Tesco profits surge, but not as much as hoped

Group sales increased 12.8% to £28.3bn in the 26 weeks to 25 August, with like-for-like sales up 2.2% thanks to improving growth in the UK, Republic of Ireland and Booker that offset worsening declines in Continental Europe.

Sales growth was driven by the core UK business, where LFL sales were up 2.5% in the second quarter after 2.1% in the first, which bested the 2.2% average analyst forecast. The UK and RoI combined to grow sales 3.8%.

Since its addition in early March, Booker's LFL sales stepped up to 15.1% in the second quarter after 14.3% growth in the first, while the integration process included 30 of the most popular Booker products being rolled out to 70 Tesco stores.

Helped by a £97m Booker contribution, group operating profits before exceptional items swelled 24% to £933m but this was short of the £992m consensus forecast, as the £685m profit from the UK was lower than the £710m expected. Profit before tax and exceptionals leapt up 42.4% to £806m, but again this was not quite as much as the £811m that City number crunchers were expecting.

Patchy performances in Europe and Asia were largely to blame for the profit miss, with Central Europe profits down 3.3% due to changes to Sunday trading regulations in Poland, while Asia profits sank 29.1% as LFL sales remained negative at 9.0% in the first quarter and 4.8% in the second plus a sales impact of nearly 2% in Thailand from issues with government welfare cards and price investment. The "highly competitive and challenging" Thai market is expected to have a continued impact in the second half as investment in price is maintained.

The group operating margin increased 29 basis points to 2.94%, or 3.02% if excluding the defunct Tesco Direct business. This was, the company said, "on track" to reach chief executive Dave Lewis' target of 3.5-4.0% by the next financial year.

The interim dividend was bumped up to 1.67p from the 1p a year ago as £1.1bn of retail operating cash was generated. Net debt fell to £3.1bn from £3.3bn a year ago after £766m cash was spent on Booker.

Lewis said the group's eleventh consecutive quarter of growth represented "a good start to the year", adding that he was delighted with performance so far from Booker.

Other strategic boasts included the launch of the new Jack's discount brand and store format, a strategic alliance with France's Carrefour in July which goes live this month, and "the biggest own brand re-launch in history" including a investment in over 300 new 'Exclusively at Tesco' products, which is due to be largely complete by the end of February.

"We are firmly on track to deliver our medium-term ambitions and are continuing to improve the quality and value of our offer for customers in all of our markets," he said.

As planned, we anticipate that synergies associated with our merger with Booker will generate a benefit of at least £60m this year, growing to a cumulative c.£140m in 2019/20 and c.£200m by 2020/21.

MARKET REACTION & ANALYSIS

Tesco shares fell 8% to 217.5, its lowest level since mid-April. Between last July and this summer, the shares had risen almost 60%.

Goldman Sachs said the underlying business remained in line with expectations but group EBIT of £933m was 4.6% below the Vuma consensus, with the miss driven by Asia around 25% below expectations and what analysts believe was a higher proportion of low-margin tobacco and drinks in the Booker mix than had been forecast. "Management reiterated margin targets and synergy guidance; however we would expect LSD FY EBIT consensus downgrades driven by the Asia miss and where investments are expected to continue in 2H19."

Visibility on margins has deteriorated in the short term, said Société Générale, seeing "a lack of obvious catalysts for the coming months" and predicting a turnaround "could take several years and prove a real challenge in the face of stiff competition, a lack of critical mass and material exposure to big boxes".

Analyst Neil Wilson at Markets.com was more positive, saying that while profits missed expectations, it looked "rather like expectations had maybe been set a little too high, rather than Tesco underperforming".

Nevertheless he said it was a "very positive set of interims" and its was "worth also remembering that Tesco shares have a habit of falling off the back of trading updates and results as expectations do tend to be rather high".

"Grocery is all about margins and these are solid. Group operating margins climbed 29bps to just short of 3% - but for Tesco Direct it would have achieved the 3% handle. Synergies from Booker are flowing already (£16m reported) and on track to deliver £60m. Booker looks to have been a very smart move, and Tesco has defied the doubters (me among them), that see management take its eye off the ball.

"Dave Lewis should probably pat himself on the back – the turnaround and his focus on core retailing is working," Wilson said.

"LFL sales are strong, the Booker acquisition has been a success and the Carrefour joint-sourcing programme is about to launch, which should deliver a further boost to margins. Jack’s may also offer some incremental gains as Tesco seeks to claw back some ground from discounters, although at present it is a tiny fraction of the pie and really a sideshow to the main event which is a strong Tesco delivering another quarter of LFL sales growth, solid profits and strong free cash."

Russ Mould at AJ Bell pointed to a sixth straight drop in like-for-like sales in Asia and a second consecutive year-on-year fall in Central Europe.

“This may add further fuel to the debate over whether Tesco is still too complex a company, despite all of the work done by Mr Lewis and his team to get the company back to basics after its failed experiments with Dobbies Garden Centre and the Giraffe restaurant chain, among others," Mould said.

“The Booker deal is clearly designed to drive both sales growth and margins across the group while the launch of the new Jack’s chain is designed to tackle the threat posed by the discounters head on. Yet both initiatives will keep management very busy at a time when competing in the UK grocery market with Morrison, Sainsbury and rival online offerings is a full-time job in itself."