An Analysis Of the Financial Situation of TESCO PLC

Introduction:

Reason for selection of this topic

The selection of topic is based on my reading about Tesco rapidly growing articles and its strategy for growth topic is based on four vital playing parts:

Growth in the UK

To expand by growing internationally

To be as strong in non-food as in food

To follow customers into new retailing services

From the list of suggested topics an analysis of the financial situation of an organization seems to be attractive and interesting topic. The making of this report help me in different ways like improvement in analytical skills and time management.

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Company Profile

Jack Cohen established Tesco in 1919, when he began to sell surplus groceries from a stall in the East End of London. In 1924, the first own-brand product sold by Jack was Tesco Tea. In 1932, Tesco became a private limited company. In 1983, Tesco stores (Holding) Ltd became PLC.

Tesco became Britain’s biggest independent petrol retailer in 1995

Tesco became the number one in this country with 17% of the market share in 1995.

Tesco is one of the largest food retailers in the world, operating around 2,700 stores.

The group operates through multiple store formats, including Extra, Superstore, Metro, Express and hypermarkets.

Tesco operations

UK (1,900 stores)

European countries

Asia

Tesco Products

Electrical goods

Home entertainment

Clothing

Phones

Broadband

Health

Beauty

Stationery

Kitchen utensils

Soft furnishings

Seasonal goods

level of products

Value

Finest

Branded

Tesco and Retail industry profile

Grocery market is one of the most evolving markets. Tesco is the third largest supermarket in retail industry world. Competition is directly with the small and independent chains and with other big names of retail industry. Today’s consumer is changing their shopping patterns with the changes in marketing strategies by the grocery market. Tesco’s is innovative in its marketing strategy and maintain its impressive figure of market share by huge spending on marketing and fulfilling the wants and needs of customer. (RETAIL INDUSTRY REPORT 2007)

It is 60 years since Tesco was first listed on the London Stock Exchange, as Tesco Stores (Holdings) Ltd, with a share price of 25 pence. It was only ten years ago that it laid out a new strategy for growth, a strategy which looked to find new customers, new markets, new products and new opportunities,thriving international business and assessing markets with over two billion people. Source:http://www.tescocorporate.com/annualreview07/01_tescostory/tescostory.html

Tesco’s market share has surpassed 30% for the first time in 2005, providing further ammunition for consumer groups who want its dominance curbed.

Source:http://www.thisismoney.co.uk/news/article.html?in_article_id=401840&in_page_ id=2

Aims & Objectives of the Report

Analysis of recent performance of Tesco

Analysis for the benefit of all stakeholders and shareholders

Future performance prediction

Methods of analysis

Method to analysis the performance of Tesco is based on the competition with Sainsbury (leading British retailer).

The main reason is to understand the concern of shareholders about their dividend income and growth of capital. Therefore the report is mainly focused on the following aspects:

SWOT anaalysis

SWOT analysis of Tesco is about the internal and external factors, which helps me to understand the current position of company.

Profitability

Comparison of the profit with their rivals

Liquidity

This is the most concerned factor for the investor to know about. Usually companies are not forced into liquidation for not making profit,but when they cannot pay their debts off.

Growth

Expectations of shareholders in highly competition

Financing

Financing should be accurate and appropriate towards their objectives.

Investment

Analysis on investment towards future profitability

Shareholder’s return

Analysis on how effective the group is returning shares of shareholders.

The few key factors

Gearing ratio Gearing is a measure of financial leverage, demonstrating the degree to which a firm’s activities are funded by owner’s funds versus creditor’s funds and is the key indicator of the share prices.

ROCE (return on capital employed)

To examine the total long-term funds invested in the group to earn the return.

EPS (Earning Per Share)

Earning per share (EPS) is widely used by both present and future investors to gauge the profitability of a company.

Gross profit margin

Compares a company’s performance with its competitors in terms of profit margin.

Limitations of Analysis

Ratios are static and it does not reflect the future trends normally.

Ratios are based on information in different articles and websites. It ignores the affect of inflation.

Financial statements themselves have limitations IAS 16 also allows a choice between measuring non current assets at cost less amounts written off, or at revalued amount (FTC Foulks Lynch Paper 2.5, 2004).

