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Tesco - Significant progress

Steve Clayton | 13 April 2016 | A A A
Tesco - Significant progress

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Full year results, to end February, show Tesco making "significant progress" on their three key transformation priorities, but with relatively little impact on underlying profits as benefits achieved are reinvested back into improving the customer offer and experience. The shares dipped by a percent of so on the news.

Group sales, excluding VAT and fuel, were fractionally ahead, at £48.4bn, whilst pre-exceptional operating profit rose 1.1% to £944m. Statutory operating profits were £1,046m, boosted by a pension fund release and far better than the £5.75bn loss suffered the previous year. Retail cash flow leapt 39% to £2.6bn and net debts fell by 40% to £5.1bn, not least due to the earlier £4bn disposal of the Korean Homeplus business.

Like for Like (LFL) sales returned to positive territory in Q4, at +0.9% in the UK and +3.8% in the International division, with all regions reporting an uplift. UK LFL sales were not quite as strong as the +1.5% reported for the six weeks around Christmas, but still the first positive quarterly result for some years. Operating margins improved 81bps in the UK over the second half and by 138bps in the international division.

The group took back ownership of seventy stores, previously placed in joint ventures with property companies, which will reduce future rent obligations by £115m p.a. but add around £1.5bn to debts. Freehold stores now make up 47% of the UK estate, with Tesco seeking to increase this further over time.

The group achieved £400m of cost reductions in the year, including a 25% cut in HQ headcount. Passing these savings onto customers in the form of pricing cuts has led to rising volumes in the UK and Internationally; and Tesco say that these are now beginning to deliver positive operational gearing.

Tesco has reviewed all 33 of its food categories and reduced the number of lines by a net 18%, whilst introducing 2,000 new lines. Sharper prices, with fewer multi-buys, led to volume growth for the first time in five years, helped by stronger availability.

Overall, CEO Dave Lewis said that Tesco had begun to rebuild profitability, whilst reinvesting in the customer offer. More customers are buying more things, more often, as the group's investment into prices, with basket prices down 3% over the year, has allowed them to regain some competitiveness.

Tesco will continue to reinvest into their competitiveness, in a still challenging, deflationary market. They are increasingly confident of creating sustainable improvements for customers that will lead to improved profitability and longer term value for shareholders. In the near term though, this investment will impact the rate of profit improvement, especially in the first half of the current year.

Our view:

Tesco is making good progress in rebuilding its customer appeal, with lower, simpler pricing, better availability and refreshed ranges. Customers are returning in numbers and volumes and transaction numbers are on the rise once more.

Cash flow is strongly positive, reflecting a radical reduction in capital expenditure in recent years. The accounting scandals that dogged the group are behind it, even if the SFO may not have had the last word on the matter, quite yet.

But the remarkable thing about Tesco at this point in its recovery under Dave Lewis is what it is not saying. Read the full year results and there is precious little about the future. There is no real mention of online, or food versus non-food, nor the vast estate of convenience outlets. Future capex plans are not shared. In short, we are being asked to admire the work achieved to date, but left to guess about where Tesco may go next, rather than Mr Lewis setting out a road map for recovery.

The only real future guidance that investors can get their teeth into is that in the near term, profit growth will be held back by the reinvestment into the customer offer. Dividend prospects are not mentioned either, so best not to expect one any time soon.

Mr Lewis is doing the right things, we believe, for no retailer can succeed without the customer on side. What is not clear is the extent to which margins can be rebuilt, given the still wide gap between Tesco and the Discounters, whose expansion continues apace. But cash is pouring in, debts are falling and the asset backing underpinning the business is improving.

Tesco may be heading in the right direction, but it still has far to go. The shares are left trading on high earnings multiples, over 20x prospective earnings, because profits have fallen further than the share price. But price to sales multiples are low by historic standards, reflecting the wafer-thin profit margins. Whether the shares offer recovery potential will depend on the degree to which margins can be rebuilt in future.

This article is not advice or a recommendation to buy, sell or hold any investment. No view is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however HL has put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing. Please see our full non-independent research for more information.