barclays' equivalent figure is 10.3% and HSBC's is 9.8%, even after the recent rights issue, Tesco should have no trouble keeping regulators happy.

So how will Tesco beat the banks at their own game?

The same way it beat retailers. Tesco hasn't always dominated UK retailing the food crown has been worn by Sainsbury's in the past, for example, and M&S was once king in non-food. But Tesco does two things very well.

First, it innovates in-town 'metro' stores, loyalty schemes, just-in-time food distribution and home delivery are all areas where Tesco stole a march on rivals. Second, it seems to know what people want, thanks to the vast amount of data on spending habits it gains from its loyalty cards.

And vitally, its size and increasingly global reach give it huge purchasing power and the ability to discount heavily, especially when it wants to win market share. Few would bet against it successfully applying these strengths to banking.

But could Tesco become the Icarus of retailing?

Any firm can over-diversify, then crash and burn. And some think Tesco's latest results hide big problems. Andrew Cleary on Bloomberg notes that profit growth is now the slowest "in 15 years", as price-cutting by low-cost rivals such as Lidl, Aldi and Morrisons hits margins.

The group's US chain also posted a worse-than-feared £142m loss. Overall group net profit (after costs and tax) rose just 1.7%, "the weakest performance since fiscal 1994" and balance sheet net debt (debt minus cash) has now reached £9.6bn after a borrowing spree to fund stores in Europe, America and South Korea.

The banks are hardly likely to let Tesco walk on to their turf without a fight. But overall, as Peston notes, like football champions Manchester United, "although Tesco can be beaten in the odd game, its grip on the title doesn't look any less firm".

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.