Tesco turnaround continues but Lewis warns of investment drag on profits

Tesco broke back into the black with a £162m pre-tax profit that marked a turnaround from the previous year's record £6.3bn loss, also delivering the first annual volume growth in five years.

The UK's largest supermarket generated a 0.9% increase in UK like-for-like sales in the fourth quarter ending 27 February, its first growth in three years, contributing to group LFL growth of 1.6% for the quarter.

Operating profits of £944m were ahead of the consensus estimate of £936m, while the 'clean' profit before tax, exceptional items and pension costs came in at £435m, down 11%. Statutory PBT was aided by impairments of £408m against the kitchen-sinking £5.4bn a year ago.

Group sales of £48.35bn were down 1.6% year-on-year, or down 3% against the statutory 53-week results from the prior year. However, across all geographic regions the business has returned to positive like-for-like sales growth.

Chief executive Dave Lewis hailed the significant progress made against the priorities he set out in October 2014, regaining competitiveness in the UK with "significantly better service, a simpler range, record levels of availability and lower and more stable prices", saying "more customers are buying more things more often at Tesco”.

Caution on profits

However, after pointing to key achievements such as a stronger balance sheet where debt has been cut by £6.2bn to £5.1bn and claiming progress in rebuilding investor trust, as the shares bounced off their January low, Lewis later took some of the froth off with cautious statements to reporters on a conference call.

Lewis said hitting the consensus forecasts of a trading profit of £1.25bn for the current financial year would be “a substantial, substantial achievement”.

He indicated that the grocer is focused on investment in the customer offer to cope with the cut-throat UK grocery market, which will impact profitability particularly in the first half of the year: “profit growth won’t be smooth, we are in a turnaround".

The grocer intends to increase capital expenditure from £1bn in 2015-16, which was around 1.8% of sales, to £1.25bn in 2016-17.

Analyst comment

Tesco's share price moved sharply down as the market opened, with sellers capitalising on the near 30% rally in the year to date.

Societe Generale welcomed the capex increase, as the 2015-16 level "was too low and not sustainable on a medium-term view", but said the key issue would be the pace of potential margin recovery in 2016-17.

"For the time being, we expect 2016-17e group EBIT before one-off items of £1059m, which is 15% below consensus (£1251m)."

Shore Capital said they saw Tesco shares as "much more robust as an investment", helped by talk of a rights issue being off the table, but said there was "much more to do", such as improving trading margins and reducing operating leverage, before dividend payments can begin again.

Retail consultant John Ibbotson of Retail Vision said Lewis was achieving "an extraordinary feat – turning around an oil tanker in a very tight spot" amid ruthless competition and food price deflation but that "much more work – and pain – lie ahead", with profits still less than a quarter of those four years ago.

“But with all the major grocers dropping prices and a backdrop of food price deflation, a quick turnaround was never going to be possible.

“The challenge for Tesco now is to keep up the momentum and stay in the game while keeping market share. Tesco’s vast size is an advantage – as it allows the fallen giant to keep down prices for longer than its rivals.

“In the current war of attrition, this could prove a decisive factor."