Tesco owns a large number of retail stores across a number of different regions. By far the most important market is the UK but the group also have operations in other, mainly Eastern, European countries (Czech Rep, Hungary, Poland, Ireland, Slovakia and Turkey). The other main region is Asia, with stores in China, India, Malaysia, South Korea and Thailand. In addition to grocery and general retail, the group also provide banking and insurance services through Tesco bank. Tesco has now released their full year results for 2013.
Overall revenues were up as a strong UK and Asian performance was somewhat counteracted by struggling European sales as continued financial issues affected the European markets where Tesco is present. We also see that cost of sales were also up, including non-cash items such as depreciation and amortisation including impairments to PPE and provisions for onerous leases, which increased by a nearly £1B and one-off non-cash items as impairments to goodwill came to just under £500M after not occurring last year. Most of the goodwill impairments were against the Polish assets with smaller amounts against Czech and Turkish assets following a period of difficult trading in those countries. Most core operating costs were also up, however, with employee costs up £334M, cost of inventories up £249M and operating lease expenses up £194M. All these increasing costs meant that gross profit was down by £1.4B on last year (although it is worth mentioning that this is roughly accounted for by the increases in depreciation, amortisation and impairments.). Admin costs were pretty much flat year on year but the group suffered a £339M loss on property items this year compared to a £397M profit last year which was related to a £804M UK property write-down due to the end of the “space race” of large store openings. This left the operating profit down by just over £2B. A small increase in interest payable and a fall in the income from associates and joint ventures was mitigated by a small increase in net pension finance income before a smaller tax charge meant that profit for continued operations was £1.386B, £1.778B less than last year.
When the discontinued operations in Japan and the US are taken account of, however, this profit is almost entirely wiped out (£1.215B of the loss came from the US operations) and the overall profit from the year was just £120M, £2.694B lower than in 2012. This seems very disappointing indeed but when £916M of extra losses from discontinued operations; £919M of extra amortisation and depreciation, and £495M of goodwill impairments are taken into account the actual profit was only £364M lower, which is still disappointing but not the disaster that it initially appears.
Total assets for the year fell by £652M on last year. The bulk of the falls were in land and buildings, down£954M; short term investments, down £721M; Goodwill, down £495M due to the previously mentioned impairment; and available for sale financial assets (relating to investments in bonds), down £449M. These reductions were partially counteracted by some increases with by far the largest increase being loans and advances to customers, increasing by well over £1B, presumably as the bank gains traction with new credit accounts. Unfortunately the fall in assets was compounded by an increase in liabilities with the largest increases being customer deposits, up £613M – again, due to the bank increasing customers; and pension liabilities up a disappointing half billion pounds. There was a smaller increase in provisions which relate to property provisions for future rents payable and provisions for refunds to customers relating to miss-sold PPI. These and some smaller increases were partially offset by just under £1B of falls in loan liabilities and £371M less in payables to associates and joint ventures. All of this means that net assets were £1.14B lower at £16.661B but due to the impairments, net tangible assets fared slightly better at £12.3B, £706M lower than last year. This is still a disappointing fall, though.
Cash profits when compared to last year were a very disappointing £1.133B lower at £4.248B. Small changes in the working capital for the retail side of things had little effect but a £1.22B increase in bank loans to customers was only partially mitigated by an increase in bank deposits by customers and a decrease in other receivables which meant that cash from operations was £3.873B, £1.815B lower than in 2012. After interest and tax took their toll, the net cash from operations was £2.837B (£1.571B down). £1.351B was made from the sale of assets but this was dwarfed by the £2.619B capital expenditure on property, plant and equipment (£755M up on last year). Another major source of cash was the £1.427B net proceeds from sale of investments (£2.194B higher than the spend last year on investments). This was mitigated by a net £1.202B reduction in borrowings and £1.184B spent on dividend payments. All of these factors gave a cash inflow of £194M compared to an outflow of £141M last year. Despite the one-off receipts from the sale of investments and assets, given the repayment of loans and hike in capital expenditure, this is actually a fairly decent cashflow.
Until late 2010 all of the Tesco bank branded insurance products were underwritten by RBS insurance and the agreement was finally settled in September 2012.
Tesco has a number of assets held for sale and discontinued operations. It was decided that overseas operations that had no realistic prospect of turning a profit within a certain time frame were to be sold. As part of this programme the operations in Japan have been sold at the start of the year and the board has approved a plan to exit the operations in the US. During the year the group also disposed of its interests in Greenenergy Ltd. The exit of the US operations is still on-going and the full financial effect is yet to be known. The asset write-downs and provisions for future liabilities have already affected profits by £1B.
Overseas markets are still an important part of profit for Tesco and they still make 29% of profit from outside the UK. The markets are split into three separate groups. Thailand, South Korea and Malaysia are currently important markets and the group still see the potential for good future growth in these countries. Although South Korea was impacted by the new regulations for opening hours, performance was strong and these fast growing economies are the international priority. In the Eastern European markets Tesco has solid and in some cases, market leading positions but the economic backdrop has affected sales. Long term the infancy of these markets offer good potential for the group but in the short term conditions are going to remain tough. China, Turkey and India offer good long term prospects but the group is adopting a steadier pace to growth that is more cautious about capital allocation. In India Tesco work with the Tata group as current regulations prevent them from committing their own capital. In the other two markets, capital will be invested but at a much more refined pace.
