Tesco’s recovery is in full swing, but much work remains to reach its ambitious margin target

Tesco’s 2016/17 results showed that it is clearly on an upward trend. 

The retailer achieved full-year like-for-like sales growth for the first time in seven years, while operating profit increased by more than a third as moves to cut operating costs start to pay off.

But the grocer is still far from its target of achieving group operating margins of 3.5% to 4% by the 2019/20 financial year, up from the current 2.3%.

The key to reaching that target will be the UK business, which accounted for just over three-quarters of group sales and 62.7% of its operating profit last year.

Tesco’s domestic operations consistently achieved sector-leading operating margins in excess of 5% prior to 2014/15.

Under pressure

However, the structural changes in the industry put pressure on its margins and the grocer was forced to invest heavily in its prices to counter the threat of the discounters.

Its vast superstore network also became a drag on its performance due to changed shopping habits.

While margins have improved again over the last two financial years, an operating margin of 1.8% for the UK retail business underlines the scale of the challenge.

Initiatives to take out operating costs from the business are starting to have an effect though.

Initiatives for change

They have included changes to the way it manages its stores, lower stockholdings and increased freehold ownership, which is helping to reduce its rent bill.

Just over 100 of Tesco’s larger stores were also reported to have returned to profitability since 2014/15.

But two main hurdles will need to be overcome if Tesco wants to have a chance of reaching its margin target – the profitability of online grocery and its underperforming general merchandise business.

It is no secret that competition in online grocery is intense and that none of the major players are at present charging customers for the true costs of home deliveries.

That is unlikely to change in the short term because none of the grocers are currently willing to sacrifice market share by increasing their charges.

More improvements

Meanwhile, Tesco’s general merchandise and clothing sales declined by 14.1% last year across the group so that is another area where improvements are much needed.

It is a part of the business that is closely tied to the fortunes of its larger stores, which are still struggling to generate the same levels of footfall as they did five years ago, while Tesco Direct faces tough competition from online rivals.

The convenience store network appears to be the only part of the business that is on track to meet Lewis’s ambitious profit targets, which does help to explain the attraction of the tie-up with Booker.

Tesco’s share price fall, despite the improved full-year performance, shows that the jury remains out on whether challenging margin ambitions can be met.