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Tesco - retail profits up despite CV19 costs, but bank a weight

Nicholas Hyett, Equity Analyst | 7 October 2020 | A A A
Tesco - retail profits up despite CV19 costs, but bank a weight

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Tesco reported a 6.8% increase in sales in the first half of the year, excluding fuel and the effect of exchange rates, reaching £26.7bn. That was driven by very strong growth in the UK & Ireland, partially offset by modest declines in Central Europe and disposals in Tesco Bank. Underlying operating profits of £1bn were down 15.8% year-on-year, reflecting increased coronavirus related costs and increased bad loans in Tesco Bank.

The board has declared an interim dividend of 3.2p, up 20.8% year-on-year.

The shares rose 2.3% in early trading.

View the latest Tesco share price and how to deal

Our view

Coronavirus has touched every part of the Tesco business. While the worst economic effects are hopefully passing, some consequences will be long lasting.

The core retail business saw sales spike, first as customers stockpiled products, and then as consumers spent more time at home. Lots of that demand has been digital, with online sales increasing as the year progressed - growing from 9% of total UK sales to 16% by the end of the half.

Online demand will hang around, and the group plans to open more than 25 Urban Fulfilment Centres over the next 3 years to improve delivery efficiency. But shifting online has required investment and, together with new social distancing rules, has seen the Tesco hire 16,000 permanent staff.

Despite the extra costs, retail profits grew in the quarter, not least thanks to a modest improvement in margins. That reflects the benefits from increased scale, but should also be looked at in the context of significant business rate relief provided by the UK government. Take that away and profits would have shrunk. The question for the next year is how much of the additional COVID cost will prove temporary. That's hard to say.

The pandemic is having knock on effects outside the retail business too.

Tesco Bank sold its mortgage book to Lloyds last year, so interest income was always going to decline substantially. However, reduced economic activity related to the pandemic and financial relief for struggling customers has knocked fee income too.

The deteriorating economic outlook for the UK, has also led the bank to set aside more money to account for bad loans, and means overall group profits have fallen. The bank's unlikely to make up that shortfall in the rest of the year, and might post more losses.

With the core UK business undergoing some major restructuring the group has sped up its exit from international markets. The sale of the Thai and Malaysian business is most notable - bringing in £8.2bn of cash. Around £5bn will come back to shareholders, reducing the number of shares in issue, and £2.5bn is earmarked for the pension deficit. This gives the group increased freedom to invest in the core UK business and leaves the balance sheet in a reasonable position.

Increased UK focus may well prove invaluable, as new CEO Ken Murphy has his work cut out. Aldi and Lidl remain a threat to the core UK business, and a reinvigorated Asda shouldn't be dismissed following its recent sale by Walmart. Another price war risks undoing the good work done on margins and Tesco's 26.8% market share and mid-market positions means it's a target for both premium and value rivals.

Tesco is a difficult one to call at the moment. Given the relative defensiveness of groceries we think there are probably worse investment ideas - especially with the shares trading a touch under their long run average PE ratio. We think the group's making the right strategic decisions too, but the competitive and economic landscape is tough right now and when industries undergo major shifts it's often the dominant player that gets left behind.

Tesco key facts

  • Price/Earnings ratio: 13.3
  • 10 year average Price/Earnings ratio: 14.2
  • Prospective yield: 4.1%

Please remember yields are variable and not a reliable indicator of future income. Keep in mind key figures shouldn't be looked at on their own - it's important to understand the big picture.

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Half Year Results

UK sales reached £19.5bn, up 7.6%, driven by increased online shopping, which grew 90% during the second quarter. Convenience sales also rose- up 7.6% year-on-year, while large stores saw sales grow 1.4%, despite a 31% decline in transaction numbers as basket size increased. Like-for-like sales eased slightly between the first and second quarters, although remains elevated.

Elsewhere, Booker sales rose 11% to £3.5bn as demand from grocery customers more than offset challenges in catering and the Republic of Ireland saw sales rise 14.5% to £1.3bn.

Central European sales fell 1.5% to £1.9bn, as demand fell in the post lockdown period. Tesco Bank sales fell 31.4% to £386m following the sale of the group's mortgage book.

The response to the coronavirus outbreak saw Tesco incur £533m in extra costs, with additional costs for the full year expected to come in at £725m. That was partially offset by £249m of business rate relief.

Despite the higher cost, underlying retail operating profits crept up 4.2% to £1.2bn, as additional sales offset the higher costs in the UK & Ireland. However, Tesco Bank reported a £155m underlying operating loss during the half (2019: £87m profit), reflecting reduced activity and a significant increase in provisions for bad loans, as the UK macro-economic environment deteriorated.

Tesco's retail business generated free cash in the half of £554m, down from £645m last year. That reflects increased capital expenditure as the group bought back more of its stores. Net debt fell 1% to £12.5bn, although the group's pension deficit increased by 28.8% to £3.3bn reflecting lower interest rates.

During the half Tesco agreed the sale of its Thai and Malaysian businesses for £8.2bn, with completion expected before the end of the year. Around £5bn will be returned to shareholders, with £2.5bn used to reduce the pension deficit. The group also agreed the sale of its Polish business in June, which is expected to complete in spring 2021.

Tesco now expects full year profits to be a t least in in line with 2019/20. However, the bank is still expected to report a loss of £175m-£200m for the year.

Find out more about Tesco shares including how to invest

The Chair of Hargreaves Lansdown is also a Non-Executive Director at Tesco.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. 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.