On the other hand IAS 17 leaves somewhat vague the distinction between finance leases and operating leases. By classifying a lease as an operating lease, it is possible for a lessee to keep leased assets and their corresponding liabilities off the balance sheet (FTC Foulks Lynch Paper 2.5, 2004).

The earning power of a business may well be affected by factors, which are not reflected in the financial statements.

Executive Summary

Tesco has shown improving results during the recent years and an excellent result this year as well compared to previous performance of the company. Tesco Group’s result for the year 2006/07 is as follows

Turnover â-²10.9%

Operating profit â-²17.7%

Profit before taxationâ-²20.3%

Group underlying profitâ-²13.2 %

Group trading profitâ-²11.1 %

Underlying diluted earning per share increased by 11.6% on comparable basis, to 22.36p (last year-20.04).

Final dividend has been proposed 6.83p per share (last year-6.10). This represents an increase of12%.

Gearing level remained at 48% as last year’s.

Cash outflow is 265m compared to last year Cash inflow 165m last years.

Above results represent the story of progress of the group, which reflects the consumer satisfaction, shareholders and stakeholders confidence in Tesco. Tesco generates their profits faster than revenue and the improvement in production.

Information gathering

Primary research

Primary information is data, which is, collected specifically by or for the user, at source for example the management accounts of a company (BPP Success in your Research & Analysis Project 2005). Most of my work is based on secondary sources.

Secondary research

Most of my research is based on secondary type of research.

Academic

Reading the textbook provided the initial outline, approach, research suggestions and structuring for the project.

Subscription publications such as “Accounting and Business”

Conventional library research

Going to the British and Corydon Library enabled me to gain access to the academic publications on research methods for business, as well as industry-specialist publications.

Electronic research

Financial Journals and Tesco website, which enabled me to obtain last three year’s annual and interim reports, and company presentations to analysts, investors and portfolio.

ACCA website (http://www.accaglobal.com/) provided an easy-to- search database of articles

Using Internet search engines (Goggle, Yahoo Finance) enabled me to collect a lot of information about Tesco and its competitors.

Other Methods to Collect Information

Specialist Accountancy Publications (Accountancy Age)

Annual Accounts of Company

Telephone calls, Email

Analysts’ reports

Newspaper articles

Discussions with superiors

Analysis and Presentation

(Note: All the figures used below are taken from Tesco and Sainsbury’s annual accounts, except where mentioned)

Strategic Analysis

Cost Leadership

Cost leadership is a generic strategic thrust that emphasizes providing products and services at the lowest per unit cost within an entire market. Porter notes (1980) “Cost leadership requires aggressive construction of efficient-scale facilities, vigorous pursuit of cost reductions from experience, tight cost and overhead control, avoidance of marginal customer accounts, and cost minimization in areas like R&D, service, sales force, advertising, and so on (p. 35)”.

from Porter, M. Competitive Strategy: Techniques for Analyzing Industries and Competitors, New York: The Free Press, 1980.

Michael Porter suggested four “generic” business strategies that could be adopted in order to gain competitive advantage. The four strategies relate to the extent to which the scope of businesses’ activities are narrowing versus broad and the extent to which a business seeks to differentiate its products.

The four strategies are summarized in the figure below:

This strategy is usually associated with large-scale businesses like Tesco offering “standard” products with relatively little differentiation that are perfectly acceptable to the majority of customers. Occasionally, a low-cost leader will also discount its product to maximize sales, particularly if it has a significant cost advantage over the competition and, in doing so, it can further increase its market share.

Source: http://tutor2u.net/business/strategy/competitive_advantage.htm

SWOT Analysis

STRENGTH

Leading British Market

Customer research and its careful positioning

Economy of scale

WEAKNESSES

Limitations in opening new outlets in UK

OPPORTUNITIES

Growth in Non-Food retails

Investment in international market

THREATS

Threats from rival

Competition in overseas market

Extension in business makes it difficult to manage

Reputation risk

STRENGTHS

Britain’s Market Leader

Tesco is the market leader of retail industry in UK and holds 31.5%share of whole market as compared to its competitors ASDA & Sainsbury’s who hold 16.7% and 16.0%.

