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Does Tesco Bank Make Tesco PLC A Buy?

Tesco (LSE: TSCO) launched its current account product today, completing a process that started in 2008.

TescoAs you’d expect, the account is focused on loyalty, rewarding customers with Clubcard points on debit card purchases, and a 3% interest rate on credit balances up to £3,000.

Although customers will be able to make deposits at some stores, the focus is on online — one of the ways in which Tesco hopes to cut costs and boost its banking profits.

My bullish view on Tesco is no secret, but I am conscious of criticism that Tesco is spreading itself too thinly, over too many different businesses. How does Tesco Bank fit into this picture — is it a valuable source of profits, or a costly distraction?

Rising profits?

Last year, Tesco Bank generated trading profits of £194m, accounting for a relatively modest 6.4% of Tesco’s underlying pre-tax profits.

However, the bank’s profit margin on its modest £1bn turnover was a whopping 19.3%, highlighting the opportunities available to smaller players in the retail banking sector: Tesco Bank’s net interest margin was 4.4% last year, double that of Lloyds Banking Group.

The question is whether Tesco Bank can gain the scale needed to have a meaningful impact on Tesco’s group profits.

Can Tesco Bank deliver?

Tesco Bank has been operating in some form since 1997, and has a 12% share of the UK credit card market. However, it only started offering mortgages in 2012, and will be hoping that this — along with its current account offering — drives a new level of growth.

Although customers do not switch current accounts as freely as they do credit cards, I think that Tesco’s current account offering should help attract new customers, not least because of the Clubcard benefits it offers.

I also believe that Tesco Bank could benefit from ‘operational gearing’ — profits rising faster than sales as costs per additional customer fall. For example, in 2013 Tesco Bank’s parent company, Tesco Personal Finance PLC, reported a 23% rise in pre-tax profits on a 6.9% increase in turnover.

Is Tesco Bank a buy?

Personally, I believe Tesco Bank is an attractive element of the Tesco business, and expect to see it start making a much more significant contribution to the group’s profits over the next 2-5 years.

Indeed, I believe that Tesco is one of the few companies in the UK with the opportunity to benefit from increased customer loyalty over the next decade. 

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Both Roland and The Motley Fool own shares in Tesco.