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Tesco - Competition and Markets Authority Provisional Findings

Nicholas Hyett | 14 November 2017 | A A A
Tesco - Competition and Markets Authority Provisional Findings

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The Competition and Markets Authority (CMA) has given provisional unconditional clearance to the merger of Tesco and Booker Group. The final report is due by the end of December.

Tesco shares rose 5.3% following the announcement.

Our view

A stronger UK performance shows that CEO Dave Lewis has got things moving in the right direction at Tesco. Nonetheless, there are still significant hurdles to clear.

The most immediate of these is the acquisition and then integration of Booker. While Tesco will need to get final approval from the CMA and shareholders before the deal can be completed, it should go through at some point this financial year. Booker is the UK's largest cash and carry business, serving over half a million wholesale customers ranging from independent grocers to pubs and restaurants.

Much like Sainsbury's purchase of Argos, the deal takes the group in a new direction. This certainly comes with risks, but there should also be some easy wins; including synergies in distribution and corporate costs.

For now however, the focus remains the core business. Stronger trading, particularly in the UK, means Tesco's dividend has returned. The payment may not be too significant just yet, with the prospective yield around 1.9%, but the plan is to build up to around half of earnings over time. The question is what will these earnings be?

Tesco is confident it can improve margins to somewhere near 4% by 2019/20. This may be lower than the 6ish% it was churning out up to 2013, but the entrance of Aldi and Lidl means things are different these days. We feel that to get back to the 4% level would still represent a good recovery.

There are numerous challenges to overcome before this goal can be reached though. Competition remains fierce and inflation is now outpacing wage growth, meaning consumer spending power is falling in real terms. The silver lining is that Tesco, helped by its sheer size, was able to limit price rises to around 1% less than the wider market. This should boost its competitive position.

Raising margins in the face of cost inflation and a price sensitive consumer is no small achievement. But while the recent uptick in performance is impressive, we feel Tesco remains a work in progress.

First half results (at constant exchange rates)

Tesco's half year results included a 1p per share interim dividend, the group's first payment since 2014. Tesco's operating profit rose 23.7% to £759m in the half, with both sales and margins rising. The shares rose 1.4% on the news.

In the UK & Ireland, a 2.1% increase in like-for-like retail sales helped first half retail revenues rise to £19bn, while profit margins increased from 1.82% to 2.13%, as Tesco removes both in-store and administrative operating costs. This helped the group deliver a UK & Ireland operating profit of £471m, a 21.1% increase.

While rising prices provided a tailwind to retail sales, Tesco was keen to point out that UK transaction numbers and sales volumes both increased. The meat and fresh produce divisions delivered particularly strong results, outperforming the wider market by nearly 6% and 3% respectively.

Tesco's other businesses, which include Tesco Bank and retail operations in Central Europe and Asia, generated combined operating profits of £288m. European and Asian sales fell as Tesco scales back its operations in these areas, however, profits in both divisions rose as margins increased significantly. Tesco Bank saw revenues rise 4.8% to £527m, but profits drop 3.4% to £86m.

Total indebtedness reduced to £13.0bn, including a £469m reduction in net debt and a £3.1bn drop in the pension deficit, which now stands at £2.4bn after tax. However, the group's contributions to plug its pension deficit have been increased from £270m to £285m per annum from April 2018.

Tesco says it is making good progress towards its medium-term ambitions to reduce costs by £1.5bn, generate £9bn of retail cash from operations and improve operating margins to between 3.5% and 4.0% by 2019/20.

Unless otherwise stated estimates, including prospective yields, are a consensus of analyst forecasts provided by Thomson Reuters. These estimates are not a reliable indicator of future performance. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.

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