Financial Review Financial Review




UK operating performance


UK Sales Chart


We achieved strong sales growth in the year with stores open more than one year increasing their sales by 8.9%. Of this, 4.8% was due to an increase in the volume of products sold and 4.1% was due to inflation. The trend in existing stores sales growth is shown in Chart 1. On this measure, we continue to outperform the industry average.

Sales from new stores continue to be encouraging, with all formats - superstores, compact, Metro and Express - trading in line with our expectations. New stores (after allowing for closures) contributed 10.9% to our overall sales growth. For the year ahead, we expect a further useful contribution despite a smaller opening programme weighted towards the year end.

Our total UK sales increase was 19.8%.This contributed to the estimated rise in our market share from 12.0% to 13.6% (see Chart 2).

The market continues to be highly competitive. Our ongoing commitment to offer customers excellent value for money has meant we have reduced selling prices on many products.Through managing improvements in our sales mix, better buying and more efficient sourcing we have been able to limit the impact of reduced prices on gross margins which fell by only 0.2%.

We have continued our drive to improve the productivity of all areas. This has helped us to finance the significant improvements we have made to checkout service and more labour intensive departments such as pharmacies. As a result, UK wages as a percentage of sales reduced by 0.2% to 9.7% and other operating costs reduced by 0.5%.

Chart 1 Chart 2

The launch of Clubcard has allowed us to target more precisely our marketing activities and improve the value for money we obtain from marketing expenditure. Clubcard has contributed to our strong sales performance which has more than offset the costs of the scheme of 0.5% of sales. For the first time in recent years, we did not advertise on television during the important Christmas trading period and instead targeted marketing spend on our regular customers.

The purchase of Wm Low was completed 20 months ago adding a further 57 stores. Since acquisition all stores have been totally integrated with Tesco replenishment and front end systems, and we are planning to complete the refit programme in the year ahead.The performance of the business since acquisition has been excellent and in line with our high expectations. Sales in former Wm Low stores increased this year which, together with integration benefits, generated an improvement in the operating margin. Wm Low stores contributed £609m (1995 - £260m) to group sales and £36m (1995 - £11m) to operating profits.

Overall, UK operating margins were maintained at 6.2%, a considerable achievement in a competitive market. We see no signs of competitive pricing lifting. However, we are working hard to offset further margin investment by better sourcing, supply chain savings, new product development as well as experiencing the benefits of trading up following the recovery from recession. We will also continue to improve on our First Class Service, which is reinforced by the recent introduction of our 4,500 customer assistants. The cost of this is some £20m.We have set ourselves the task to offset a large part of this by productivity initiatives.

For additional information on UK operating performance:
Chairman's statement - Performance


Europe


European Performance


Sales in the year were £596m up 19.9% on the previous year. Operating profit decreased to £11m (1995 - £17m). Sales in Europe are going well, but profits, inevitably, are affected in the short term by the substantial investment in infrastructure and other projects which we are putting in place.

In France, Catteau increased retail sales by 13.9% of which 4.2% was due to the increased volume of products sold and 1.4% of deflation. New stores contributed 11.1% to sales growth. We have continued to invest in lower prices in addition to people, systems and infrastructure. This caused operating margins to fall by 1.6% giving an operating profit of £10.5m (1995 - £16m). The investments we have made will provide benefits in future years.

Sales at Global in Hungary increased by 52% in local currency. Sales in existing stores were ahead by 37.5% of which volume growth accounted for 7.9%. We are starting to invest in supply chain systems and people to provide a platform for the growth of the business. In November 1995, we opened our second new Tesco store since acquisition and we plan to open our first superstore in Budapest in the year ahead.

On 9 November 1995 we acquired a majority stake in Savia, a small food retailer operating in southern Poland, for £8m. Savia operates 36 stores with a total sales area of 190,000 sq ft. The results of Savia have been consolidated for the seven weeks from acquisition to 31 December 1995. In this period, Savia contributed £4m to group sales with a negligible effect on profit.

