Tesco (LSE: TSCO) recently announced that hourly pay rates for its store staff will rise by 10.5% over the next two years. Rising wages sound like good news for the supermarket’s employees, but what about for its shareholders?
To some extent, growing wage costs are to be expected. Although wage growth in the UK has been sluggish in recent years, inflation has been growing at a steady pace and rival supermarkets have announced similar pay rises. As such, Tesco needs to do more to attract (and keep) the talent it needs to stay competitive. And what’s more, despite the proposed pay increases, its staff will still be paid less that those at Aldi and Lidl, its two German low-cost (but higher-pay) rivals.
Nevertheless, wages are one of the largest single expenses for Tesco, with the total employee pay bill totalling £7.4bn last year. That’s equivalent to almost six times the group’s annual operating profit, which means even a modest increase in pay would be a serious drag on margins and profits.
By 2019/20, Tesco expects to deliver group operating margins of 3.5% to 4%. That’s almost double today’s margin of around 2%, but still significantly below the 6.5% it enjoyed in its glory days.
To lift its margins, the company has undertaken big steps to simplify its product range and improve its store operating model to increase customer satisfaction while also cutting costs. The supermarket giant has conducted a thorough review of its entire cost base and has plans to remove another £1.5bn from its annual operating cost base. But is the company still on track to meet its ambitious profit targets?
I reckon it’s too early to say as the group has recently shown some mixed results. Although it reported its strongest quarterly like-for-like sales growth in the UK, international sales have weakened dramatically. In addition, City analysts are divided over whether Tesco can keep a lid on costs as inflation rises and as real household incomes come under pressure.
Tesco is not the only company looking to turn its profits around. Outsourcing outfit Capita (LSE: CPI) is similarly looking to bounce back from tough times.
The company announced a series of profit warnings last year as clients delayed making big investment decisions amid the Brexit uncertainty. As a result, underlying pre-tax profits for 2016 fell by 19% to £589m.
Lately though, things appear to be turning a corner as the business process manager is seeing activity in the private sector return to good levels and has secured multiple contract wins.
Capita’s balance sheet is also set improve as it recently announced the sale of its asset management services arm to Australian firm Link Administration Holdings, which would net the outsourcing firm £888m. This would help to ease its debt position, which currently stands at just over £1.7bn.
As such, I have more confidence that Capita will be able to maintain its dividends at current levels. And although its shares have recovered in value by 34% since the start of the year, I reckon they still represent reasonable value, with Capita trading at just 13.5 times expected earnings this year and yielding 4.6%.
Jack Tang has a position in Capita plc. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.