Tesco Plc (OTCPK:TSCDY) Q2 2007 Results Call October 2, 2007 4:00 AM ET
David Reid - Non-Executive Chairman
Andrew. Higginson - Finance and Strategy Director
Sir Terry Leahy - Chief Executive
David Reid - Non-Executive Chairman
Good morning everyone and thank you very much for joining us. I'd just like to make a few introductory remarks and then we'll all be very happy to take your questions.
I am delighted that Tesco is on track to deliver another year of good growth. Even after taking into account the planned major start-up cost of launching Tesco Direct and our entry into the U. S. market. Sales in the first half have increased by 9.2% to £24.7 billion and underlying profit before tax has grown by 14.3% to £1317 million.
This strong performance shows that the management team has coped incredibly well with the worst summer on record. The strong instincts of the team have also been crucial in handling the petrol contamination incident as well as the household insurance claims following the major floods. In both cases, our teams demonstrated speed and integrity in helping customers affected by these events.
We are also making good progress on enhancing value for our shareholders. Our property funding program is going well and it means, we've delivered on our commitment to enhance dividend growth, which is up almost 14% in the first half. It has also funded our share buyback program, which is also well on track. And I am pleased to say that since commencing under this program, we've repurchased and cancelled shares with the value of over £800 million.
International has made particularly good progress in the first half, from the early stages emerging from a strong base in the developing markets in Europe and Asia, our international business is really coming of age, growing in a self sustaining way and beginning to add real momentum to the Group. The international platform together with the opportunities in China, where we've just started, the United States where we are about to start and the Indian market where we are looking to start.
These results clearly demonstrate the well executed strategy. The addition of a new fifth element through our long standing four-part strategy that of the community really puts community and sustainability at the heart of what we do. It further hard wires into our business the excellent progress we've made as well as our plans for the future.
I am glad that we've made big commitments on the community and environment and the thing about Tesco, it's not about what we say it's about what we do. For example, when we launched our Green Clubcard scheme for reusing carrier bags, we set ourselves a target of saving 1 billion bags by next year. Well, I am delighted to say that thanks to our customers, the scheme has recently celebrated its first anniversary and we've hit our target.
We are a responsible retailer and this means being open and honest about the way we work and sharing what we learn with others. We work with suppliers from all over the world and recognize the importance of worker welfare. We're committed to auditing and monitoring labor standards and developing external reporting so that others can see just how serious we are. These developing countries like Bangladesh really do benefit from Tesco's commitments to source goods and to improve the quality of life on a sustainable basis.
People are Tesco's most important asset and it is their hard work that enables us to deliver these strong results as the business grows... as the business grows, so does the Tesco team. 25,000 new people who joined us this year and over half of these jobs will be outside the U. K. So, I'd like to thank all of our staff for their hard work and commitment in doing a great job for customers every day. I know this will continue through the busy Christmas period and into the New Year, helping us deliver further progress in the second half. Thank you. I will now hand over to Andy to take you through the financials.
Andrew. Higginson - Finance and Strategy Director
Thank you David. Good morning everyone. So first, I'd like to outline the main financial headlines of the Group. We delivered good growth in sales, profits and earnings in the first half. We have done so even in tough trading conditions and whilst carrying significant start-up costs. Our program to release value from property assets is going well. An appetite for our property is strong. Shareholders are continuing to benefit directly from this through more share buybacks and strong dividend growth.
Our strong cash flows and balance sheet allow us to comfortably fund the growth in our existing business and make the necessary investment in the new businesses which will drive future growth. I'll now take you though the Group performance starting with sales.
Total Group sales for the half year ending 25th of August 2007 were £24.7 billion, up 9.2%. This is a good performance, so not helped of course by the summer weather and petrol deflation in the U. K. Group trading profit rose 10.1% to £1249 million. Profit is stated after absorbing significant start-up cost on Direct in the U. S. and those total £32 million for the first half. Our guidance of £65 million start-up cost in the U. S. for the year as a whole remains in place, and we expect the loss for Direct to be around £25 million, similar to last year.
