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Tesco - challenging conditions weigh on outlook

Tesco has reported a 3.5% rise in half year group sales, excluding fuel and ignoring the effect of exchange rates, to 28.2 billion.

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Tesco has reported a 3.5% rise in half year group sales, excluding fuel and ignoring the effect of exchange rates, to £28.2bn. Underlying operating profit fell 9.8% to £1.3bn as inflation pushed costs higher and consumers shifted to own brand items.

Full year underlying retail operating profit is now expected toward the lower end of the guided range of £2.4 - £2.5bn. Guidance for retail free cash flow has improved, now expected to be at least £1.8bn.

Since April, Tesco has purchased £450m worth of shares and has pledged to continue with the remainder of the £750m buyback programme in the coming months. The group proposed an interim dividend of 3.85p, an increase of 20.3%.

The shares were up 1.0% following the announcement.

View the latest Tesco share price and how to deal

Our View

Tesco's valuation has come under pressure this year as earnings in the short term look more volatile. Concerns look to have been justified, with management issuing a slight drop in full year profit guidance. The unwind of pandemic spending habits added with increasing pressure on consumer spending and higher cost inflation are all starting to weigh sentiment.

To its credit, though, Tesco looks to be managing these pressures about as good as anyone.

That's being helped by Tesco's enormous scale. The mature, deeply rooted, nature of its relationships have been a key tool in allowing Tesco to keep its prices down. The strategy relies on being able to offer better all-round pricing than the competition, and Tesco's delivered remarkably well on that in the past couple of years.

Promotions like Aldi Price Match, Low Everyday Prices and Clubcard Prices have helped Tesco retain market share over the past three years, despite discount retailers increasing the scale of their operations.

Tesco's online offering is also noteworthy, with 1.1m orders being filled a week and sales up 52% over the last three years. As spending habits continue to normalise, customers are returning to stores and online growth is coming down. But an elevated level of online demand looks sticky, and Tesco's market leading position means it's well positioned to hold onto that.

There are some other things to keep in mind though.

Inflation remains arguably the biggest headwind, though it's certainly not one that Tesco faces alone. From the customers' perspective, increased living costs mean wallets are going to feel tight. Tesco's value focusshould mean it can retain customers, but it does mean higher investment in keeping prices low and a further shift toward more own brand products. An acceleration of the cost saving programme, now set to deliver £1bn in savings over 2 years rather than 3, is already helping to mitigate rising costs.

Ultimately, these challenges can't be avoided but what's pleasing is a continued focus on delivering value for shoppers, which is what's set the group in good stead over the next few years.

Tesco's dividend is of significant interest. A reinforced balance sheet and impressive cash conversion helps underpin a 5.1% prospective yield and buyback scheme. Remember yields are variable and not guaranteed.

There's no escaping the reality that conditions are challenging, and likely to remain so in the short term. The group's valuation, now below the longer-term average reflects those challenges. But for investors willing to accept the risks, Tesco looks like one of the stronger options in the grocery sector with an attractive income potential.

Tesco key facts

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.

Half Year Results (sales growth on a like for like basis)

In the UK & Republic of Ireland, retail sales rose 2.7% to £25.6bn. That was driven by a strong performance from Booker, with sales up 13.9%, as the catering business saw a sharp recovery in demand. In the UK, sales fell 0.1% as Tesco continued to inflate prices behind the market to combat shifting consumer spending. Underlying operating profit for the division fell 11.5% to £1.2bn as higher costs weighed on margins.

Online sales in the UK fell 11.3%, with many customers choosing to return to shopping in stores. Though that remains 53.4% up on a three-year basis.

Retail sales in Central Europe grew 10.4% to £2.0bn, with growth spread across all geographies. Significant levels of cost inflation were offset by higher sales and cost saving efforts, which helped underlying operating profit grow 19.1% to £79m.

Tesco Bank saw revenue rise 24.6% to £540m, driven by an increase in new credit card customers, higher levels of retail spending and an increase in travel money demand. Impairment charges and a weaker economic outlook meant underlying operating profit fell 6.9% to £67m.

Retail free cash flow of £1.3bn was £260m lower than last year, driven by lower levels of profit and working capital inflows. The group reduced net debt by £0.5bn, to £10bn or 2.5 times cash profit (EBITDA). That's within the target range of 2.3-2.8.

This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. 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 disclosure for more information.

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Written by
Matt-Britzman
Matt Britzman
Equity Analyst

Matt is an Equity Analyst on the share research team, providing up-to-date research and analysis on individual companies and wider sectors.

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Article history
Published: 5th October 2022