Source: – http://scotlandonsunday.scotsman.com/business.cfm?id=68862007

Customer Research and its carefulpositioning

Tesco’s ability to empathies with its customers is the result of in-depth research, and has been key to its resoundingly successful entries into so many new markets. Their market research doesn’t stop at new customers, but covers existing customers’ buying habits too.

Tesco has expanded its customer base by its increased efforts to embrace customers from all levels of society, and all income brackets. For example, two popular food product ranges – the luxury range called “Tesco Finest” and the budget version, “Tesco Value” – are both carried within all of its stores.

Source:http://www.growthbusiness.co.uk/expansion/259636/what-tesco-can-teach-us.thtml

Economy Of SCALE

Tesco’s has massive buyer power over suppliers; these economies of scale allow Tesco’s to compete fiercely on price without imperiling its own margins in a mature industry in which aggregate revenue growth is unspectacular.

WEAKNESSES

LIMITATIONS IN OPENING NEWOUTLETS

The massive volume of sites under development and owned by the supermarket groups, and particularly by Tesco’s, is a central plank in a new Competition Commission investigation into the grocery sector.

The Commission is considering to review the rules that govern store openings. Under current guidelines, a retailer keen to open in a particular town must simply prove that the location needs a new supermarket. The national market share of that supermarket chain is not taken into account.

The Commission will also take a close look at the controversial issue of “land banking” – retailers’ supposed practice of buying vast tracts of land merely to thwart rivals from opening on them.

Source: http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2006/04/30/cctesco30.xml

OPPORTUNITIES

Growth in non-food sector

According to Retail research company Verdict, in 2007, for every £10 spends on non-food shopping, £1 will be spent at the supermarkets.

And Tesco is set to become the UK’s number one non food retailer, with Verdict predicting it will capture 3.6 percent of the non-food shopping market this year, overtaking the current number one GUS (owner of Argos and Homebase) which currently has 3.5 percent market share.

Source: http://www.clickajob.co.uk/news/tesco-to-become-uk-s-largest-non-food-retailer–3675.html

Tesco stores sell some non-food, it is Tesco’s ‘Superstore’ and ‘Extra’ formats that offer the biggest choice. These offer electrical, home entertainment, clothing, health and beauty, stationery, cook shop and soft furnishings, plus seasonal goods such as barbecues and garden furniture in the summer. The company has launched a highly successful range of own brand goods from microwaves to garden furniture.

Source: http://www.999today.com/homeandgarden/news/story/1804.html

Investment in International Market

International growth forms a key element of Tesco’s four-part strategy and the business currently trades in 12 countries outside the UK, mainly in Asia and Central Europe. Over half of Tesco’s selling space is now outside the UK.”

Source:http://www.tescocorporate.com/page.aspx?pointerid=14163CB2412F41B1BD7765AC8DBE49EB

Total international sales grew by 5.3% to £11.0 billion. On a comparable 52-week basis, sales increased by 17.9% at actual rates. International contributed £564 million to trading profit, up 10.8% at actual rates (up 18.0% on a comparable 52-week basis). (Annual Report)

The US represents the biggest job for Tesco expansion in international world.The fact that the USA has been such an embarrassing graveyard for almost every British retailer that has opened there merely adds an extra frisson to Tesco’s plans. J Sainsbury, Marks & Spencer and Dixon’s have all returned from stateside adventures with their tails between their legs.

With this in mind Tesco has gone to extraordinary lengths to keep its plans secret. It has also carried out one of the most thorough pieces of market research in corporate history to ensure that its efforts are not lost in translation

Source: http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/06/10/cntesco110.xml

Tesco’s new US convenience store chain is struggling to attract shoppers. “If Fresh & Easy fails, it will add to the list of UK retail brands unable to break into the US and also be very dilative to international returns.

Threats

Threats from Rivals

Tesco is facing a lot of competition from its local and international rival. It has diversed its business in different products, which increased its competitors so it requires more efforts and attention to deal with the competition and to secure its position in the market.

Competition faced in overseas markets

Consistently maintaining the No 1 position in the UK, Sir Terry and Tesco are looking overseas for growth. Over the last decade Sir Terry has led Tesco into Asia and Europe, opening stores in different countries. America is the major item on the table and India is expected to follow. Managing the international business takes up an increasing amount of attention and clear understanding of political, spending, religious and many other factors.

