The finding of the analysis is that Tesco is a sustainable company with comfortable level of liquidity, huge fixed assets base and is generating excellent profits from its consistently increasing revenue. The company holds sufficient resources and access to market funds to fund its on going expansion programmes.
The present competition condition is in favour of the company, positively contributed by some of the most important factors "its size", great bargaining power, huge market share and Sainsbury's weaker position which was one of its major competitors.
The company's shares has started out performing in the stock market due to its fundamentally strong position based on excellent financial results and positive news about its plans ahead.
1.1. Reason for choice of topic
Being a professional accountancy student and an active investor in stock market back home in Pakistan, it was my usual practice to perform tests on the financial data of the different companies in order to analyse their financial health for the investment purposes , although I have left my country for the studies , but still my inside investor is still keen to look at and analyse things as an investor's point and the professional accountant inside me gives me the opportunity to make use of my knowledge, which I have gained during my studies, in this analysis process. Therefore I preferred this topic over others.
The purpose of the research is review and synthesis existing knowledge and investigate existing situation s and problems , (Collis and Hussey 2003)
This project will be focusing on analysis of the financial situation, and investigations of the irresistible driving force behind Tesco's growth .
1.2 Objectives
1.2.1Company and industry context
The supermarket industry in UK is a fiercely competitive market, dominated by three large supermarket groups, Tesco, Sainsbury and ASDA. The chasing pack of second Rank super markets (Wait rose , Morrison's ,marks and Spencer's) could only challenge the big three if they joined forces and get some foreign investment backing. However the competition commission does not encourage such practices in UK.
Tesco has been a success story for the past decade. The company which was founded in 1919 as a small grocery stall has now grown up to the largest UK food retail chain. The company now runs more than 2,460 supermarkets, hypermarkets and convenience stores in The UK, Ireland, central Europe and Asia. Its operations include different format stores consisting of Tesco express (petrol stations), Tesco metro (small Urban), Tesco extra (hypermarket), Tesco direct (catalogue) and Tesco.com Tesco also owns 35 % stake in Us grocery Chain Safeway Grocer works. (Extracts from Eastlondonhistory.com/Tesco)
1.2.2 Competition
The main competitors of Tesco (30.5% ) include ASDA( 16.7%), Safeway/Morrison's and Sainsbury(15.7%). Source TNS. Out of these three Sainsbury ranks as the biggest competitor of the company in respect of the turnover and lines of businesses, ASDA is American owned and not listed while Morrison's have a relative small market share.
1.2.3 Research and Analysis Objective
The aims and objectives of this research can be summarized as:
Review of the financial position of the company
Asses the company's capacity to meet the challenges in the retail industry
.
Research can be approached in various ways:
Quantitative
Qualitative
Applied
Basic
Inductive
Deductive
(Source: Effective learning service, University of Bradford)
Here I will be following combination of quantitative techniques with the Inductive research, as I will be analysing company's published Data and drawing conclusions there upon. The inductive approach is preferable to deductive approach when the purpose is not to test any particular hypothesis. (Saunders, Lewis and Thornhill)
For doing this research I will be performing vertical and horizontal analysis for Tesco. I will also calculate the following ratios for Tesco and its peers and will compare their share price.
liquidity ratios,
profitability ratios
gearing ratios,
investment ratios
1.3 Information gathering
Primary research
Due to the confidential nature of Data I did not have any access to the any financial data which was primarily available, information is only obtained from publicly available data (for both Tesco and Sainsbury).
Secondary research
Academic and professional training
Attended the Seminar conducted by BPP called "Success in your Research and Analysis Project".
Read the BPP text book " success in your Research and analysis project" which provided the initial outline, approach, research suggestions and structuring for the project.
Subscription of financial publications and news papers such as "The Economist" "Financial Times" and "Daily Telegraph".
Conventional library research
Going to the British Library enabled me to gain access to the academic publications on research methods for business, as well as industry-specialist publications.
Internet Resources Research
Tosco plc's website, from which I could obtain three years' worth of annual and interim reports, and company news.
Sainsbury's and ASDA's Websites.
