The Hidden Nasty In Tesco PLC’s Latest Results

Tesco (LSE: TSCO) (NASDAQOTH: TSCDY.US) is a firm that I rate highly, but if you’re a shareholder, like me, then you need to be aware that the company’s profit margins are thinner than they might seem.

The problem is simple: Tesco’s preferred measure of profitability, which it calls ‘Trading Margin’, is an adjusted metric that can’t be reliably compared to those of its peers, or to the standard accounting measure of trading profit, which is called operating profit.

For example, in the 2012/13 financial year, Tesco’s trading margin was 5.3%, while its operating margin was 3.4%. However, during the first six months of Tesco’s current financial year, trading margin was 4.9% and operating margin was 4.9%.

Don’t believe everything you read

The press and City analysts don’t help matters, either. Tesco’s trading margin is often incorrectly referred to as its operating margin, creating potential confusion for private investors, who don’t always have time to read and analyse company results themselves.

Using Tesco’s trading margin and its operating margin interchangeably gives the impression that the UK’s largest supermarket is more profitable than J Sainsbury and Wm Morrison Supermarkets, despite this not always being true, as last year’s results show:

2012/13 profits Tesco Sainsbury Morrison
Supermarket’s preferred profit margin 5.3% 3.6% 5.2%
Reported operating margin 3.4% 3.8% 5.2%

Source: Company results

Morrison’s margins have historically been higher than those of Sainsbury, and last year overshadowed those of Tesco, too. However, 2013/14 may see a reversal of this trend, as I’ll explain.

There is some good news

For Tesco shareholders like me, the good news in 2014 may be that things are starting to change.

Tesco has been criticised by some analysts for protecting its margins rather than starting an all-out discounting war with its peers. However, given that it controls 30% of the UK grocery market, I think Tesco can afford to concentrate on finding ways to add value and retain customers, rather than simply slashing margins, in what could be a futile attempt to further expand its market share.

Tesco CEO Phil Clarke is opposed to cutting profit margins, and the firm’s latest interim results suggest that he might be right — and the supermarket could be regaining its position as the most profitable of the big three UK-listed firms:

H1 2013/14 profits Tesco Sainsbury Morrison
Supermarket’s preferred profit margin 4.9% 3.5% 4.3%
Reported operating margin 4.9% 3.9% 4.3%

Source: Company results

If Tesco can maintain its first-half profitability through the second half of the year, the firm’s forward P/E of 10.5 could start to look decidedly cheap.

Tesco's supreme dividend record

Tesco's 4.5% prospective yield is backed by a 28-year record of unbroken dividend growth, but that record could be broken this year, if analysts' forecasts for an unchanged payout of 14.8p are correct.

In my view, Tesco shares remain a buy, but ultimately, the decision is yours. To help you get started, the Motley Fool's latest special report, "How To Create Dividends For Life", includes five 'golden rules' against which you can test any dividend.

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> Roland owns shares in Tesco but not in any of the other companies mentioned in this article. The Motley Fool owns shares in Tesco and has recommended shares in Morrisons.