Reputation risk

Tesco is the largest retailer in the UK; expectations of the Group are high. Failure to protect the Group’s reputation and brand could lead to a loss of trust and confidence. This could result in a decline in the customerbase and affect the ability to recruit and retain good people. (Annual Accounts)

Extension in makes it difficult to manage

Tesco’s extension itself is big challenge. The competition commission is enquiring about Tesco’s land bank holding and in some areas not approval for store development is one example. Tesco’s diversified its business in different segment which means downfall in one will have impact on other business area as well.

Review of 2007 results

Group Summary

Group sales, including VAT, increased by 8.1% to £46.6bn (last year £43.1bn) and by 10.9%on a comparable 52-week basis. At constant exchange rates, sales increased by 7.9% and10.8% respectively.

Group operating profit rose by 17.7% to £2,648m. Total net Group property profits were £139m, comprising £98m in the UK, a £6m loss in Asia and a £47m profit within Joint Ventures and Associates.

Return on capital employed

In April last year, Tesco renewed its commitment to increasing their post-tax return on capital employed (ROCE), having exceeded their 2004 aspiration two years early. The strong performance of the business delivered slightly higher ROCE in 2006/07 – at 12.6% (last year 12.5%), (Including the one-off benefit from Pensions A-Day, ROCE was 13.6%). This represents good progress and was achieved despite carrying the extra start-up costs and investment in the US and Tesco Direct as well as the integration costs and capital employed in their International acquisitions and increased stake in Hymall. This means that ROCE is on track to meet their new target. (Annual Accounts)

Whereas, Sainsbury has shown magnificent improvement in their ROCE (2.76% in 2006 and 6.3% in 2007) (refer to Appendix) but still has to do a great deal of effort to challenge the market leader in terms of absolute figures.

Return on capital shareholders fund

The Group’s total shareholder return performance (i.e. share price movements plus dividends reinvested) for the year 2006 and 2007 relative to the FTSE 100 index of companies is 143:116 for FEB 06 and 195:132 for FEB07. This index has been selected to provide an established and Broad-based comparator group of retail and non-retail companies of similar scale to Tesco, against which the Group’s TSR performance can be measured. There has also been a very strong performance in TSR over the last three and five years against a comparator group of our major retail competitors in the UK, Europe and the US.

Source: http://www.tescocorporate.com/annualreview07/pdf/review/annual_review_and_sfs_2007.pdf

Gross Profit Margin

Profit earned is the sales revenue less cost of goods sold. The relation between them is the gross profit margin, which in terms of percentage shows profit made out of sales. Gross profit margin is obtained by dividing gross profit by sales.

Tesco Group sales, including VAT, increased by 8.1% to £46.6 billion (2006 – £43.1 billion) and by 10.9% on a comparable 52-week basis. At constant exchange rates, sales grew by 7.9% and 10.8% respectively. Group profit before tax increased by 18.7% to £2,653 million (2006 – £2,235 million) and by 20.3% on a comparable 52-week basis. Underlying profit before tax (excluding IAS 32 and IAS 39 and the non-cash elements of IAS 19, which are replaced by the normal cash contributions) increased to £2,545 million, up by 11.8% (13.2% on a comparable 52-week basis Gross Profit Margin is 10.24% which increased by 4.70% compared to Sainsbury’s Gross Profit Margin of 10.29% which increased by 7.41%. This shows that Tesco has well control on cost cutting and productivity programme and focusing on the sales growth trying to keep the prices at lower margin. While, Sainsbury’s improvement demonstrates well pursue of their recover plan in which they include cost control as well.

Asset Turnover

Asset turnover is the relationship between sales and assets i.e. sales per nominal value of Asset. This ratios has dropped from 2.62 for 2006 to 2.58 for the year 2007 indicating slight inefficiency of asset utalisation.(Appendix B) compared to Sainsbury’s which improved from 2.02 to 2.50(Appendix C).

Tesco’s figure has decreased but it still is better than Sainsbury’s that shows Tesco is utilizing its assets more efficiently.