London Stock Exchange for providing details of historic share performance of the companies under consideration.
Specialist trade publications such as "KPMG retail publications Library" provided operational information on the retail industry .
Accountancy magazine
Online version of Student Accountant magazine online provided an easy access to huge data base of articles useful in performance appraisal modelling.
Using internet search engines (Goggle, Msn, Yahoo)
Using highly informative financial news websites like , CNN money, yahoo business, BBC, CNBC , Reuters and Bloomberg.com
Web sites like Investopedia.com and Investorwords .com , which contained useful information about technical details about financial analysis.
1.4 Methods of Analysis
The most common approaches at analysing a company's situation involve using trend analysis, horizontal analysis and ratio analysis. All have strengths and weaknesses.
Vertical Analysis
This is also called as the Trend analysis where the company's performance is compared over a period of time. This can be used to Identify trends For example, increase / decrease in profits or increase or decrease in sales. However, as Steve Scott points out, because you are looking only at the company itself, there are no independent benchmarks, so you cannot determine whether the performance is good or bad in comparison with its competitors or an industry average (Student Accountant).
Horizontal analysis
This method compares an entity's performance over a period to that of a similar entity or entities operating in the same industry, for a particular period. Comparison only offers a meaningful result if the companies operate at the same scale and/or in the same markets. This introduces an independent yardstick to operate in the same industry. Again, this type of analysis is not without criticism - it may be that the company selected as a comparator may have performed particularly well or particularly poorly.
Ratio Analysis
The ratio analysis is normally used to measure profitability and return, liquidity and working capital requirements, gearing / long term solvency and stock market performance of the company
Profitability and return
Gross and net profit margins can show the relationship between turnover and profits, and efficiency of cost and overheads management. These ratios only give meaningful results when tools of horizontal and vertical analysis are applied on them.
The other measures of profitability include return on capital employed ("ROCE") or Return on Shareholder Capital ("ROSC"), ROCE is a widely used ratio with two elements, profit margin multiplied by asset turnover. While Share holders return is measured more commonly via EPS.
Long term solvency, gearing and stability
Gearing represents long-term debt in relation to shareholders' funds. High gearing indicates a high proportion of debt in the capital structure. Companies with high gearing are considered more risky because interest payments have to be met, regardless of profitability. However, interest payments are tax deductible making debt cheaper than equity. As equity is more expensive, a company with low gearing may have an inefficient capital structure.
Debt ratio: total debt to total assets, which show that to what extent company is using its debt o finance its assets.
Interest cover: means how well are interest payments covered by the current earnings.
3. Liquidity
Current ratio: current assets/current liabilities or the proportion of current assets available to settle the current liabilities. Ideally it is thought that this should be between 1.5 or 2:1, but it can vary depending upon the market sector (e.g. retailers have relatively few debtors so the current, and quick, ratios may be meaningless for such businesses.
Quick ratio express the proportion of current assets less stock to current liabilities, Therefore it is more applicable in stock holding operations. This is expected to be at Parity( Steeve Scot) so that short-term liabilities can be met.
4. Investment ratios
Price/Earnings (PE) ratio
This is most widely used investor ratio. It is the ratio of the current share price, to the EPS. High PE ratios indicate the market has strong confidence in the company.
Dividend yield
This is defined as "return a shareholder is currently expecting on the share of a company" (ACCA Financial Reporting for ACCA paper 2.5).
2. PRESENTATION
AND
ANALYSIS OF FINDINGS
2.1 Trend analysis of company's performance
Tesco's own performance over the last three years of published accounts shows most strikingly a story of massive revenue and asset growth (all figures from company Annual Report and Accounts).
Revenues
When analysing the retail industry sales on year on year basis, there is a need to focus on the growth rate of sales from the existing stores rather than looking at the new store acquisitions, this way of comparison gives us the more accurate picture of the revenue. So actually this is the way of comparing identical sales with the identical sales, But the Tesco does not publish the identical sales figure, and it only publishes the Like for Like sales figures, which normally include many stores which have undergone an expansion .