Excluding start-up cost on the U. S. and Direct, trading profit rose by 11% to £1281 million and Group trading margin was up at 5.7%. Group underlying profit before tax was £1370 million, up 14.3%. This is a good growth rate and is helped by the strong property profits in the first half, which were up significantly on last year. This slide shows the breakdown of these property profits. As you can see, the majority of the increase is driven by the U. K where property profits grew to £121 million following the latest of our property joint ventures with British Land.
The deal was completed at the beginning of the year and brings proceeds released from our property program so far to over £1 billion. With small losses in international and the inclusion of £36 million property profit last year in the JV line relating to the sale to a third party of the Weston Favell store, total property profits in the first half were £119 million compared with £74 million last year.
We're making good progress on our plan to release more than £5 billion from our property portfolio. Appetite for Tesco's property and covenant remain strong as demonstrated by the recent on-sale by Topland of its share in one of our JVs and we expect to be able to complete further disposals on attractive terms in the months ahead.
Statutory Group operating profit was up 18.9% and Group pre-tax profit was up 18%. This is stronger than our underlying profit growth due to non-cash IFRS effects including a reduction in our... in our IFRS pension charge which I will talk about later.
Underlying diluted EPS were up 17.2% to £0.119 benefiting from strong property profits, a lower tax rate and the effect of the share buyback. The proposed interim dividend, this £0.032, up 13.9% as a strong dividend reflects in the improved tax rate and the expected phasing of our property transactions this year. We intend to continue to grow annual dividends broadly in line with underlying diluted earnings per share growth.
Now, I am going to take you through the performance of the U. K. Sales in the U. K. were solid with ex-petrol sales growth of 6.4%. Ex-petrol like-for-like sales were up 3.5% including volume of 2.6%. Net new stores contributed 2.9%. In-store inflation in the half was 0.9%. In the first quarter, there was inflation of 1.8% reflecting market prices for seasonal fresh food and commodities. Inflation fell to zero in the second quarter, partly as a result of our latest round of price quotes.
First quarter sales in the U. K were above budget but our sales growth slowed at the start of the second quarter, as we hit at long period of cold wet weather and traded against the very warm early summer last year. Terry will tell more about this in a moment.
U. K. trading profit was £978 million, up 8.2%, U.K. trading margin was 5.8%, up on the same period last year. Improvement in the margins was driven by good productivity growth and both had the last year's margin was after absorbing high energy costs.
And now I am going to take you through our international results. Total international sales were £6.4 billion, up 22% at actual exchange rate and 23.1% at constant rates. These sales include China for the first time following the increase in our stake in Hymall from 50% to 90% in December 2006.
International trading profits were £271 million, up 17.8% at actual rates and 19.3% at constant rates. International trading margins rose before the effect of including China. This was an excellent performance reflecting the growing strength and maturity of our existing markets.
In Asia, sales were £2.9 billion, up 26.1% at actual rates, 31.2% at constant rates. Trading profits in Asia rose to £124 million, an increase of 18.1% at actual rates, 22.8% at constant rates. Excluding China, margins rose to 5.3%, driven by strong performances in Korea, Thailand and Malaysia. Malaysia was profitable despite carrying £3 million of integration costs and the initial operating losses on the eight Makro stores we bought last year.
In Europe, sales were £3.6 billion, up 18.8% at actual rates, 17% at constant rates. Trading profit rose to £147 million, an increase of 17.6% at actual rates and 16.03% at constant rates. Trading margins were stable at 4.7% despite carrying £3 million of integration cost.
Our retailing services have made further good progress, led by an excellent performance from Grocery.com, which had sales growth of 24%. Dotcom availability and customer satisfaction at their highest levels ever and Dotcom now attracts more than 300,000 customers a week.
New initiatives are also working well. The launch of bag-less delivery had a terrific 40% take-up. Our Dotcom only store in Croydon is a great success with sales approaching a million pounds a week. We are also very pleased with Tesco Direct. We are expecting its sales to exceed £150 million pounds this year. The second full size catalog was launched a couple of weeks ago and customer response has been very encouraging, with order levels trekking up 25% against the launch of our first full size catalog.
So you may recall sales from Tesco Direct currently contribute to net new stores. As Tesco Direct annualizes during the second half it will then switch into like-for-like. Direct is already the tenth most visited shopping website in the U. K., which is a great performance after just 12 months of operation. Grocery.com incidentally is now in third place.
