While other retailers struggle to make a profit online, Tesco is busy rolling out its internet-only stores. Does it know something the others don't? Chloe Ryan investigates


When Tesco.com chief executive Laura Wade-Gery laid out plans, on the first day of a recent two-day investor seminar, to roll out internet-only 'dark' stores at a rate of one a year , it was impossible not to be impressed. Dotcom had contributed £109m in profits to the Tesco business in 2008/9, she claimed, on sales of £1.5bn (£1.9bn including non-food). On an EBIT basis, the online operations would be making better margins than the stores.

Unfortunately, a trip to show off to the analysts the new Aylesford dark store, on the second day, had to be abandoned due to a systems failure. But red faces aside, the rollout and the numbers behind them demand serious examination. How is Tesco alone managing to make online profitable?

Asda and Sainsbury's refuse to break out the internet numbers, but even more telling is the fact that outgoing Morrisons chief executive Marc Bolland continues to insist the Bradford-based retailer won't offer internet shopping until "we can find a profitable model by which to do so." (When Bolland moves to Marks & Spencer in the new year, the niggling question of profitability will follow him.) And Ocado, the only retailer to offer a heavily automated warehouse-based model rather than its rivals' manual picking methodology is now making money on each order, but can only claim to be profitable at EBITDA, as opposed to EBIT, level.

So how does Tesco do it? In its calculations for the dotcom business, Tesco says it does not account for the costs of the stores, rates or store managers, but claims it does include its share of inbound delivery, unpacking and holding costs, plus website software development and marketing costs, staff picking and driver delivery costs, and the vans.

Some analysts dispute this, accusing Tesco of marginal cost allocation. "It is loss-making if you fully allocate costs," claims one. "The moment part of the business is cannibalised, then you lose. Only if it is all incremental or if you have a huge gross margin like Waitrose can you make money."

Adds another analyst: "[The City] believes that if you allocated every single cost as you should do then it is probably not profitable."

Rival retailers go further, arguing Tesco should come clean and acknowledge its current stores are "subsidising its online business". Yet Tesco insists the only costs it doesn't account for would be there anyway costs such as the store and the manager and says even if it did account for its share of the stores, it would still be profitable.

"Tesco dotcom is profitable because we have designed a very efficient business that uses the existing stores network," says a spokesman. "Using that network keeps our transport costs down because our stores are close to customers, unlike other retailers with centralised distribution."

Some analysts agree, arguing it is both plausible and commendable that Tesco.com is in profit. Tesco's numbers are "on a reasonably fully costed basis apart from some property costs," says Shore Capital analyst Clive Black, "so one could slice some of the margin down if the dotcom business had to fully cover the cost of property. I think the margin might be a little lower, but not structurally lower."

Once Tesco starts rolling out its internet-only store estate, however, analysts believe the margin will be dragged down. Wade-Gery insisted, at the investor meeting, that profitability was possible for the dark stores and one analyst noted that these stores can hit the ground running, with the Croydon store launching with £750,000 sales "because they've pulled the business out of the existing stores".

For now, David McCarthy of Evolution Securities says even if Tesco is being somewhat creative in its cost allocation, it is justified in doing so. "It is an age-old accounting issue. I think if online is making a marginal contribution it is right to do it, but at some point all the bills have to be paid."

Accounting policies aside, however, the Tesco business has a distinct advantage over its rivals, he adds. "Tesco is doing £1.5bn. It's got the scale, it's got the intensity of deliveries, and it's got the buying power."

Read more
‘Dark stores’ fuelling Tesco’s online growth (28 November 2009)

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