Tesco's Lewis sets out margin ambitions as interim sales growth doubles

Tesco reported much improved sales and operating profits in the first half of the year and set out ambitious plans for growing profit margins, though its pension deficit soared to a whopping £6bn.

UK like-for-like (LFL) sales doubled to 0.6% and operating profits grew 38.4% to £515m as chief executive Dave Lewis continued to turn around the supermarket colossus, which he plans accelerate with a new set of growth "ambitions".

While also aiming to strengthen the customer offer, Lewis's ambition is to lift group operating margin from its current 2.2% to 3.5-4.0% by the 2019/20 financial year, helped by cost cutting and a solid level of capital expenditure.

For the 26-week period to 27 August, group sales grew 3.3% to £24.4bn and UK LFL sales improved to 0.6% from the 0.3% in the first quarter as the once-ailing grocer that Lewis inherited completed a third consecutive quarter of growth.

Group LFL sales grew 1.0%, from 0.9% in the first quarter, as volumes and transactions both continued to rise in the UK and overseas.

Retail operating cash flow widened almost 21% to £955m, with some of this cash used to cut net debt to £4.4bn, a reduction of 49% over the year and almost 15% in six months.

But lower bond yields have inflated the pension deficit by £3.2bn to £5.9bn, ahead of its triennial pension valuation in March, also lifting Tesco's total group debt to £18bn.

At the statutory reporting level, revenue was up 1.4% to £27.3bn and the cost of Lewis's ongoing restructuring meaning profit before tax was down just over 28% to £71m.

"Whilst the market is uncertain, we have made significant progress against the priorities we set out two years ago, stabilising the business and positioning us well for the future," Lewis said.

His ambition to deliver a wider operating margin is to be "underpinned by six strategic drivers including the identification of £1.5bn further operating cost reductions which we will secure over the next three years", which he foresees enabling further investment in the customer offer, offsetting expected inflationary pressures on costs and continuing to rebuild profitability.

"Alongside these cost reductions, we will be looking to further differentiate our brand, continue our focus on strong cash generation, maximise the margin mix from our sales, maximise the value of our property portfolio and continue to innovate both in how we operate the business and in our offer for customers."

The investment required for some of these plans is expected to need an average capital expenditure of £1.4bn a year over the period to 2019/20.

"The benefits of the initiatives should start to become evident over the coming months, however given their nature and profile, the margin improvement will likely be more weighted towards the end of the plan."

Market and analyst teaction

Investors' initial impression was positive, sending the shares shooting up 9% to above 200p for the first time since March, altough City analysts' reaction was more mixed.

Laith Khalaf at Hargreaves Lansdown described the pension deficit as "the mammoth in the room" that the company would be forced to face soon. "For now the ballooning of the deficit is simply a problem on paper, but in March of next year Tesco undergoes its triennial pension valuation, at which point the deficit might start to harden into a cold hard cash call for the supermarket."

For Richard Hunter of Wilson King also flagged the lack of a dividend as "prudent" but "disappointing given the wider interest rate environment", but overall saw the results as showing "a glimmer of light at the end of the tunnel".

He said: "Some time ago Tesco announced that it would be returning to its knitting in the form of the UK customer and there is increasing evidence that this strategic change is beginning to gain traction."

Shore Capital's Clive Black and Darren Shirley said the results represent "demonstrable operational improvement from the business with cash sales and not just volumes now positive in the UK".

"However, the operations in isolation do not characterise the Tesco investment thesis. The burden of broad level indebtedness and the corresponding high solvency ratios, continue to prevent us from taking a more positive view on the group's shares," they wrote.