Tesco Telecom has continued to build the foundation for a substantial business, growing profitability whilst increasing its customer base. Tesco Mobile remains the number one network for customer satisfaction and it's the UK's fastest growing mobile operator pay-as-you-go.
TPF had a good recovery in the first half with our share of profits at £26.05 million, up from last year despite being held back by home insurance. Claims resulting from the June floods in Yorkshire and the July floods in Gloucestershire and Oxfordshire are likely to total £31 million. Our share of the cost of flood liabilities for the year after tax and interest is likely to be around £11 million. About 40% of that is being charged in the first half.
Underlying progress in TPF has been good, with the new management team getting the momentum back into the business. It has a strong pipeline of new products and has just launched the Tesco Compare, a new car insurance comparison website. Feedback on the website is good. Customers particularly like the extensive range of insurance providers that are on the site and the ability to search based on features not just on price. In the first couple of weeks since launch the site has proved very popular providing around 6000 quotes a day to customers.
The credit experience in TFP has been solid. Our experience of bad debts is improving and continues to be considerably better than the banking industry average as you can see on this chart which looks at the arrears rate on TPF credit cards compared to the total market.
So overall, JV and associates' profit was £32 million. Whilst was down on last year's £60 million remember as I mentioned earlier, last year's number included the £36 million property profit arising on the sales of Weston Favell. Excluding that, JV profit rose 33%.
Net finance cost were down £70 million on last year of £52 million excluding the impact of the net return on our pension schemes assets and liabilities and the impact of IAS 32 and 39, underlying net finance costs were up slightly.
Interest cover has improved significant, strengthening to 25.8 times. Taxes being charged at an effective rate of 27.2% for the half, that's quite a bit lower than last year's 29% and it's due to the change in the corporation tax rules that will take effect from the 1st of April 2008. This year's benefit arises from the one-off adjustments of our deferred tax balances to reflect the lower rates going forward. Of course the corporation tax change will also reduce the tax rate going forward as it kicks in in April. The rate next year will be around 27.5%.
Net debt has increased to £5.3 billion from £4.9 billion at the year-end and gearing was broadly stable at 50%. I'm pleased with the progress we've made on the share buyback. This half year we've bought and cancelled 96 million of our own shares, representing an investment of over £400 million. This would mean we are meeting our commitment to end earnings dilution arising from issuing new shares. It also means we are well on track to repurchase shares worth in excess of £3 billion over five years.
Quick word on pensions, based on our actuarial assumptions, I'm pleased to say our scheme remains fully funded. The IFRS pension valuation which as you know uses high quality corporate bond yield to measure liabilities in the scheme still produces a deficit. But even that has reduced by £135 million in the first half to £530 million on a post tax basis.
Group capital expenditure during the first half of the year was £1.6 billion. U.K. CapEx was £1 billion including £443 million on the new stores and £209 million on extensions and refits. It was £93 million of capital invested in the U. S. and we expect our U. S. investment this year to be in line with our guidance of £250 million. Total international CapEx rose slightly to £0,. 6 million pounds reflecting our enlarged new store opening program and broadly was split evenly between Europe and Asia.
You can see that first half CapEx has increased over the last couple of years. Two-thirds of this is simply due to timing. We now spend a greater proportion of our annual CapEx in the first half. In addition, the increase reflects a higher level of international CapEx and also our new investments in the U. S. In line with previous guidance, we still expect Group CapEx this year to be around £3.5 billion.
Operating cash flow was £1.9 billion, up from £1.8 billion last year and £0.3 billion above CapEx. So in summary, we delivered a good performance in the first half, both in the U. K. and overseas. We've done so even in tough trading conditions and whilst carrying significant start-ups on new business. Thanks very much. I will now hand over to Terry.
Sir Terry Leahy - Chief Executive
Thanks David, Andy and good morning every one. Now these results demonstrate that Tesco has made strong progress in the first half. Sales and profits have grown well. The growth has come from across the group and we are delivering on our commitments to shareholders. I am pleased about that because we have to cope with some real challenges to produce this performance, recovering compositors, some tough markets around the world and of course the British summer has not made things easy. And at the same time, we have been investing in our future growth in the United States and in Tesco Direct.