On 5 March 1996, we announced that we had agreed to acquire the two retailing businesses of the US retailer Kmart in the Czech Republic and Slovakia for £77m.The businesses consist of 13 food and general merchandise stores in the main cities in these two countries. We expect to complete the acquisition by the end of April.

Our Central European businesses will then allow us to start exploring the benefits available through buying opportunities, logistics and systems, in addition to our plans to develop new stores.

For additional information on France/Hungary:
Notes to the financial statements -
note 1 and note 30


Group profit before tax
Profit sharing for our employees increased to £29m (1995 - £25m). This represents over 4% of qualifying employee's earnings and more than 70,000 of them will benefit this year. Over the last five years, the profit share awarded has totalled over £125m.

Net losses on the disposal of fixed assets were £6m (1995 - £5m). This is mainly the loss arising from surplus sites which did not receive planning permission. The net interest payable of £43m (1995 - £22m) was in line with expectations and reflected a higher average level of borrowings and interest rates. Capitalised interest came down again to £33m (1995 - £42m) reflecting reduced capital expenditure on new stores. Interest cover remains strong at 9.5 times (1995 - 9.6 times), as shown in Chart 3.

Profit before tax increased by 22.5% to £675m. After excluding Wm Low integration costs from the 1995 figure and the net loss on disposal of fixed assets from both years, the increase was 14.5% to £681m (1995 - £595m).

Chart 3 Chart 4

For additional information on Group profit before tax:
Chairman's statement - performance


Taxation
The effective rate of tax was 31% (1995 - 30.9%). In the year, the underlying tax rate rose to 33% from 31% because less of our capital expenditure qualified for capital allowances. The effect of this increase has been partially offset by favourable agreement of prior year tax computations. We would expect the effective rate for the year ahead to remain at 31%.

For additional information on Taxation:
Notes to the financial statements -
note 8 and note 20


Store development and capital expenditure
During the year we opened 23
superstores, compacts and Metro stores in the UK with a total sales area of 673,000 sq ft as well as six Express stores (see Chart 4). Three stores were closed.

We continue to invest in our supporting infrastructure. During the year we opened a new semi-automated composite warehouse in Southampton and eight regional recycling centres. We also continued with the development of our leading edge supply chain system to improve product availability to our customers, reduce stock levels and lower supply chain costs.

Total capital expenditure for the year was £649m (1995 - £771m) of which £42m was spent in Europe. Our core UK capital expenditure is running at close to £600m which is higher than we anticipated three years ago.This is partly due to our ability to negotiate a reasonable supply of planning permissions for our flexible formats, and partly to the opportunities we have identified to invest in existing stores, particularly through major extensions. In addition to our investment in France, with the Kmart acquisition, we will have established operations in four Central European countries. We expect to spend almost £100m in the year ahead principally in developing new stores in Europe. Total group capital expenditure is therefore expected to be somewhat ahead of £700m.

For additional information on Store development and capital expenditure:
Store locations
Notes to the financial statements - note 11 and note 27


Cash flows
As planned the business generated a net
cash inflow of £5m (1995 - £329m outflow).The net cash inflow from operating activities was £1,046m (1995 - £872m) reflecting our strong trading performance. Our total cash outflow on investments, including our acquisitions and capital expenditure programme, was lower than in previous years at £612m (1995 - £865m). Group net debt reduced from £1,040m to £813m primarily due to conversion of the £200m convertible capital bonds in October 1995 and £22m from the issue of share options. As a result, year end gearing fell to 22.7% (1995 - 33.5%).


Shareholder returns and dividends
Fully diluted
earnings per share (excluding the net loss on disposal of fixed assets and Wm Low integration costs in 1995) was 21.9p, up 9.0% on the previous year.

