UK operating performance
Strong sales growth of 12.8% was achieved in the year with stores more than one year old increasing their sales by 7.5%. Volume growth was 4.5%, a notable achievement in the current competitive climate and in view of falling inflation in food prices.

New store sales were good, and in line with our expectations. Our flexible store formats have helped us maintain a healthy opening programme.

A good year of sales growth has enabled us to increase our market share from 13.7% to an estimated 14.5%.

UK operating profit has increased by 6.6% to 760m.

A strong performance on food allowed us to increase profit despite the substantial cost of the petrol price war, which occurred in the first half of the year. We estimate the cost of this was around 35m and impacted UK profit growth by about 5% and the gross margin by about 0.3% of sales for the full year.


Existing stores sales growth (%)


During the year, we have driven our food sales and profits forward. This has been achieved through our trading strategy of continuing to improve the shopping trip for customers through our initiatives.


UK market share (%) (source: IGD/Tesco) Year ended 31 December
*estimated



Customers want low prices, and we have invested to keep our prices low. This has been achieved mainly by our investment of over 30m in Unbeatable Value. Better buying, savings from our supply chain and an improving sales mix have limited the impact upon margins of our investment to only 0.1% of sales. This, combined with petrol, means that total UK gross margins were down 0.4% of sales in the year.

Looking ahead, with our continued investment in prices through Unbeatable Value being balanced by an improving position in petrol, we would expect gross margins in the year ahead to be relatively stable.

We continue to focus on customer service. During the year, we introduced more service counters, extended our opening hours - including 24-hour trading in some stores - and introduced 5,000 new Customer Assistants to provide greater service. We achieved these real improvements in service with a minimal increase in our cost ratios. Our wage cost of 9.8% of sales represents an increase of only 0.1%, thanks to our strong volumes and general productivity.

We have continued to improve Clubcard. We now have 1.5 million more members, a higher sales participation at over 70% and increased customer spend. This has been achieved by our initiatives of extending Clubcard to petrol, lowering the minimum spend threshold and through our direct marketing activity and promotions. The cost of this was 0.2% of sales, increasing our Clubcard investment to 0.7% of sales. Productivity continues to be a priority in being able to fund the costs of our customer initiatives. This year, we have improved our general productivity by 0.3% of sales. As a result of all this, UK operating margins are now 5.8%.

Additional Information
Chairman's statement
Customer loyalty
Stores
Notes to the financial statements - note 1

Europe
European sales increased from 596m to 868m in the year and now represent 5.8% of group sales. The first time sales contribution of 145m from the stores acquired from Kmart was the primary reason for this rise. Operating profit rose from 10.7m to 14.4m.

In France, new store sales were up 15%, while sales from existing stores were broadly flat in a difficult market. The management at Catteau are committed to investing in prices, supplying quality products and making our stores attractive places in which to shop.

In the year ahead, we will be introducing more Tesco brand products, more fresh produce and undertaking a number of major store refits. After last year's fall in profits, management are encouraged by the increase of 5% in profits in the year to 10.8m (1996 - 10.3m).

Central Europe has shown good sales growth in all countries, and we now have sales in excess of 200m in the region. This includes sales from the 13 Kmart stores we acquired in the Czech Republic and Slovakia, on 17 April 1996, for 79m. Profit growth is naturally being held back by the cost of establishing a new infrastructure within each subsidiary, to support the new store opening programme for the next five to ten years, as well as the cost of opening new large stores in this region.

From a business viewpoint we will be focusing on operating profit prior to central costs and pre-opening costs, as it is this we need to drive forward. At this level, profit increased substantially, including the benefit from Kmart for the first time. As the new stores come on stream, we would plan that operating margins before central and pre-opening costs should increase, reflecting the economics of large stores and good volumes and the benefit of central costs reducing over time to a more normal level.

European sales performance was as follows:



Return on capital on this organic expansion route will not immediately be high. Our plan is to have a minimum five year programme of investing in new large stores, individually successful, but having to absorb, as a group, the effect of capital being largely immature and the associated heavy start-up costs. If successful, we will build over time a significant market share and profit stream, with commensurate returns.

Additional Information
Chairman's statement
European opportunities
Notes to the financial statements - note 1
Notes to the financial statements - note 31
List of stores
Directors' report

Group profit before interest and tax
Group profit before interest and tax increased 6.9% to 774m (1996 - 724m). After interest this increased 10.1% to 750m (1996 - 681m), reflecting improving cash flows and returns.