Total Revenues have grown from FY 02/03 (£26,004 million) to FY 003/04 (£30814 Million) by 18.49% and by a further 10.2% in the following year (FY 04/05 - £33,974Million), in absolute terms. All the revenue figures are net of value added tax and excluding share of Joint ventures. ( See Appendix A)
Increase in turn over reflects, growth from UK operations mostly, as in 2004 a new sales area of about 1,778,000 sq ft was opened and out of the total 18.49% increase 7.5% came from the new stores, so leaving behind about 11% sales growth on Like for Like basis. While in 2005 new area of 1,519,000 sq ft was opened only contributing 2.9% to the sales not as much as new area did in 2004 on per Sq ft basis, But the Like for Like sales showed a growth of about 10.52%. We should also consider 53rd week trading factor in FY 04/05 as compared to previous year which contributed about 2.2 % in the UK sales.
Generally the company is rapidly growing its like for like sales mainly due to increased number of products sold and very much improved on shelf availability.
Profits
Tesco's Gross profits have risen from FY 02/03 (£1,997M) to FY 03/04 (£2,409m) by 20.6% and to FY04/05 (2,703M) by12.2% in absolute terms. (See Appendix A)
As the company's gross profit ratio is almost the same for the last three years since 2003(around 8%) therefore it is obvious that the company is using the strategy to maintain steady gross profit margins but to increase its turn over by using different techniques (as discussed above), hence resulting in generating more profit from the marginal revenue. (See appendix A for GP ratio)
Company's operating profit was £ 1484million, £ 1735million and £ 1949 million for the year 02/03, 03/04and 04/05 respectively showing an increase of 17% and 12.33% in the year 03/04 and 04/05 in the absolute terms. This almost shows to be in line (or slightly better) with the increase in revenues.
Capital Employed
Capital employed increased in FY03/04 to £13,004 by 16.91% from the £11,129 of year FY02/03 and another 10.25% in year FY 04/05 £14,338 from FY 03/04.(See Appendix A)
A large proportion of the assets of the company is made up of the real estate, consititut ing a large out of town stores/hypermarkets and convenience stores in prime town locations. This prime real estate is reported at the historical cost, and does not account for any fair value adjustments for the present market value of the property and possible increment in the value of assets. Hence resulting in understated capital employed and overstated ROCE.
The company has recently thrown a proposal to make a real estate investment trust of its 12 billion Pound free hold property portfolio, bringing more benefits to share holders (source Dow Jones new wires march 24, 2006)
2.2Horizontal analysis
Tesco is an international grocery retailer operating in United kingdom central Europe and Asia with its major operations in United kingdom (about 85%).its portfolio includes Extra, Superstore, Metro and express. The company also offers Banking and Insurance services, company also holds 50% holding in tin Hsin's Hymall business , which operates Hypermarkets in Shanghai and North east of china ( Annual Report 2005)
Although Tesco has also developed the UK food based brand with the broadest appeal
The Rivals of the company include ASDA, J Sainsbury's and Safeway/Morrison's.
Out of these three ASDA is not Listed and its financial results are not available publicly so its financial performance cannot be compared to tesco.As far as Morrison's is concerned at the point of scale it is considerably smaller than the tesco and only has the market share of 11.3 % as compared to Tesco's 30% (Source TNS as per BBC news, Sep 20 ,2005) Therefore, there are not many directly comparable companies to Tesco in the UK which release their accounts publicly ,come to the same scale of operations, and operating in same business lines.
So I will be looking at Sainsbury's which is Tesco's nearest competitor in terms of scale of operations( 15.7% market share)
Sainsbury Plc is in many ways the best comparison for Tesco. Sainsbury has a revenue of Pound Sterling 1,5409 million for FY 04/05( See Appendix B) bringing it to the second position to Tesco, although it does not have its international presence under its brand name (it had stores in USA called Shaw's , But the company has sold it now) but it operates throughout the UK and consists of Sainsbury's Super markets , Sainsbury's local, bells stores ,Jackson stores, Jb Beaumont , Sainsbury' to you, an internet based home delivery and a Sainsbury's bank.