Our last review of dividend policy took place in January 1994 when we committed to pay progressive dividends well ahead of earnings growth. Since then, our corporate return on capital has increased from 15.7% to 16.9% reflecting a better performance in the base business and investment in new stores. In the light of the investment opportunities available, we believe it is now appropriate to pay progressive dividends but at a rate of growth which is much closer to that of earnings and thereby retain dividend cover close to current levels. We will also aim to deliver good returns to shareholders as the business grows.The Board has proposed a final dividend of 6.55p taking the total net dividend for the year to 9.6p (1995 - 8.6p) as shown in Chart 5.This represents an increase of 11.6% over last year and leaves dividend cover at 2.3 times.

Chart 5

Shareholders' funds rose by £484m to £3,588m. Of this £260m resulted from retained profits, £236m from the issue of new shares, principally in connection with the conversion of the convertible capital bonds, offset mainly by a goodwill write-off of £11m arising on the small acquisitions we have made during the year. Return on shareholders' funds improved to 20.4% (1995 - 20.3%).

The share price finished the year at 271p having reached a peak of 338p in September 1995 and a low of 245p earlier in the year.

UK opening programme
1995/96
Sales area
(sq ft)

UK opening programme
1996/97
Sales area
(sq ft)
superstores

superstores
Ashby de la Zouch 32,000

Ashford, London 39,000
Beckenham 31,500

Bangor 32,500
Brent Cross, Hendon 36,500

Barkingside 32,500
Falkirk 32,000

Bury St Edmunds 29,500
Handforth 49,000

Llandudno 32,000
Norwich 39,000

Newport, Gwent 32,000
Osterley, Brentford 46,000

Sheffield 39,000
Portsmouth 47,000

Sutton 33,500
Prestwich 46,000
Winchester 39,000
compact

compact
Aberdare 25,500

Ashford, Kent 26,500
Blandford Forum 20,000

Aviemore 9,000
Dunblane 10,500

Braintree 17,500
Hammersmith 26,500

Cupar 13,000
Henley-on-Thames 24,500

Faversham 21,500
Honiton 23,000

Havant 26,000
Leyton 20,000

March 23,000
Maidstone 24,500

Penzance 21,000
Midsomer Norton 26,000

Pinner Green 21,000
St Neots 25,500

Potters Bar 24,500
Thornbury 20,000

Princes Risborough 13,000

Woodford, London 21,500
metro

metro
Andover, Chantry Way 15,500

Belfast, Royal Avenue 9,500
Richmond, George Street 15,500

City of London, Cheapside 8,500
Total
We also opened six Express stores
546,000

Dundee, Murraygate 11,000

Manchester, Market Street 9,500

Total
A further six Express stores will be opened
673,000


Treasury management
Our treasury activity is managed through policies which are regularly reviewed by the Board and monitored by our internal and external auditors. The operating parameters of treasury management are established under formal Board authority. Dealing mandates have been issued to all banks with which deals are authorised.

One of the main group policies is to maintain debt at prudent levels. In this respect the mix of debt between fixed rate and floating rate is monitored to take account of expected relative interest rate movements and future cash flows.Where debt has originally been raised in fixed rate form, interest rate swaps have been used to make our funding costs largely variable with floating interest rates. In the long term this policy should reduce our interest bill and counter balance the cyclical nature of the retail sector. At the year end, 84% of our net debt was in floating form and the average interest rate paid during the year was 8.4%.

In support of our short term funding activities, £365m of committed bank facilities with an average maturity of four years was available at the year end. The average maturity of our net debt and committed facilities was over six years with no more than £250m repayable in any one year.

We also cover a substantial part of our translation exposure to exchange rate movements by using foreign currency swaps and loans. Only basic financial instruments are used as they are more cost effective and easier to monitor and control.

The counterparties to our dealing activities are selected from banks and financial institutions which have good credit quality for the relevant transactions. Credit quality is normally determined by reference to the major credit rating agencies.

For additional information on Treasury management:
Notes to the financial statements -
note 7