Within these numbers, profit sharing to our employees increased to 32m (1996 - 29m), as more than 63,000 of them qualified for this payment in shares which represented over 4% of earnings. The number of people qualifying has risen by over 46% during the last five years.

Net loss on disposal of fixed assets was nil (1996 - 6m). There was a consideration of 29m received following the disposal of a subsidiary to BAT, which was offset by property losses and provisions mainly with respect to the rationalisation of our non-food distribution network.

Additional Information
Chairman's statement
Notes to the financial statements - note 4

Interest and taxation
Interest payable was reduced to 87m (1996 - 139m) as a result of lower interest rates, lower average levels of borrowing and the elimination of 9m interest on the 200m convertible capital bonds. Interest receivable also fell to 34m (1996 - 63m). Net interest payable, after capitalising 29m (1996 - 33m), fell to 24m (1996 - 43m).

The effective rate of tax for the year fell slightly to 30.7% (1996 - 31%) and we expect it to be 31% in the current year. The rate remains below the UK statutory rate of 33% because of a prior year tax credit arising from a settlement of earlier years' capital allowance claims.

UK new stores sales area opened and planned (000 sq ft) - including Express
*Forecast


Additional Information
Notes to the financial statements - note 7
Notes to the financial statements - note 8
Notes to the financial statements - note 20
Accounting Policies

Store development and capital expenditure
In the UK we opened 32 stores in the year with a total sales area of 603,000 square feet. This comprised nine superstores, 12 compact stores, four Metro and seven Express stores. There were nine closures in the year. In addition, we completed 26 extensions which added another 120,000 square feet. In the year ahead, we plan to open 26 new stores with a total sales area of about 600,000 square feet. In addition, subject to planning consents, we will open a further 200,000 square feet through extensions.

In Europe, we opened five new stores adding 190,000 square feet. We have already opened one new store in France, at La Madeleine, and plan to open another large store in Budapest, Hungary, adding approximately 100,000 square feet. We are looking to build about six to eight new stores in Central Europe over the next two years.

Group capital expenditure, including stores purchased as acquisitions in France, was 758m (1996 - 666m). Our new stores, refits and extensions and Europe continue to account for the bulk of our expenditure. In the year ahead, we expect our capital expenditure to be slightly higher, reflecting lower expenditure in the UK and a higher level of around 100m in Europe, relating to the build up of our new store development programme in Central Europe.


Group capital expediture (m)
*Forecast



Over the last few years capital expenditure has levelled off below the peak reached in the early 1990s. Compared to 1994, expenditure in the UK has fallen by 88m and we have started to invest in Europe, which has increased by 66m. Within the UK, expenditure on new stores has significantly reduced, but we are investing more in refitting and extending our existing stores.

The return on capital from our smaller new store programme has increased, boosted also by the focus on compact stores which give good returns, and also more recently, store extensions. This, together with strong trading, has improved group return on capital from 15.7% in 1994 to 17.1% for the year just ended.

Additional Information
Stores
Notes to the financial statements - note 11
Notes to the financial statements - note 25
List of stores
Directors' report

Cash flows and change in net debt
Total net debt at the year end amounted to 749m (1996 - 813m), a reduction of 64m. This reflected strong cash generation from the main business of 1,219m (1996 - 1,046m) against our net capital expenditure and acquisitions of 726m (1996 - 612m). The acquisitions included the purchase of Kmart in the Czech Republic and Slovakia for 79m and stores in France for 27m. As a result, year end gearing fell to 19.3% (1996 - 22.7%).

Additional Information
Notes to the financial statements - note 18
Notes to the financial statements - note 30
Group cash flow statements

Shareholder returns and dividends
Fully diluted earnings per share was 23.5p up 7.3% on the previous year. The Board has proposed a final dividend of 7.1p, giving a total dividend for the year of 10.35p (1996 - 9.6p) per share. This represents an increase of 7.8% and is covered 2.3 times by earnings.

Shareholders' funds rose by 302m to 3,890m. Of this, 295m resulted from retained profits, 49m from the issue of new shares, offset by goodwill write-off of 30m from acquisitions made during the year and 12m loss on foreign currency translation. As a result, return on shareholders' funds was 20.1%.

During the year the share price rose from 271p at the start of the year to 349p on 22 February 1997 giving a market capitalisation of 7.6bn. The share price reached a high of 370p on 22 January 1997.