J Sainsbury is selling about 30,000 products with the help of 153,000 directly employed people. (Sainsbury's Annual Report 2005)
It is also listed don London stock exchange and thus has to meet the same disclosure requirements as tesco, making it bit more reliable for the comparison purposes.
Sainsbury's Trends in Comparison to Tesco
Revenue
Sainsbury's sales were stagnated at about 17 Billion marks in FY02/03 and 03/04 and then they took a sharp decline to 15 Billion, which was due to the discontinuation of some business interests like Shaw's supermarket (USA).
Sainsbury's sales from the continued operations figures for the FY40/05 Pound Sterling 15,202million which are 5.2% higher than the FY03/04 sales figure which were Pound sterling14, 440 million. Similarly the sales did not show a very significant growth in 03/04 as compared to the sales figure of FY02/03 and were only up by 2.3%. (See Appendix B).
However it is worth mentioning here that the Tesco's international sales /business cannot be possibly compared with the Sainsbury due to their different business model in the terms of international marketing.
Profitability
Sainsbury and Tesco seemed to be in line in terms of gross profit margins in the FY 02/03 and 03/04 at about 8% , but in FY 04/05 Tesco sustained the profit levels at the same level but Sainsbury had a drastic drop down to 4% which resulted in the net operation loss before exceptional income.
2.3 Ratio analysis
The ratios can be calculated as per the 'method' section above.
Returns and Profitability
Gross profit margin
Gross profit margin kept 8% since 2003 and it is still the same at the end of year 2005.This shows that the Tesco have demonstrated the effective management of their cost cutting programme and maintained their purchases at low cost margin and is focusing on the volume growth and trying to keep the price at the same level ( Andrew fowler's report dated march01 ,2005). This would indicate the ability to either set their sales prices at a margin above cost, or the company's ability to squeeze lower costs out of their suppliers.
While Sainsbury's which was maintaining a higher gross profit ratio of 8-9% in the year 2003 and 2004 has taken a very sharp decline and it is gone down to 4%.
ROCE
Tesco's return on capital employed remained steady at 14% for the year 02/03 and 03/04 and then it increased in 04/05 (see appendix A), although the company' PBIT margin remained steady at about 6 % but the company' showed a nominal increase of 1% in ROCE in 2005 taking it to15%, due to the nominal increase in operating margins, however it is worth mentioning here that the company is stating its assets on cost less accumulated depreciation , so that effect of not taking fair value into account is understating to capital employed and hence overstating the ROCE.
Tesco has also achieved the before and after tax return on capital employed ( 02/03 10.3%, 03/04 10.5% and 04/05 11.5%) that are consistently higher than its weighted average cost of capital.i.e its weighted average cost of capital is 7.3% for 03 and 7.9% for FY 04 and 05. In comparison to Sainsbury Tesco is been consistently well performing with a constant ROCE above Sainsbury for FY02/03 and FY03/04 ,while in FY04/05 Sainsbury's ROCE dangerously dropped down to 2% to worst efficiency and Tesco's sustained at 13%.
(See Appendix A and B)
ROSC
Return on shareholders funds is also steady for the last 3 year and is in between 23-24 %( See appendix A) showing that the company is performing well and generating a return well above its cost of capital.
When comparing it with Sainsbury, it is obviously well performing over Sainsbury's
15% for FY02/03, 13%for FY 03/04 and dangerously low 2% for FY04/05, which might be even lower than the cost of capital.
(See Appendix A and B )
Gearing
Like any cash rich company Tesco is also looking to drive down the gearing and as we analyse past three years the company's debt ratio has decreased from 49% to 44% (See Appendix A),this shows that the company has been successful in driving down the reliance of its assets financing from the debt. Although value of debt increased slightly but the company managed to increase its equity and reserves from the healthy profits which the company has earned during these years. So it looks quite obvious that the company is going towards success in its objective of the continuity of continuous funding and to maintain its policy of smoothing the debt maturity profile so that it can arrange sufficient funding for the needs ahead and it can do so by maintaining the sufficient undrawn committed facilities from the banks.
