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Tesco: Among The Fitter Players In A Challenging Environment

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British grocery retailer Tesco (OTCQX:TSCDF) reported a 6% YoY increase in sales which reached GBP 61.3 billion for the year ended February 2022, a good result after elevated figures from the previous year. UK and ROI (Republic of Ireland) like-for-like sales, which accounts for the bulk of Tesco’s top line, increased 2.2% during the year on top of ‘exceptional’ growth the previous year driven by strong non-food sales in the UK, and a 15% increase in sales from Booker (Tesco’s grocery wholesaler) thanks to a sharp recovery in Booker catering sales which rose 56% YoY on a like-for like basis driven by a reopening of the hospitality sector.

A 48% increase in fuel sales as consumer mobility increased following loosening government restrictions further supported revenues during the year.

Tesco segmental revenue performance

Tesco Annual Report 2022

Operating profit was up 58% YoY to GBP 2,825 billion, a solid performance despite an increase in cost inflation, particularly in distribution costs.

Tesco’s operating profit jump was driven by strong retail sales, a reduction in COVID-related costs (which stood at GBP 220 million during the year, significantly lower than the GBP 892 million incurred the previous year), and a return to profitability in Tesco Bank (Tesco’s retail banking arm).

Tesco results 2022

Tesco Annual Report 2022

Headwinds from inflation likely to impact profits this year, receding pandemic-induced tailwinds as economies reopen

Last month CEO Ken Murphy said that Tesco tends to raise prices “a little bit later and by a little bit less than the market” and this commitment to ‘Low Everyday Prices’ suggests the retailer may not fully pass on rising input costs to customers which in turn could impact margins and profits in the near term. Tesco management expects retail operating profit of GBP 2.4 billion to GBP 2.6 billion in the coming year ie2023 (from GBP 2.6 billion in 2022). The soft outlook is in line with peers such as Morrisons and Sainsbury who have issued sales and profit warnings this year due to the Russia-Ukraine conflict and rising inflation.

Retailers including Tesco benefited from a major sales lift during the pandemic as an increase in at-home meals drove grocery purchases. As economies reopen however, away from home foodservice channels which shrank during the pandemic are recovering which could impact grocery sales. Tesco noted a decline in food sales in 2H 2021 as consumers began eating more out of home, however this was offset by increased non-food sales driven mainly by Clothing (up 19.4%) as consumers spent more time shopping Tesco’s ranges in-store and Tesco responded accordingly with in-demand ranges. Further normalization of consumer grocery shopping behaviors could limit Tesco’s food sales in the coming year driven by a continued shift towards away-from-home consumption as well as a possibility of hard discounters such as Aldi and Lidl (who lacking a brick-and-mortar store network and ecommerce services were at a considerable disadvantage during the pandemic resulting in them losing market share for the first time in more than a decade to the Big 4 incumbents Tesco, Sainsbury (OTCQX:JSNSF), Morrisons, and Asda) retaking market share from value chains such as Tesco as consumers revert to in-store shopping and turn to cheaper grocery retailers to deal with the country’s highest food inflation in a decade. It remains to be seen to what extent Tesco’s non-food sales can help offset food sales weakness; however, an inflation-driven squeeze to consumer purchasing power may limit non-food’s ability to lift overall sales as well.

Restructuring program delivering results

Tesco’s business restructuring efforts over the years appear to be generating results with margins showing a consistent upward trend since a turnaround plan was launched in 2015 to revive the retailer’s flagging performance amid rising competition from German discount chains Aldi and Lidl, and an accounting scandal that drove Tesco’s worst financial performance in its then nearly 100-year history. Withdrawals from unprofitable markets, and job cuts implemented as part of the plan have boosted profitability with gross margins and operating margins increasing from low-to-mid single digit figures to high single digits over the years.

Tesco gross margins and operating margins

Author

Although smaller rival Sainsbury, UK’s second-biggest retailer, also witnessed a similar upward trend in margins over the past several years, Tesco’s margin improvement is noticeably stronger with Tesco closing the gap with Sainsbury in terms of gross margins and Tesco overtaking Sainsbury in terms of operating margins and consistently remaining ahead.

Tesco and Sainsbury gross margins and operating margins

Author

Meanwhile asset sales and strong cash flow generation have helped the company strengthen its balance sheet with long term debt dropping to GBP 6.7 billion as of February 2022 from about GBP 10.5 billion as of February 2015. Debt to equity has also dropped and with continued financial prudence remains relatively low compared to historical levels. A stronger balance sheet can help Tesco fund inorganic growth opportunities that may arise.

