TESCO on the Move...

Location: New York
Author: Peter Welch & Steve Worthington
Date: Monday, August 11, 2008

At the end of July 2008, Tesco, the U.K.’s largest supermarket group, announced it is to buy the Royal Bank of Scotland’s (RBS) share in their 50/50 joint venture Tesco Personal Finance (TPF) and take full control. The move, widely expected, brings to an end Tesco’s eleven year partnership with RBS. It forms part of a strategy by Tesco to increase its share in fast growing services markets.

Tesco’s decision appears nothing if not brave. In the wake of Northern Rock and the credit crunch, the U.K.’s financial services looks like a market to avoid rather than invest in. Yet despite a deteriorating climate, Tesco has signaled ambitious plans for TPF. Over time, the retailer plans to "extend its financial services business from a collection of popular financial products to that of a full service retail bank." Given market conditions and retailers’ mixed record in financial services, can Tesco make this work?

TPF is profitable, reporting profit before tax of £206 million for 2007 on net assets at year end of approximately £560 million. But the business is comparatively small, with, in Tesco’s own words, material market positions in only two core segments – namely car insurance (4.3 percent) and credit cards (6.9 percent). Insurance represented over 60 percent of TPF’s 2007 profit before tax. Tesco’s buyout of RBS is based on the objective of expanding TPF beyond car insurance and credit cards. It plans both to build TPF’s share in those segments where it currently has smaller market positions [for example, home insurance (two percent) and savings (0.8 percent)] and to enter new retail banking segments.

However, even before considering where TPF might expand, it is worth noting that the business faces tough challenges in its current core markets. Both car insurance and credit cards are highly competitive, with the latter under major economic and regulatory pressure. While TPF currently has a high quality credit card book, the U.K. market is now ex-growth and a downturn may put the loan books of even the most conservative issuers under pressure. In addition, regulatory intervention is squeezing or threatening key revenue streams, notably overlimit and late payment fees, PPI commissions, and interchange.

Tesco and TPF also face specific strategic questions in each of the segments. With car insurance, TPF launched its insurance comparison portal, Tesco Compare, in 2007. But will it be credible for TPF to be both an insurance provider and comparison site operator in the longer-term? With the credit card business, there is the tension on interchange between TPF as an issuer and parent Tesco as a card acceptor. While interchange is an important revenue stream for TPF, its retail parent is a strong opponent of the way in which rates are set and supporter of regulatory intervention by the OFT and European Commission.

Of the other retail banking segments that TPF might consider entering, the two largest are clearly mortgages and current accounts. Indeed, it is difficult to see how TPF could be developed into a full service retail bank without offering at least one of the two. With the former, TPF has made a virtue of its absence from mortgages and therefore lack of exposure to some of the difficulties currently being experienced by may banks. This hardly suggests a keenness to enter the market. And, from a new entrant’s perspective, prospects for the U.K. mortgage market are probably as bad as they have been for a decade. With the latter, Tesco intriguingly says its plans for the future development of TPF include the possibility of a current
account product. However, the characteristics of the U.K. current account market – notional "free banking" and, in the words of the Office of Fair Trading (OFT), much of banks’ revenue "derived opaquely" – make it difficult for new entrants to develop a viable product. Consumers would no doubt welcome a TPF current account with a decent credit interest rate and lower unauthorized overdraft charges. But then where do TPF’s current account revenues come from?

TPF may be anticipating that the OFT’s current investigation of unarranged overdraft charges and actions following its recent study of current accounts will change the market’s economics. For example, were the OFT to limit unarranged overdraft charges in the way they have limited overlimit and late payment fees on credit cards, this may force significant changes in banks’ pricing of current accounts. And this in turn may allow TPF to introduce a product that is both competitive and financially viable. But the full implications of the OFT’s investigation remain far from clear.

No longer under any pressure or obligation to do things the traditional bank way, TPF may bring some fresh ideas to the design and delivery of financial services. TPF has already shown an innovative approach with its travel insurance. Clubcard holders can pick up a pack in-store and take it to the checkout with the rest of their shopping. As soon as the insurance pack is scanned along with the Clubcard, the customer is insured. But even here, TPF’s capacity to innovate may in practice be limited. There are very few financial services that can be sold in this way, and regulatory and data protection constraints often push in the opposite direction. And the hard truth is that bringing greater transparency to financial services can mean losing the opaquely derived revenue on which profitability may depend.

Given its size and track record, few would want to bet against Tesco. And its move is a welcome boost for the beleaguered financial services sector. But expanding its presence in U.K. retail banking at this point in the cycle is an ambitious move indeed.