This compares favourably with Sainsbury's, whose results were 55% in FY 02/03 and rose up to 59 % in FY 04/05. Despite of the fact that the company had a massive cash inflow of Pound Sterling 1,170 million from its sale of its American based Shaw stores, which also resulted in a net profit Pound Sterling 275 million on the sale.(Source Sainsbury's 2005 annual report).
But on the other hand Tesco has been successful by driving down its Debt/Equity ratio from 62% to 50% while Sainsbury's is staying at around 40% since FY02/03.
Here it is worth mentioning that the excessive reliance on debt makes the company very risky as it has to bear huge interest and principal repayments, but when deciding the optimal ratio it should also be noted that the respective tax benefits arising from the interest payments may be forgone.
(See Appendix A and B )
Liquidity
Companies live or die by how quickly they get in their payments relative paying their bills and by how much liquid resource they possess (Peter Temple ,First Steps in Shares), Normally 1.5:1 ratio is considered very healthy.
Tesco's Credit rating in the year 04/05 has been confirmed stable by Moody's and standards and Poor's at A1 and A+ respectively.
Tesco's current ratio has also been increased from the last year by 33% in absolute terms .The nature of the Fast moving consumer goods retailing is that with the effective stock management , most of the times it will have a positive cash flow while analysing tesco's current liabilities we can see from its published accounts that the 66% of the current liabilities consist of trade and other creditors and the bank loans ,corporation tax and payment of finance lease ,which are more risky in terms of non-payment add up to only 12% of the current liabilities. Remaining components of the creditors balance consists of deferred revenue and accruals.
All the liquidity analysis suggests that Tesco is "cash comfortable"company. Its debt ratio is in the comfortable zone of 44% (See Appendix A)
Comparison with Sainsbury's show that its debt ratio is in slightly weaker position than Tesco, being on 59%.
Interest Cover:
Tesco' initial interest cover was 8x in 02/03 but this increased dramatically to 13 x in 04/05.
A few factors have contributed to the equity build-up:
The policy of the group is to finance its operations by a combination of borrowings,equity and leases to ensure to continuty of the funding.
Lesser amount of interest to be paid due to less borrowing , reflecting healty cash flows
Continuous revenue growth (Appendix A) means that the day-to-day cash balance is increasing, in positive correlation.
Sainsbury's comparison shows that Interest cover ratio was maintained at 11-12 times but it drastically fell 1x in 2005, main reason for which was the poor financial results in the year 2005.
Share Price, PE Ratio and EPS
Share prices are normally evaluated on the basis of price earning ratio (PER)
A high PE ratio tends to indicate strong shareholder support for the company.
So by comparing Tesco and its competitors of the respective PE ratios and comparing it with the industry average we can have an Idea about the future prospects of the company.
The EPS of the Tesco increased from 13.42pence per share to 14.93 in 03/04 and 17.52 pence per share in FY 04/05 showing that it is in line with the steady increase of groups profits during these years. (See Appendix A)
When we have a look at the EPS of the competitor , we see that it was healthier in FY02/03 with an EPS of 23.7, then it dropped down to 20.7Pin FY03/04 and then took a fall down in FY 04/05 to 3.5P. This decrease in EPS seems to be very much in line with the decreasing profits of the troubled Sainsbury. ( See Appendix B)
However when we have look at the PE ratio of Tesco , it is almost the lowest in the UK supermarket industry , Tesco stands at about 14.7 (march 2005), while morisson is at 17.6(march 2005) and Sainsbury is at 28.4.(Merrill Lynch Report march 1, 2005).
This shows that the share price of Tesco being on the 308.5P (March 2005) seems cheap than what it should has been when we compare it to the industry average (excluding the Sainsbury, due to its troubled scenario). As Andrew fowler says that the " placing the UK/Eire EPS stream on 17x 2005/2006E EPS ,only a modest market premium, would justify a Pound 3 share price on its own and give international for free".
The time has proven that the share price of the company has fetched greater interest of investors through time and as at 27march2006 the price of the share is 342p which is at about 19.52x.
