Tesco's (TSCDF.PK) investment case has been clear for many years. The UK business has been the cash cow, with profits ploughed into international expansion.
So far this strategy has worked pretty well. For some time now, Tesco occupies the number three global retailing spot by revenue, lagging only behind US' behemoth Wal-Mart (WMT) and France's Carrefour (CRERY.PK).
However, following the shocking post-Christmas warning about its UK performance, when the group posted its first profit warning in more than 20 years, the recently announced results reassured, at least somewhat.
Tesco's 2011-12 Results
Not that the overall results were that bad. At least, Tesco's trading results for the year ending February 2012 were not worse than expected. More importantly, there was not a second profit warning nor a dividend cut. Instead, Tesco 'surprised' with the group reporting better than expected total sales up by 7.4 per cent to £72bn ($115.2bn), generating pre-tax profits up 5.3 per cent to £3.8bn ($6.0bn).
Nevertheless, worryingly, UK profits fell for the first time in living memory by 1 per cent to £2.5 bn ($4bn), while in contrast international profits jumped 17.7 per cent to £1.1 bn ($1.76bn) - the first time Tesco has made more than £1bn from its non-British businesses.
Also, Tesco's UK profits still compare favorably: no other British retailer makes more than £1bn ($1.6bn), let alone £2.5 bn ($4bn). Also, Tesco has more shops in the UK than Sainsbury's (JSAIY.PK), ASDA and Morrisons (MRWSY. PK). And they are, in most cases, in prime locations.
But, what matters to us most, as Dividend Income Investors: the widely mooted dividend cut did not materialize. Instead, the 2011-12 final dividend payment is set at 10.13 pence ($0.16); up by less than 0.4 per cent when compared to last years' final dividend of 10.09 pence, and this will be paid on July 6th, with the shares going ex-dividend on 25 April.
Tesco's turn-around UK plan
Announcing the results, chief executive Philip Clarke admitted that Tesco and the rest of the UK grocery industry had been building too many big stores. Instead, he confirmed belatedly "too much new space, too many big stores when customers were moving online and back to the high street".
In the face of revived competition from the likes of Sainsbury's, ASDA and Morrisons, Mr Clarke released Tesco's long awaited strategy update outlining a £1bn ($1.6bn) investment plan to turn-around the UK business mainly funded from cash flow.
1. Tesco real estate
Tesco's plan is to scale back substantially the openings of new hypermarkets in the UK. Instead it will focus on opening more local - Tesco Metro and Express - convenience stores which are more food-focused, reducing its capital expenditure budget this year to £3.3bn ($5.3bn) from £3.8bn ($6.1bn).
2. Tesco food
"The Tesco standard food ranges, which comprise more than 8,000 products and represent around 40pc of our UK food sales, are being comprehensively upgraded with a programme of range-by-range improvement, including over 2,000 new lines, through to April 2013."
Tesco will also continue to invest heavily in its internet offering: Tesco.com. It intends to spend £200m ($320m) this year on improving its online operations, while doubling the number of non-food product lines to 200,000 lines by Christmas it sells via the internet. It is also opening up its click and collect offering to third parties products.
Tesco internet sales are huge and are growing at 15 per cent a year. Tesco.com is one of Britain's biggest online retailers, selling books, music, broadband, financial services, groceries, household goods and so on.
3. Click and collect locally
Using its massive store footprint in the UK, Tesco intends to radically increase its "click and collect" side of its business, where customers order online at Tesco.com and pick up from their local supermarket.
A year ago this was offered in 500 shops; now the click and collect service is in 770 stores, and the intention is to double this this year, particularly in its Express stores, in turn becoming a serious rival not just for Argos, but for Amazon.com (AMZN), which has no physical locations in the UK for customers to collect parcels.
4. Supermarkets revamp with shop staff levels up
In its quest to put the "heart and soul back into Tesco", the group will invest another £200 ($320m) to improve some 430 supermarkets this year by "warming them up and making them less clinical", improving service and product availability, while spending another £200m by putting more staff in its stores, to improve levels of customer service, recruiting some 8,000 new staff, particularly in its fresh food departments and larger stores.
While Tesco pointed out a 1.1 per cent improvement in like-for-like sales in the initial 16 trial stores, where they had tested the revamp - this was subsequently rolled out to another 200 stores - analysts were rather dismissive about the improvement. They pointed out that the improvement takes Tesco only back to comparable levels of like-for-like growth with the competition.
5. Every little bit helps
Finally, another £350m ($560m) is earmarked for cutting prices, discount vouchers and the introduction of more 'upmarket' value ranges, although some of this is part of the £500m cuts in prices committed to last autumn.
International operations holding up, for now
International sales rose by 9.5 per cent last year to £23.6bn ($37.8bn), with the trading profit coming in at £1.13bn ($1.8bn). However, while eight out of 12 of the international divisions are now cash positive, like-for-like sales in a number of the regions are significantly lower than last year, in particular in Eastern Europe.
While losses from its lossmaking US west coast chain Fresh & Easy have gone down from £186m ($298m) to £153m ($245m), Tesco revealed that it expects the chain to remain lossmaking this year. Instead, Fresh & Easy is now expected to break even during the 2013-14 financial year. Tesco announced that new US store openings are on hold as it strives to make existing stores profitable.
There are also signs of weakening demand in both Europe and important Asian markets, such as Korea and China. Eastern Europe, once a driving force for Tesco, slowed to almost a standstill, with profits climbing just 0.4 per cent to £529m ($846m).
The question now is: how quickly can Tesco complete its UK's makeover, regain some momentum and re-instate its above inflation dividend growth?
Many analysts and some institutional investors appear to be wary as to whether the actions set out will be enough to revive, let alone turn-around, Tesco's UK's operations and performance.
I do not disagree that Tesco faces an uphill struggle and indeed many things can go wrong, and it may take longer than expected.
Nevertheless, Tesco is comfortable with analysts' forecasts for the current year and it has confirmed that its dividend will be "maintained", which in my book means that Tesco's dividend growth is unlikely to match UK's inflation rate.
However, once all the actions announced are duly implemented, we should expect a return to profitable growth in the year to February 2014, with a consensus view expecting pre-tax profits to break through the £4bn ($6.4bn) mark that year, allowing for dividend growth to resume in the upper single digits for calendar year 2014.
Disclosure: I am long (TSCDF.PK). Our Dividend Income Portfolio owns a shareholding in Tesco Plc, purchased during 2011 and most recently in 2012, following the trading profits update. At current levels, Tesco remains historically undervalued as per our valuation methodology.