Tesco raises profit forecast as cost pressures ease

Tesco (TSCO) raised its full-year forecasts on the back of surging profits and market share gains, as easing input cost pressures helped it cut prices and attract customers "at both ends of the basket" according to chief executive Ken Murphy. 

Britain’s biggest supermarket now forecasts a retail adjusted operating profit of £2.6bn-£2.7bn for the year, up from previous guidance of £2.5bn. Retail free cash flow expectations also received a bump, with this now forecast to come in at £1.8bn-£2bn against medium-term guidance of £1.4bn-£1.8bn.

The grocer’s focus on price – it is passing on falling commodity prices to shoppers – means it is benefiting both from consumers trading down from more expensive retailers and from becoming more competitive against the German discounters. Tesco cut prices on 2,500 items in the half, with an average saving of 12 per cent. The combination of Clubcard deals with other pricing schemes is paying off, although consumer advocates may take account of the 62 basis point gain in the adjusted gross margin.

Evidence of the positive impact of pricing policies was seen in market share gains of 30 basis points in the UK and 70 basis points in the Republic of Ireland. There was also a boost to online performance, with basket size up by 5 per cent and weekly order numbers up by 4 per cent. 

UK like-for-like sales were up by 8.7 per cent, outstripping analyst forecasts. The UK and Republic of Ireland operating margin came in at 4.4 per cent, up by around 50 basis points on last year, on an adjusted profit of £1.4bn. Volumes improved in the second quarter, too. 

It was a different story in central Europe, where currency devaluation and food price caps in Hungary dragged operating profits down by 42 per cent to £46mn. The margin fell by 160 basis points to just 2.1 per cent.

Elsewhere, the solid performance at Tesco Bank highlighted the opportunity for operational streamlining. Revenue was up 17 per cent to £702mn and operating profits climbed by a quarter to £65mn. It was revealed earlier this year that Tesco is considering offloading its finance arm, and these postings could feasibly accelerate the process.

Shore Capital analysts argued that “if Tesco sustains such recent execution, against what we believe can be an improving consumer economic backdrop in the UK, then further upgrades should ensue”. That is a tasty prospect, especially when combined with the broker's forecast of a free cash flow yield of 9.4 per cent for this year. 

The shares are on offer at a discount to the historic trend, at 11 times forward consensus earnings compared to a five-year average of 13 times. That is an undemanding rating in the context of strategic and financial progress, with £600mn of annual efficiency cost savings expected. Buy.

Last IC view: Buy, 273p, 13 Apr 2023