3.CONCLUSION
General
The grocery industry is a very simple one: both produce and perishable goods are distributed and sold to customers through the normal and traditional retail channels. But in this changing environment of business through out the world face of the grocery industry has also changed, and here in UK Tesco is leading this change by creating the greater value in comparison with its competitors
There is no doubt that the Tesco is delivering outstanding results. The above analysis that it has shown the strong performance along the board in all the geographical locations and segments and has become a leader and very strong market player among its UK rivals.
PE Ratio and Share price
The PE Ratio at the point of final results is directly dependent on share price which moves in relation to company performance, but is also affected by events not directly controllable by the company, such as international oil prices and international terrorism and in tesco's case they even matter more because a business segment of Tesco consist of fuel retailing also. Hence this metric is not a sound guide to the financial health of the company.
However, the upward movements in the share price have increased the PE ratio, which currently stands at 19.93 at the price of 342P showing greater investor confidence in the company. This is mainly due to the company's outstanding performance and the positive news circulating the market. "Supermarket giant". The positive movements are not always but most the times is a result of any positive news about the company like "Tesco is considering placing its 12 Billion free hold property into a real estate investment trust in a bid to enhance share holders returns" (Daily telegraph March 24, 2006)
Liquidity
The liquidity ratio shows that the Tesco is at comfortable level as far as the cash needs are concerned, one reason is the nature of the retailing industry where no credit sales are involved and the other can be the efficient use of its resources (as evident from the Analysis above). Although the company is making huge expansions in its national and international store portfolio and still planning ahead to expand across continents as it has been announced in the news " After months of speculation the UK's largest retailer has announced its plans to enter the united states retail market through the convenience sector" ( Source Food and Drink Europe .com, report published on Feb 09,2006)
The company is paying good dividends and covering interest payment at very good levels and is still able to maintain very good liquidity ratios.
Strategy and competition
The financial analysis above points out that the company's growth strategy is the key to its success.
As the owner of the largest market share Tesco needs to continue to deliver customer satisfaction so that its customer would be loyal to the company.
Tesco's international expansion has delivered magnificent results, far better than any of its rivals who have tried the same strategy, so Tesco need to remain focused on this area in order to maintain its position.
The company has settled its strategy focus on the greater customer satisfaction,
For example:
On shelf availability of goods is very much improved
Full range of products on Tesco.com
Introduction of new technology, like self service checkouts , launching of music down loading site (BBC news Nov 8,2004)
Huge investments to improve price position ( Annual accounts 2005)
Branding
If the Tesco can make its profitability sustainable at this high level, it is crucial that the company defend its strong lead by holding onto its competitive advantages
The size of the Tesco means that it is so strong that it would be able to bear bad economic conditions better, the company has grown to such a size now having 30% market share ( Source TNS) that it is just 5 points behind monopoly thinks George Monbiot in his article published in the guardian May 17,2005.
So we can predict that it be able to operate on the low margins when the competitors cannot afford to do so.
Tesco also has edge of geographic diversification over its competitors
Brand equity' and goodwill
Tesco works on the strategy of expanding through acquisitions, therefore the goodwill which came from acquisitions has already been capitalised in the balance sheet of the company, however Tesco does not record the goodwill created by the growth of its network and the Tesco brand itself, which is in line with the treatment as described in the IAS 38 and/or IFRS 10.
Future of the company
There is a strong positive feeling in the press about the future of UK's largest retailer. The company has come to that stage where it is just 5 points behind monopoly , it is expanding tremendously throughout the world capturing some of the most high income and large potential markets like USA , China and Europe. As the chief executive Mr Terry Leahy told Reuters on Feb7, 2006 that Tesco is going to make its first venture in the US by starting its first convenience store at west coast. So the company is moving forward with the high hopes and excitement and it is obvious from the Terry Leahy's statement "A strength of Tesco is that we don't just plant a format and hope that it works well we think it will bring something new to American market".
With almost 30% market share and still growing ,soaring profits from well diversified business segments and geographical areas ,success fully penetrating into new high potential markets , capitalising it resources in the most efficient manner ( for example Starting new real estate investment trust to make use of its free hold property) and being in line with latest technology, Tesco will be far a head from its present in the near future in terms of growth and profitability and investor confidence.