Gearing and Liquidity

Gearing represents long-term debt in relation to shareholder’s funds. A gearing ratio of about one-third is usually regarded as acceptable for a company, suggesting that it is not over-reliant on external borrowing. A figure in excess of this indicates a higher-geared company. High gearing ratios are most suitable to those companies with steady and reliable profits, whose earnings are sufficient to cover interest payments and where total dividends are low. However, wide fluctuations in profitability would make a highly geared company extremely vulnerable t market conditions

Source: http://vig.pearsoned.co.uk/catalog/uploads/Griffiths_C02.pdf

High gearing indicates a high proportion of debt in the capital structure. High-geared companies are deemed to be financially risky, because interest payments have to be met, regardless of profitability.

Tesco’s gearing ratio has increased slightly from 60.39 to 62.87, on the other hand Sainsbury’s gearing ratio decreased by 44.74%. But with a high interest cover good current and forecast profitability and low level of net debt the high gearing ratio should not present Tesco with any problems. (See Appendixes)

A combination of retained profits, long and medium-term debt, capital market issues, commercial paper, bank borrowings and leases finance Tescos operations. The objective is to ensure continuity of funding. The policy is to smooth the debt maturity profile, to arrange funding ahead of requirements and to maintain sufficient undrawn committed bank facilities, and a strong credit rating so that maturing debt may be refinanced as it falls due.

The Group’s long-term credit rating remained stable during the year. Moody’s and A+ by Standard and Poor’s rate Tesco Group A1. New funding of £1.8bn was arranged during the year, including a net £0.5bn from property joint ventures and £1.2bn from medium-term notes (MTNs). At the year-end, net debt was £5.0bn (last year £4.5bn) and the average debt maturity was nine years (last year six years). (Annual Accounts 2007)

Current ratio

This ratio shows indicates the company’s ability to meet its short-term obligations. The higher the ratio, the more liquid the company is. Current ratio is proportion between current assets and current liabilities. If the proportion between current assets and current liabilities is more than 2 then that company is generally considered to have good short-term financial strength. If current liabilities exceed current assets, then the company may have problems meeting its short-term obligations.

The current ratios of Sainsbury’s group are better than that of Tesco group. For 2007, the ratios were .56:1 and .71:1 for Tesco and Sainsbury’s respectively. (See Appendix)

This means there is less assurance that Current liabilities of Tesco could be paid quickly comparative to Sainsbury. But the other point of concern is that Tesco’s has shown an improvement by 7.69% whereas Sainsbury’s current ratio shows a decline of 11.25% that again indicates not very effective management and utilization of assets as compared to Tesco.

Interest cover

It states how many times a company can repay the interest from the current earning. The higher the cover, the safer the company is from liquidity crisis.

Tesco improved its interest cover from 9.48 to 12.32(Appendix B) whereas; Sainsbury’s improved its interest cover from 1.47 to 4.76(Appendix C).

Tesco’s increased profits have improved its interest cover. Tesco is a highly geared company but it delivers great return to investors so there is no threat that it would not be able to cover its interest cost.

LIMITATIONS specific to the ratio analysis

There are limitations to the usability and understandability of these rations and the analysis made from them. Almost all of these ratios are inter-linked and interdependent and shows fluctuations if a few variables are gauged. Also, there are more than one agreed criteria for the choice of nominators and denominators so care must be taken while considering them in absolute figures (e.g., as more than 2 Quick ratio is considered excellent) and for comparisons between two or more entities.

A better asset turnover ratio might as well be because of the under valuation of assets and a decline might as well be because of acquisition of assets of increase in the market value f the assets as most of the assets held by retailers as Tesco and Sainsbury’s are in the real estate.

Current ratio has been defined good or worse depends on industries as well, as debt is cheaper than equity Industry such as retail where Tesco has working capital days in negative (i.e. they have a chance to earn interest on the sales they have made as their suppliers finance those sales.) the more a company is geared (but within the safety margin) the better will its performance be, as the interest cover is pretty handsome.

Growth and investments

Tesco’s has been investing in new markets overseas, seeking out new opportunities for growth and ways of generating long-term returns for shareholders. Tesco is also investing in diversified nature of business like investment in software; properties and recently investment in gardening are proof of well pursuit of its diversifying strategy.

