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Tesco - costs bite into profits, expected to reverse next year

Nicholas Hyett, Equity Analyst | 14 April 2021 | A A A
Tesco - costs bite into profits, expected to reverse next year

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Tesco plc Ordinary 6.333p

Sell: 261.60 | Buy: 261.90 | Change -0.40 (-0.15%)
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Tesco reported full year sales of £53.4bn, a 7.0% increase at constant exchange rates. However, increased costs associated with the pandemic, including three staff bonuses and substantial losses at Tesco Bank, meant operating profits fell 28.3% to £1.8bn.

The full year dividend remains unchanged at 9.15p per share.

The shares fell 3.5% in early trading.

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Our View

Tesco reported solid revenue growth in 2020, growing market share and gaining customers from "all key competitors". However, servicing extra demand during a pandemic has come at significant cost as the group took on extra staff and expanded its online offering - knocking profits hard.

It hasn't helped that Tesco Bank sold its mortgage book to Lloyds last year, leaving it more exposed to credit cards and travel money. Activity in both has slumped, and together with extra provisions for bad loans, means the bank reported a substantial loss.

The good news is that the extra costs and bank headwinds should be temporary. Sales will slide a bit when the end of lockdown allows customers to shop elsewhere, but the stage is nonetheless set for a strong earnings recovery once the pandemic passes.

We suspect the longer term impact will be a permanent uplift in online shopping, and Tesco has used the last year to dramatically increase its delivery capacity. Weekly slots have more than doubled to 1.5m a week and new fulfilment centres are under construction and due online shortly. In the long term we think that will hold the group in good stead - online shopping may dip from its pandemic peak over the coming months, but we think it's here to stay.

Tesco has almost completed the sale of its Thai and Malaysian businesses this year - raising £8.2bn. While most of the cash made its way back to shareholders through a special dividend, the £2.5bn has been used to plug gaps in the pension fund. That leaves the balance sheet in pretty good shape, and gives the group options with its £1bn+ annual free cash flow (compared to an ordinary dividend of £770m).

One less favourable point from full year results was some relatively cautious guidance. Operating profits are expected to be similar to 2019/20 in the coming year, suggesting that while the pandemic hasn't done the group much harm, a year of captive shoppers hasn't done it much long term good either. We suspect that may turn out to be an overcautious forecast, but as things stand it has clearly left the market disappointed.

However, even if profit growth remains unexceptional Tesco could be interesting to a certain type of investor. A reinforced balance sheet and prospective dividend yield of 4.7% that's well covered by free cash could be of interest for income seeking portfolios, despite the fact the PE ratio's in line with its ten-year average. For now Tesco is well placed, although online disruption and increased competition can't be ruled out in the medium term.

Tesco key facts

  • Price/Earnings ratio: 11.2
  • 10 year average Price/Earnings ratio: 11.3
  • Prospective dividend yield (next 12 months): 4.7%

All ratios are sourced from Refinitiv. 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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Full year results

Sales growth was driven by a substantial improvement in the UK & Republic of Ireland - which saw sales rise 8.6% at constant exchange rates to £48.8bn. Like-for-like sales rose 6.8%, with a 7.7% increase in the UK and 14.0% increase in the Republic of Ireland, partially offset by an 0.8% loss at wholesaler Booker. Central European sales fell 0.6% at constant exchange rates to £3.9bn.

COVID related costs had an £892m negative impact on UK & Ireland operating profits of £1.9bn. That primarily reflected higher payroll costs, as well as additional spend on safety equipment. The group expects about a quarter of these costs to be repeated in the new financial year. Central Europe and Booker faced similar headwinds.

Tesco reported operating profits across its retail businesses of £2.0bn, down 14.8% at constant exchange rates, with a 13.7% decline in the UK & Ireland and a 29.0% decline in Central Europe.

Tesco Bank reported an underlying loss of £175m, compared to a £193m profit a year ago, as the pandemic hit lending activity and led to increased provisions for bad debts. The bank is expected to return to profit this year, although the strength of the recovery will depend on the wider economic outlook.

Full year capital expenditure rose 9.5% to £1.0bn. That was largely due to increased maintenance spend on UK stores and investment in technology to support the online roll-out - where capacity more than doubled during the year.

Free cash flow from the retail business fell 29.8% year-on-year to £1.2bn, reflecting lower profits, higher capital expenditure and increased net expenditure on property purchases.

Overall indebtedness fell £1.9bn to £13.0bn, reflecting a reduction in the pension deficit following the sale of the group's Thai and Malaysian businesses.

The group expects retail operating profit to recover to 2019/2020 levels this year.

Find out more about Tesco shares including how to invest

HL's non-executive chair is 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 Refinitiv. 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.

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