A few years ago any one of these challenges could have held us back, but I think these numbers show the breadth and momentum of the Group and therefore the resilience that the business now has. And I begin my update this morning with international where we've made excellent progress, both in our existing markets and with our preparations through open Fresh & Easy stores in the United States.
Sales in international have increased strongly, up by 22% in the first half including a first time contribution from China. We saw positive like-for-like growth similar to last year and good performances across Europe and Asia. Profits also advanced well with good margin growth, before integration costs and the effect of adding in China. Returns are on track and I will update you on these in the normal way at the full year.
I am delighted that we are emerging as the clear winner in Central Europe, but times passed as you know it's been hard yards but our persistence is paying off. And we are now the largest, fastest growing and most profitable retailer in the region and there is a lot more to come. For example, we are just starting to see the benefits of recent acquisitions; success with smaller formats is also opening up new growth opportunities. And regional initiatives such as Pan European buying for own brand, produce and non-food is starting to make a meaningful contribution.
Our performance in Central Europe has been particularly encouraging because the market in Hungary which as you know is one of our bigger countries has remained tough. But our strategy there of investing hard in our offer for customers and pushing on with the development of our store network is delivering. We've resumed good growth, good profit growth and like-for-like has turned positive in the second quarter, putting us in a strong position for when the economy does begins to recover.
Elsewhere in Europe, both Ireland and Turkey did well. Although the commissioning costs of major new DCs at Donabate near Dublin and Izmir in Turkey of course did hold profit growth back in the first half. We expect to achieve substantial benefits from these infrastructure investments going forward.
The rapid development of our store network in Turkey means that we added 33% to our selling space there in the first half alone, adding 8 hypers and nine Express stores. We opened our first hyper market in Ankara in the next few weeks and we've got a very good pipeline of stores as we build the national business.
I'm pleased with progress in Asia. Our two largest countries, Korea and Thailand achieved strong growth despite challenging market conditions. And Malaysia has delivered an excellent performance moving towards market leadership now as the macro stores are successfully re-launched with 60% uplifts on those completed so far.
In Japan, our work on adapting the Express format for local customers is coming together well and in China, having taken full control of the business we've moved into profitability and we've begun to push on faster with new freehold stores in prime locations. As usual, I'm going to highlight the significant developments of the past few months using the six key elements of our international strategy, which as you know is about being flexible, local, maintaining focus, using multi format, developing capability and building the brand.
So we've strengthened our position in existing markets through organic growth and selective acquisitions. Of the nearly 10 million square feet of group space that we'll open this year, 80% will be in international. In Czech Republic, the acquisition and remodeling of the Carrefour hypers and the Edeka stores has transformed the business there. We are now the number two retailer. And in Poland, our space is up 27% on a year ago and the leader price stores with only partially converted are achieving sales uplift averaging over 40%.
Multi-formats are opening up new growth opportunities. Customer response to the 1K, 2K and 3K formats in Central Europe has been very positive and these now form the backbone of our expansion plans in all four countries because they've allowed us to extend our reach into neighborhoods, smaller towns and cities. They can provide us with years of strong growth complementing our program of hypers.
The development of Express is also going well with stores now in eight countries following the very successful first Central European openings in Prague and Budapest. And we've resumed openings in Thailand and with the Korean format now profitable, we're accelerating our opening program there too.
Having the skills to adapt these formats to the needs of local customers is of course crucial to the success internationally and this capability is behind Fresh & Easy, which will open its first stores in the United States next month. Preparation is going very well. Our focus on putting quality stores, investments and new jobs into the heart of neighborhoods means that we've been welcomed by communities and town halls across Los Angeles and San Diego, Las Vegas and Phoenix. We've already secured enough sites to open 50 stores in this financial year versus significant portion of next year's plan and program.
Fresh & Easy is about fresh, nutritious food at affordable prices to the customers. The 3000 product range is ready, suppliers are lined up, the DC is complete. Because we've designed low cost into the business model, at every stage we know that we're going to be price competitive. Fresh & Easy is also about been a great place to work. The strong team at the El Segundo office and at Riverside where the depot is now over 200 and our package of paying benefits including pensions and healthcare is proving very attractive as we begin recruiting store staff and management. We've thousands of applications for jobs in the first stores.