Profit wise, the UK is by far the most important market (£2.272B) with Asia providing the next highest amount of trading profits (£661M). About half as important as Asia is Europe (£353M) with the bank profits still fairly modest at £191M. Unfortunately trading profits were down across all regions with the UK falling by 8.3%. Asian profits fell by 9.8% with the Sunday closing regulations in South Korea impacting profits there by £100M. Going forward, the group expects the regulations to have a detrimental effect of £40M on profits. In Thailand, sales were up 3.1% and Tesco continued to gain market share as 300 new Tesco Express stores were opened. As mentioned elsewhere, expansion in China has been more cautious as in the market as a whole there were more stores opened than there was customer demand. Tesco opened 12 new stores and closed 5 underperforming ones.
European trading profit was down 33.3% as the group faced continued strong macroeconomic headwinds. Performance in Slovakia was strong, as was underlying Hungarian performance, although profits there were held back by the crisis tax. In the Czech Rep and Poland, the group faced increased competition with retailers who had a greater proportion of smaller stores fared better. The performance in Turkey was poor with very intense completion and a number of one-off issues giving a loss in the country which dragged the European result down. The group is no longer looking to open any new stores in the East of the country. These difficult market conditions led to a write-down of goodwill on assets in Poland, Czech Rep and Turkey.
The bank completed the final stage of migration this year and started focusing on marketing their products and introducing some new ones, such as mortgages and a new ISA range. During the year there was good growth in customer accounts and balances but the insurance business was held back by a challenging market with considerable downward pressure on prices. Trading profit was down 15% due to fair value releases and the run-off of the legacy agreement with Direct Line. Without these two issues, profits would have been up by 13% driven by strong consumer lending. Another non-cash issue was the £115M increase in provisions for PPI miss-selling.
During the year the group undertook a number of sale and leaseback operations. One involved UK properties sold to the Cambridge University Endowment Fund. In this transaction, four trading stores and three sites under development were sold for £493M. There were also two sale and leaseback transactions in Thailand as 17 trading malls were sold to the Tesco Lotus Growth fund, an associate of the group for £360M. The second transaction involved five further malls sold for £143M. The board have signalled their intention to slow down the rate of sale and leasebacks in the future. This is a decision that I agree with and have never really liked the short termism of sale and leaseback programmes. After the current refresh of the UK stores, the group is targeting a much lower capital expenditure level to an amount that is only 3.5% of sales. This will enable the group to wean itself off the need to sell and leaseback its stores to boost cash flow.
It is noticeable from reading the annual report that the board are trying to shift the focus for Tesco. The future for grocery retail in the UK seems to be online and convenience stores and Tesco is already in a good position in both of these areas with a huge convenience store portfolio and a profitable online business (not actually that common for grocery retailers). Other practical moves are to end the so called “space race” for more and more large stores. Another focus is on UK customer experience and a more disciplined expansion in China. An example of this is the fact that Tesco invested £200M to employ 8000 more staff and to train up the rest of their staff so they can serve customers in a more appropriate way. This already seems to be working as customer surveys indicate that service levels are improving. There was also a refurbishment of 300 stores during the year.
Another area that the group has made moves to improve is the customer experience in stores so that it rivals that of shopping malls. In order to achieve this they have purchased Giraffe and invested in Harris + Hoole, a new coffee shop that may even have the potential to be a money spinner in its own right given the success of Costa for Whitbead. Increased investment in technology is shown by the investment in blinkbox and the launch of Clubcard TV which is a free service offering films and TV series to their “most loyal” customers. I am not sure what this means in actuality but they are also launching Blinkboxmusic and Blinkboxbooks.
The property portfolio continued to be a decent source of income and profits on property related items were £370M due to transactions that took place in the UK and South Korea. There was continued investor interest in the property and the value of the group’s property exceeds £38B.
The main issues that affected the international business were continued economic challenges being experienced in some Eastern European markets and legislation restricting opening hours in South Korea, which is currently Tesco’s second largest market after the UK. Revenues were mixed with increases in the UK and Asia, despite the new regulations in Korea counteracted by falls in Europe where conditions were tough, and the bank which is still being affected by some legacy items. Profits for the group were nearly non-existent this year but the blame can put on one-off items and the performance of the US business held for sale. Underlying performance looks pretty decent outside of Eastern Europe and Poland and Turkey in particular.
Net debt is currently at £6.597B which is an improvement of £241M over last year due to reduced capital expenditure and a small increase in property proceeds. Not including the discontinued US and Japanese operations, the P/E ratio is currently 21.1, which is certainly not cheap, although this is predicted to be just 11.9 in 2014. At the current share price the dividend yield is 4.1% which is not bad, but only just covered by continuing operations. There does seem to be a decent cashflow cover though. There is no doubt that Tesco is going through a challenging transformation at the moment but I can see enough underlying performance to convince me to stick with them for the medium term.
On 9th January Tesco released their results for the six week Christmas period. At constant exchange rates overall group sales fell by 0.6% excluding petrol. In the UK, sales also fell by 0.6% reflecting a weaker grocery market. The stores that had recently been refreshed did perform better, though. Overseas Asian sales fell by 0.6% on the same comparison due to falling sales in Thailand as they continued to experience political problems, slightly offset by a small improvement in Korean trading. Sales in Europe fell by 0.8% but included positive like for like sales growth in Poland and Hungary. It is worth noting that the group were hit by adverse exchange rates and due to this, actual international sales fell by 2.2%. The board expect the full year results to be within market expectations. Overall, this is a disappointing performance, particularly in the UK but not a total disaster.