Group non-food sales have grown to £10.4bn, including £2.9bn in International. Sales growth, in the UK alone, was11.6% in the year, with total non-food sales increasing to£7.6bn (included in reported UK sales). In non-food product which shown growth include clothing sale grew by 16%, health &beauty sales increased by 9%, toys and support sale rose by 35%, stationery and DIY both sales grew up by 23%, consumer electronic sales rose by 35%. (Annual Accounts)

Investor’s Outlook

The EPS is primarily a measure of profitability and states earnings/profit earned for one share and so an increasing EPS is seen as a good sign.

Tesco’s Basic earning per share from continuing operations has raised from 20.20p to 23.61p compared to Sainsbury’s Basic earning per share which has raised from 3.8p to 19.2p which is massive. (See Appendix)

Tesco’s returns are well ahead from Sainsbury’s basic earning per share that’s why Tesco’s share price gives better return to shareholder.

Chart below shows the comparison between the share price of Tesco against one of its competitors namely Sainsbury and against the FTSE 100 index over two years. Tesco has performed slightly better than the FTSE 100 index over the second half of the year but Sainsbury’s performance is much better which has been amplified by the rumor of takeover bid of Sainsbury’s by Delta two and Qatar and also the role played by the successful Sainsbury’s recovery plan.

Total shareholder return (TSR), which is measured as the percentage increase in the share price, plus the dividend paid, has increased by 36% in 2006/07, its largest value increase for ten years – and the fastest percentage growth rate for three years. Over the last three years, TSR has grown 87% compared with the FTSE100 average of 58%. Over five years, the increase has been 102% compared to the increase in the average for FTSE100 companies of just 50%. (Annual Account)

Conclusion

“Tesco’s latest results show that it has been another successful year for Tesco.

The most encouraging thing about Tesco’s performance is that Tesco’s coped well with the head-wind from recovering competitors, rising costs and tough conditions in some markets. Tesco’s come through in good shape and have done it by staying focused on doing the right things for Tesco’s customers and at the same time investing for future growth. (Annual Accounts)

Tesco chief executive Terry Leahy said, “Overall sales growth has strengthened in the period, with international delivering a particularly strong performance, and the UK has again done well, with good growth in our core food categories.”

Its non-food offering Tesco Direct, and the group’s online grocery operation tesco.com had both delivered “very strong sales” in the quarter, said the company.

Source:http://icwales.icnetwork.co.uk/business-in-wales/business-news/2007/12/05/good-progress-for-tesco-in-autumn-sales-91466-20203900/

Tesco has laid solid foundations for future growth. Tesco is always looking to improve the way the owners of the business benefit from that growth.

It has also been a good year for shareholders return. Of course, Tesco’s shares are higher in buoyant markets but Tesco’s is also doing more to contribute. Dividends are up to approaching £800 million, driven by last year’s change in policy, combined with the effect of our rising flow of property profits now ranking for dividend. Tesco’s also bought back and cancelled almost £470 million worth of our own shares so far.

(Annual Accounts)

Tesco’s financial performance in 2006/07 was excellent. Turnover of £46,611m grew by 8.1%, diluted earning per share of £23.31m grew up by 17% and dividend per share£ 9.64 increased by 11.7%, putting Tesco in top place in retail industry in the UK. (Appendix A)

Tesco’s position holds strong position in UK and now Tesco is concentrating towards International markets for improved return for its shareholders and to establish its business and loyalty of customers around the world. Tesco’s produced very good performace – particularly against the background of political uncertainty and economic problems in three of its markets – Hungary, Thailand and South Korea. This demonstrates that International now has the size and momentum to get through these things and still deliver.Tesco’s got much stronger in Central Europe, through rapid growth in new space and acquisition. In Asia as well, having done the groundwork in a couple of our newer markets, we’ve used acquisition to get on faster.(Annual Accounts)

The biggest challenge in international market is its fresh move in the US market. If Tesco’s get fails in US it would be a disaster for their strategic planner.

According to CNN, Tesco’s is aiming to open 200 Fresh & Easy outlets by February 2009, with projections suggesting that annual sales could hit US$4bn,

But Michael J Dennis, a senior research analyst with Minneapolis investment bank Piper Jeffrey, described sales at the chain to date as ‘a disaster’.

Based on interviews with suppliers, he said sales were running at about US$60,000 a week – 70% down on targeted weekly revenues of