Precise details of the format of growth remains under wraps for just a few more weeks, but hopefully, many of you will have the opportunity to see it on the Investor Relations trip, which I think is at the end of November.
Overall then, international has had an excellent first half and I would now like to turn to the U. K. where we've made good progress in the first half. The first quarter was strong; like-for-like was ahead of budget at 4.7%. This might be impact of the petrol contamination in the early weeks. The trade then slowed as you know in June and July as last year's good weather and this year's wet weather combined to make sales growth harder to come by. You can see from this chart which tracks ex-petrol like-for-like through the second quarter, just how strongly correlated our sales can be to the weather in the summer.
The blue line shows our sales like-for-like and the red line shows the average difference in the number of hours of sunshine versus the same week last year across the country. And as you can see the correlation is pretty striking. A typical day in June and July this year had nearly four fewer hours of sunshine than last year. Retail businesses of course are set up with the seasonal buyers nowadays and if the normal weather doesn't come, that customers just don't buy the fresh food, the drinks, the cloth and so on when it's warm.
If we now add in August, you can see a strong bounce back in like-for-like. The good weather broke in early August last year and although August 2007 wasn't particularly good, you can see that the earlier big variance on sunshine hours reduced significantly. So in more normal conditions, we exited the second quarter with good growth which was well ahead of the industry, like-for-like in August was around 5% ex-petrol with strong volume.
Looking back, the summer slowdown, which could have signaled something more fundamental about consumers was in fact all about the weather. And we coped well with its effects on our profits and margin. We also came through the summer in good shape operationally, we stayed focused on doing the right things for customers by investing to improve the shopping trip and I want to highlight a few other things we've done in the first half on price, service, range and availability.
Our price position has never been stronger and with our latest round of cuts covering 3000 products we've improved it again. We are so confident about it that we have been using it... using our weekly price check data which compares 10,000 products against leading competitors in our advertising and that's the first time we've done that. It's very well received too.
With our new checkout technology now fully implemented, the renewed focus on reducing queues has delivered one of the biggest ever improvements in checkout service. As a result, about 4.5 million customers in the first half received our one-in-front promise and we are able to advertise that on television as well.
We're continuing to do more on our food range; the finest range has been increased by nearly a quarter. The sales growth more than doubled the business overall. So the sales growth of healthier products are more than double the business overall. We've introduced a lot more organics, there are now 1200 organic products in Tesco brand alone. And we've added the third more lines to our free from range. Despite subdued industry demand during the summer, the fundamental shift that we've seen in the priority consumers place on food driven by the link between diet and health is continuing.
Growth in healthy products and organics local fair trade is twice as fast as other foods. And the switch to premium is also very clear right across the spectrum, actually with the fastest growth in both organics and finest coming from the least affluent consumers. I believe these trends will remain and constitute a big positive for the industry going forward.
On shelf availability, which we measure in-store using the Dotcom picking operation has reached record levels allowing more customers to get everything they want when they shop in Tesco. We've been able to fund these investments through our step change program, which drives cost and productivity improvements across the business, is delivering biggest savings than ever before with well over $350 million planned savings for this year as a whole. For example, we have invested in new technology to reduce energy costs, resulting in-store lighting and heating consumption falling by 15% in the first half and in distribution, improved working methods and vehicle scheduling will save £15 million this year.
Non-food has again performed well, growth accelerated actually through the first half despite the impact of unseasonal weather in categories like clothing and gardening. In the first half overall U. K. non-food grew by 10% to £3.9 billion. Although the rate of growth is bit more moderate than this time last year, we're still seeing good market share gains across all categories. Hardlines, which include electrical, entertainment, toys, sport and DIY delivered excellent growth of 17%.
Entertainment sales were subdued in the first quarter and picked well in the second quarter helped by a stronger sequence of new releases. Health and beauty sales grew well again with stronger performed progress in the second quarter driven by a big remerchandising of the category. Softline growth of course was slower than normal and clothing sales, which are now running at an annualized rate of around £1billion affected by the poor weather. Clothing grew though by 7% in the first half and also our autumn and winter ranges have had a very good start.
