Are Supermarkets Bracing for a British Invasion?

This is shaping up to be an interesting year for international supermarket expansions. At the beginning of June,  Whole Foods --one of our favorite retailers and a bargain at the current stock price--opened an 80,000-square-foot store in Kensington, a well-heeled area of London. In late autumn, Britain's supermarket powerhouse Tesco will make its first forays into the U.S. with a new chain of neighborhood markets in California, Arizona, and Nevada called Fresh & Easy. We like both firms' chances for success, but think Tesco's U.S. effort has more disruptive potential.

Supermarkets and the Home Turf Advantage
Food retail is an intensely local affair, making it difficult for foreign firms to crack new markets. International supermarkets like Carrefour and  Royal Ahold  have had mixed results outside their home markets of France and the Netherlands, respectively.  Wal-Mart (WMT), the world's largest retailer, has done well in Latin America but recently beat an ignominious retreat from Germany and South Korea.

The very competitive American and British markets seem particularly tough to crack. The same few supermarkets--Tesco, J. Sainsbury, Asda, and Morrisons--have long dominated the U.K. Even Wal-mart's much-ballyhooed purchase of Asda in 1999 has failed to shake up the market. Asda continues to fight it out with Sainsbury for the number-two slot while Tesco continued to extend its market-share lead. Overseas firms' attempts to succeed in the U.S. haven't fared much better. Royal Ahold's supermarkets in the Northeast have struggled. After many years of poor performance, U.K. retailers Marks & Spencer and J. Sainsbury recently divested their U.S. supermarket chains (King's and Shaw's, respectively).

Have Price Gun, Will Travel
In light of past failures, the skepticism that surrounds any new overseas supermarket venture is understandable. In our opinion, however, Whole Foods and Tesco are avoiding some of the mistakes their predecessors made. Both firms spent considerable time testing the water before taking the plunge. In 2004, Whole Foods bought Fresh & Wild, a chain of six natural-food stores in London, to learn the market.

Tesco spent almost 20 years looking for a way into the U.S. market. Over the past two years, Tesco personnel lived with U.S. families to better understand local cooking and eating habits. Tesco also built a mock Fresh & Easy in a California warehouse so the firm could observe shoppers and test different store layouts.

Whole Foods and Tesco also bring something new to the overseas markets. In the case of Whole Foods, it's basically the same formula that worked so well in the U.S. The firm offers an eye-popping array of high-quality products and food-service venues combined with a unique company culture and mission. British chains like Marks & Spencer and Waitrose sell a wide range of excellent foods, but they don't offer the same product selection, shopping experience, and "third place" (not home, not work) atmosphere available at Whole Foods.

On the other side of the pond, Tesco's Fresh & Easy neighborhood markets will focus on convenience and quality. The stores will carry a range of healthy and organic foods, as well as ready-to-eat meals, in a 10,000-square-foot format designed for quick and easy shopping. American consumers increasingly make two kinds of shopping trips: a major "stock-up" shopping excursion and smaller, more frequent "fill-up" trips. Low-price retailers like Wal-Mart and  Costco (COST) do an effective job handling the former. Tesco, however, doesn't think the "fill-up" trips are adequately serviced and aims to address that market with the Fresh & Easy stores.

Expansion's Bigger Impact: America or Britain?
We like both strategies, but each firm does face some risks. Unlike the U.S. market when Whole Foods started, organic and natural foods are widely offered in Britain. Even Asda, the low-price grocer, stocks 700 lines of organic products. Premium vendors like Waitrose and Marks & Spencer already offer high-quality foods and take-out meals and won't cede customers to Whole Foods without a fight. In the U.S., Tesco lacks brand equity and there's no reason that rivals can't eventually copy the small-format, convenient-shopping concept.

Despite the risks, we think both ventures can do well. Success for the two companies, however, will mean very different things for their new markets. Given the sizes of Britain's major supermarkets, as well as Whole Foods' prices, we don't think the U.S. retailer poses much of a threat to incumbents even if it makes a go of it in Britain. We doubt Whole Foods will ever grow large enough to seriously threaten entrenched U.K. players.

Tesco's success, however, could have a big impact on the U.S. industry. U.S. supermarkets have only recently recovered from years of multiple business restructurings and the damage inflicted by low-price leaders Wal-Mart and Costco. The last thing no-moat traditional supermarkets need is a new entrant offering more convenience and high-quality fresh products, challenging their remaining value propositions. Supermarket chains like  Safeway  wouldn't be the only ones to feel the pinch. Convenience stores such as 7-Eleven and drugstore operators like  CVS (CVS) also currently benefit from "fill-up" trips.

Starting with 100 small stores in the southwest, Tesco's Fresh & Easy chain won't radically alter the U.S. grocery landscape overnight. The retailer, however, is making a long-term commitment to the U.S. market and has grand ambitions. Sir Terry Leahy, Tesco's CEO, thinks the U.S. business could one day equal the U.K. operation, which generated roughly $65 billion in sales last year. Even a fraction of that success would deal yet another blow to the already shrinking U.S. supermarket industry.

Mitchell P. Corwin, CFA, CPA, contributed to this article.