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Tesco - Profits rise as momentum continues

Equity research team | 5 October 2016 | A A A
Tesco - Profits rise as momentum continues

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Tesco plc Ordinary 5p

Sell: 226.60 | Buy: 226.70 | Change -0.40 (-0.18%)
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Interim results confirmed a third successive quarter of improving sales trends and, perhaps more importantly, some longer-term profit margin guidance. The shares bounced by over 12% on the news.

Our View

While the goal of achieving an operating margin of up to 4% by 2019/20 may be less than the 6% the Tesco of old routinely achieved, returning to these highs from the current 2% level was never likely. Aldi & Lidl have changed the industry, leading to sustained pressure on pricing. After a few traumatic years, Tesco is at last now confident enough to provide some reassuring guidance on its future profitability.

As the price wars raged, Tesco took the hit on margins to stay competitive, and as the discounters built market share Tesco's profits tumbled. The dividend was scrapped and investors became increasingly concerned about how long the group would be in recovery mode for, and indeed what Tesco would look like once the industry emerged from its deflationary spiral.

Today, after re-focusing on the core UK operation, even Tesco's largest stores, previously easy picking for the discounters, are turning in an improved performance. Service levels are improving across the board and the group's move towards store ownership, away from leasing should mean free cash flow improves in the future.

However, problems of a different kind are now looming for Tesco. Falling bond yields are causing the pension deficit to expand, and the total debt hanging over the group is therefore growing despite the disposal of many non-core assets. This means that more cash is likely to be diverted into the growing pension shortfall after the next review in March. There are other wider factors too, for example the challenge of managing with higher import costs as a result of the weak pound.

That pension deficit will be a thorn in his side for some time to come, so Tesco is certainly not out of the woods yet, but the turnaround under CEO Dave Lewis is looking increasingly tangible.

Interim result details - 5 October 2016

In the UK, second quarter LFL sales were up by 0.9%, with international LFLs increasing by 2.1%. UK transaction numbers and sales volumes increased by 1.6% and 2.1% respectively, with increases also achieved in Tesco's international businesses. Overall, group sales (ex. fuel) were up by 1.3% at constant currency rates.

Before exceptional items, group operating profit has increased to £596m, up 60%, with margins improving from 1.4% to 2.2%. UK margins are 1.8%.

Tesco continues to see price deflation, and prices are now 6% lower than in September 2014. The focus remains on lower everyday pricing, including the new fresh foods brands which have performed ahead of expectations.

3,000 more customer-facing staff have helped service, with availability and checkout waiting times improving customer satisfaction.

Despite further disposals, including the Turkish business, total indebtedness grew to £18bn, up £2.5bn on last year. This is due to a £3.2bn increase in the pension deficit, caused by declining bond yields. Tesco's pension deficit now stands at £5.6bn.

Looking ahead to the full year, Tesco acknowledge that the market remains uncertain, but expect to deliver £1.2bn group operating profit before exceptional items. Longer term, the group hope to deliver a group operating margin of 3.5 to 4% by 2019/20, supported by a further £1.5bn cost reduction programme. Capital expenditure is set to average £1.4bn per year in this time.

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