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Tesco - Strong Q4 underscores confidence on margin targets

George Salmon | 11 April 2018 | A A A
Tesco - Strong Q4 underscores confidence on margin targets

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A strong finish to the year helped Tesco's UK & Ireland like-for-like (LFL) sales (excluding fuel) rise 2.3% in 2017/18. The group also delivered margins and profits slightly ahead of market expectations.

The shares rose 2.3% on the news.

The group has declared a final dividend of 2p, giving full year dividend of 3p

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Our View

Full year results are further evidence of the progress Tesco is making with its turnaround plans.

Tesco's goal is to improve margins to somewhere near 4% by 2019/20, and it's reassuring to hear the group adopt a confident tone about reaching this. 3.5-4% may be lower than the 6ish% it was churning out up to 2013, but we think it would still represent a good recovery. After all, the entrance of the discounters has re-written the rule book in UK food retail.

Growth has helped the dividend return earlier than many had expected, which is a good sign. However, with the prospective yield at a below-market 2.3%, Tesco will need to grow the payout. The plan to build earnings to around half of profits over time puts earnings growth under the spotlight.

Progress has been good so far, particularly given sustained competition and a challenging economic backdrop. Uncertainty continues to linger over the economy, and recent months have seen inflation outpace wage growth. This has hit the spending power of consumers.

However, there's reason for optimism. There are signs the expansion of rivals like Aldi and Lidl is slowing, and the Bank of England expects wages to start climbing again in the near future.

The other task facing the group is the integration of Booker. Booker is the UK's largest cash and carry business, serving over 500,000 wholesale customers ranging from independent grocers to pubs and restaurants. The £3.7bn acquisition completed in March, and trading seems to be ticking over nicely. Tesco is confident of generating £200m of synergies from distribution and corporate costs.

However, much like Sainsbury's purchase of Argos, the deal takes the group in a new direction. That means it's one we'll be keeping a close eye on.

All in all, we think Tesco is now pretty well-placed. There might be a few obstacles to navigate yet, but the shares could be considered an attractive recovery play. However, it shouldn't be forgotten that this type of investing comes with extra risk.

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Full year results (changes at constant exchange rates):

Total group sales (excluding fuel sales, which rose 7.1% to £6.5bn) increased 0.6% to £50.1bn. Operating margins, boosted by further cost savings of £594m, continue to rise and came in 0.57 percentage points higher at 2.9%. This helped operating profit jump 76.6% to £1.8bn.

In the UK & Ireland, a strong performance in fresh food and another quarter of LFL sales growth helped sales rise to £38.7bn. Despite continued cost price inflation, underlying operating profits were £1.1bn, up 30.3% as cost efficiencies saw margins rise 50 basis points year-on-year to 2.3%.

All store formats and channels achieved like-for-like growth, with the large store business growing at 1.9% and online grocery sales growing 5.1%.

In Central Europe, Tesco closed 28 unprofitable stores, which together with a weak showing from general merchandise, dragged sales down 1.6% at constant exchange rates to £6.3bn. However, on a like-for like basis, sales rose slightly. Increased efficiencies, from improved stock management and the new distribution centre in Slovakia, helped operating profits rise 89.7% to £119m.

Sales in Asia fell 9.4% to £4.9bn, impacted by the withdrawal from unprofitable bulk selling activities in Thailand. Operating profits rose 7.6% to £299m.

Net debt reduced by £1.1bn during the year to £2.6bn, driven by higher retail cash flows of £2.8bn and greater proceeds from asset sales. The post-tax pension deficit fell too, down £2.8bn to £2.7bn, helped by favourable movements on bond yields and life expectancies. Tesco's discounted lease obligations also fell, as the group continues to repurchase stores from landlords.

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Hargreaves Lansdown's Non-Executive Chair is also a Non-Executive Director at Tesco.

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.

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.