Tesco debt to equity

macrotrends

Improving profitability and cash flow generation helped Tesco reinstate its dividend in 2017, and fund its ongoing share buyback program. New CEO Ken Murphy who took over in 2020 looks committed to maintaining a shareholder-friendly capital allocation policy. Last October the company highlighted its intention to pay a progressive dividend, broadly targeting a payout of around 50% of earnings, alongside the announcement of a share buyback program. In addition to this ‘refreshed’ capital allocation framework, the company went a step further this year; after purchasing GBP 300 million since the share buyback program announced last October, this April Tesco announced a commitment to buying back a further GBP 750 million of shares over the next 12 months. The company earned about GBP 5 billion in operating cash flows and after expected capex of around GBP 0.9 – GBP 1.2 billion, the company has about GBP 4 billion for dividends, share buybacks and debt repayment (which amounted to GBP 980 million, GBP 560 million , and GBP 1.8 billion in FY 2022 respectively).

Going forward, Tesco expects to squeeze out GBP 1 billion in cost savings over the next three years in an effort to tackle rising wages and energy costs. The retailer has already shut 317 deli counters and closed its Jack’s discount store chain less than four years after it was launched in 2018 to win back customers from Aldi and Lidl. Cost savings could further help increase profitability and competitiveness.

risks

UK’s grocery market is fiercely competitive and while Tesco has devised tactics to retain consumers (such as its ‘Aldi Price Match’ campaign which aimed to lure consumers with Aldi prices and Tesco range) and Clubcard (Tesco’s loyalty points scheme which already has more than 20 million households signed up making it a rich source of consumer data for Tesco), competition is set to become even stiffer as online grocery giants like Amazon (AMZN) turn up the heat (Amazon entered the UK grocery market in 2016 but the newcomer has gained some traction accounting for about 3% of UK’s online grocery compared with 30% for Tesco).

Amazon may have quite a long way to catch up to Tesco however the company has several competitive advantages that could help it close the gap; not only is Amazon likely to have a considerable advantage in terms of technology, the company also has the advantage of other revenue streams such as AWS and advertising to help invest in its grocery ambitions whether it is through technological innovation or poaching talent. Last July, Amazon hired Tesco veteran Tony Hoggett to run its physical stores, dealing a blow to Tesco (Hoggett, who was at Tesco for over three decades stepped down from his role as Tesco’s Chief Strategy and Innovation Officer to become Senior VP of Physical Stores at Amazon). Stiff competition for wallet share, talent and other resources could result in market share erosion and potentially diminishing profitability for Tesco.

Tesco does however have a key advantage over Amazon – a wide store network, which can be a tremendous advantage in offering omni-channel fulfillment options at potentially unrivaled speed to consumers (Walmart (WMT) for instance, America’s top grocery chain is leaning on this advantage in its battle against Amazon).

Financials

Tesco is comparable to peers such as Sainsbury’s in terms of profitability and debt. American rival Walmart is ahead on all metrics however with a higher level of profitability and lower debt.

.

Tesco

Sainsbury’s

Walmart

Return on assets %

3.8%

2.6%

6.3%

Total debt-to-equity %

98.2

88

77

P/E

12.3

7.4

19

Yield

4.3%

1.7%

Summary

Tesco delivered strong results in FY 2022 on top of elevated performance during the pandemic. Macro challenges notably inflation, which is impacting all grocers, is affecting Tesco as well with the retailer expecting profits to decline in the coming year as rising costs are likely to be only partly passed on to customers in an effort to retain market share and competitiveness. Tesco’s long-term restructuring efforts appear to be generating results with margins on the rise, and debt burden declining. The retailer’s GBP 1 billion cost saving effort could further improve profitability and cash generation going forward which could support its shareholder friendly policies and any inorganic growth opportunities. Competition is perhaps the biggest risk, notably from American e-commerce giant Amazon who has an edge in terms of technological prowess, and diversified revenue streams. Tesco however does have an advantage in terms of a massive physical store network which would take considerable time and cost for Amazon to replicate. It remains to be seen whether Tesco would be overtaken by Amazon as some speculate, however the market is not likely to be a winner take all market and as the UK’s largest supermarket chain, Tesco’s unrivaled scale, long standing supplier relationships, and improving balance sheet makes the company among the better positioned to weather competitive pressures.

Analysts are largely bullish on the stock.

Analyst rating Tesco

WSJ

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