Tesco share price (pence)


Total shareholder returns, which is measured as the percentage change in the share price plus the dividend, has been 68% over the last three years, compared to the market average of 43% (see diagram below). In the last year, total shareholder returns in Tesco has been 34% compared to the market average of 19%. This reflects our efforts to generate growth in the business while ensuring returns to shareholders are improved.




Additional Information
Chairman's statement
Notes to the financial statements - note 9
Notes to the financial statements - note 10
Notes to the financial statements - note 22
Five year record
Reconcilliation of movements in shareholders' funds

Recent developments
In the last few months, we have announced our financial services joint venture with the Royal Bank of Scotland, called Tesco Personal Finance, and our acquisition in Ireland.

Our move into financial services is likely to involve a cash investment of about 15m-20m for Tesco in the year ahead. The joint venture will incur start-up costs of which our share is likely to be between 5m-10m. In the medium term we believe that we shall see satisfactory profits from this investment.

In Ireland, we have entered an agreement to acquire for 630m the food retailing and related businesses of Associated British Foods plc. The acquisition, which is subject to merger approval by the European Commission, will bring Tesco a further 109 food stores and a leading position in both the north and south of Ireland.

These businesses had turnover of approximately 1.2bn excluding VAT and operating profit of approximately 58m for the year to 14 September 1996. We will consolidate the results of the businesses once the acquisition is completed. We expect the acquisition, excluding integration costs, to be earnings enhancing in the year ahead, with increasing profit growth in later years.

Treasury management and financial instruments
The group's treasury operations are managed by Group Treasury within parameters defined formally and regularly reviewed by the Board. Group Treasury's activity is routinely reported to members of the Board and is subject to review by the internal and external auditors.

Consistent with group policy, Group Treasury do not engage in any speculative activity, particularly relating to the use of derivatives and the use of capital to make profit. Derivatives are, however, used in a controlled manner as detailed below for the purposes of managing the cost of underlying debt and in hedging the cost of overseas investments. To achieve financial targets, it is policy to use simpler financial instruments which are more cost effective and easier to monitor and control.

The main financial risks faced by the group relate to interest and exchange rates. The Board reviews and agrees policies for managing these risks as summarised below.

Credit exposures may be created only with banks or other institutions previously approved by the Board as adequately credit-worthy for the relevant transactions. Credit quality is normally assessed by reference to the major credit rating agencies. Deals are only authorised with banks with which dealing mandates have been agreed.

Additional Information
Notes to the financial statements - note 8
Notes to the financial statements - note 18
Notes to the financial statements - note 20
Accounting policies

Finance and interest rate risk
The group's policy is to finance operating subsidiaries by a mix of retained profits, bank borrowings, commercial paper, long term debt market issues and leases. Close attention is paid to planning our gearing levels when we review our funding and set our investment budgets.

Derivatives, predominantly interest rate swaps, forward rate agreements and interest rate options such as caps, are used to create our desired mix of fixed and floating rate debt. The policy is to fix or cap between 20% and 50% of the interest cost on outstanding debt, although a higher percentage may be taken within a 12 month horizon. At the year end, after taking account of interest rate swaps, 310m (41% of our net debt) was fixed for a period of six years. A further 70m (9%) was covered by interest caps at an average rate of 8.1% for a period of 4.5 years.

The average rate of interest paid during the year was 7.8% (1996 - 8.6%). Excluding capitalised interest, interest is covered 14.6 times by profit before interest (1996 - 9.5 times). A 1% rise in interest rates would reduce profit before tax by less than 1%.


Interest cover - no. of times


The group ensures continuity of funding by arranging for short term borrowings and commercial paper issuance to be fully backed by committed bank facilities, by limiting the amount of debt repayable in any one year, and by managing the average debt maturity in line with gearing levels. At the year end undrawn committed facilities amounted to 400m and the average maturity of net debt, including these facilities, was over five years.

Foreign currency risk
The group's policy is to use foreign currency borrowings, forward exchange rate transactions and exchange rate swaps to offset a significant part of the impact on the group's balance sheet of exchange rate movements on the small proportion of its net assets before financing (5%) which are not denominated in sterling.

The group does not hedge exposure to currency movements on the translation of the 2% of profits made overseas except to the extent that those profits are matched by foreign currency interest costs.

Significant transactional currency exposures resulting predominantly from purchases in currencies other than the subsidiaries' reporting currencies are hedged by forward foreign currency transactions, currency options and by holding foreign currency cash balances.