Both of our two new non-food businesses, Tesco Direct and Homeplus performed well. Tesco Direct has made a good start with a lot more to come. Customer feedback is very positive on the catalogues and the new one features almost 3000 new products. It's... it's doing very well, higher ticket items particularly electricals have been selling well and so the confidence on the build up to Christmas. We're on track to install 200 of our very popular order-and-collect desks in stores by the end of the year. Customers tell us that they really appreciate the ease of being able to pick up an item when they do their regular Tesco shopping. So the combination of channels is proving very powerful.
Some of the busiest desks are in our largest Homeplus stores actually, and the combination of a comprehensive in-store non-food offer with the catalog could be a winning formula. So we are extending the trial of these 50,000 square foot units to a further 10 sites.
Finally, on non food a quick word about Dobbies, which I am delighted to say, is now a part of Tesco. It's a great business, which gives us access to the great pound. We intend make it larger and better by helping it to develop a national network and giving it access to our global sourcing capability. It will also be a platform for the group to attract the green pound by developing an offer for customers that are looking for sustainable solutions for more through recycling through wind and solar power.
To sum up, our non-food is strong and it's improving all the time. It's shown great resilience in challenging market conditions reflecting the fact that more customers seek our Tesco value, if they are looking to make their budgets go further. Most important of all, it's still a huge opportunity for growth.
Our growing strength on the internet is also opening up opportunities for the service businesses. The Tesco website is one of the most if not, the most visited in the U. K. with over 3 million hits a week. And we are steadily building traffic flow to it with innovative new online services and the most recent example as Andy mentioned is Tesco Compare, the insurance comparison website developed in conjunction with RBS. tescodiets is now very profitable business and its very popular; it has 35,000 regular users and we are also moving our clubs online with the baby and toddler cycling line a couple of weeks ago.
Customers like the convenience and value of buying online, that's why internet product sales with Tesco Personal Finance have grown by 22% in the last 12 months. More than 55% of TPF total new product sales are now online. It's easy for customers, its also helping to further reduce the costs of an already very good TPF business model.
Dotcom has once again been on great form with customer numbers and orders per week continuing to grow rapidly. Total sales including Direct are up 35% and profits before the start-up costs of Direct increased almost 62% in the first half. Telecom has also had a good and profitable first half having seen strong growth in sales particularly in mobile.
I want to complete my presentation today by telling you more about something David emphasized in his introduction and that is the integration of our work with communities and the environment into our strategy. Tesco has built its success on listening to customers and because these things are growing in significance for them, we have made sure that being good neighbors, behaving responsibly and doing what we can to deal with challenges such as climate change are increasingly at the heart of what we do. So from today, Tesco no longer has a four part strategy but a five part strategy which gives equal weight to our work on community and the environment alongside the other four elements.
Now climate change is going to have a profound effect, profound economic effect and we aim to be a leader in equipping our business to meet this new challenge and that's why this is the first alteration to our strategy in 10 years. We've kept up the pace in this area just to highlight a few recent examples. We are about to hit the important milestone of the first billion carrier bags saved through our Green Clubcard scheme. And we've just opened the next generation low carbon footprint store at Shrewsbury, which is more than 60% more carbon efficient than one of a comparable size.
We now have similar Green stores in five countries outside the U. K. First one opens in China later this year, may have heard we are investing £25 million in establishing a Sustainable Consumption Institute at Manchester University; this will be a world leading center for academic research into climate change and the effects on consumer systems. And our efforts to get hundreds more local products into stores for customers is working, backed by the opening of five new regional buying offices and you saw some of the products out there in reception.
In summary then, Tesco has delivered a good first half performance. Sales and profits have grown well; we're on track to see further improvements in return. We don't miss against the background of cautious consumers in some tough markets demonstrating once again the resilience of our business model. As our strategy matures, our growth is increasingly broadly based coming from across the group. Our strategy now also reflects our community environmental priorities.
We continue to invest hard in new businesses, which will drive growth into the long-term and we've delivered by staying focused, as always on things that really matter to ordinary people. The business is in good shape and I believe well placed to meet the challenges which lie ahead. Thank you.
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