The Business Of

Tesco | What Do They Do With Their Profits?

Morning All!

Okay, so we’ve looked at Tesco’s topline (How They Make Money). We’ve looked at their costs and the impact on the bottom line (What Are Their Costs). But have you ever wondered what Tesco actually does with their profits and the cash flow from their operations?

Well, for any company, there are 3 main buckets for how they can use their profits/cash flow;

(i) Return cash to shareholders.

(ii) Invest cash back into the business.

(iii) Keep cash on the balance sheet.

Let’s dive into each!

Return Cash To Shareholders

Companies have shareholders who own a percentage of the company. They are the people for whom management are running the company for. You often hear CEO’s talk about doing what’s best for shareholders. The 2 ways shareholders can make a return from their equity investments, is from either the stock price rising (and then they can sell their shares and make profits) or by receiving a dividend (the company gives them cash).

Many companies in a ‘growth’ phase, choose not to return cash to shareholders in the form of a dividend because they believe that by investing back into the business (through increased R&D investment, increased marketing, etc), they’re actually benefitting shareholders more (because the future value they’re creating will translate into future stock price rises) than if they were to return cash to shareholders now. Amazon has long held this belief with the US giant still yet to pay out any dividends despite being massively profitable.

However, Tesco is far beyond its growth phase and management decided a while back, that given the lack of growth opportunities, the best thing to do is to give cash back to shareholders. And in fact, this is the main way Tesco uses its cash flow! Tesco’s dividend policy is to return at least 50% of its earnings through a dividend. The chart below shows how the company’s dividend (DPS = Dividend Per Share) has grown consistently alongside earnings (EPS = Earnings Per Share) over the last 5 years.

Whilst shareholders like dividends because it puts cash in their pocket, it actually has a welcoming secondary impact too. When potential investors see that a company is consistently paying out more and more dividends every year, it makes the shares more attractive (because more people want to have the increasing cash in their pocket too). This often ends up putting upward pressure on the share price and shareholders benefit from this secondary effect too!

The chart above shows some of the highest dividend-yielding companies in the FTSE100 as of Feb 1, 2023. And we can see how Tesco fits in vs the wider market. Persimmon’s 16% dividend yield means that if an investor bought £100 worth of Persimmon shares, they would expect to receive a dividend of £16 at the end of the year. However, whilst that looks incredibly attractive… the key word here is expect. Many times the dividend yield is high because investors have sold the company’s shares, expecting that management will cut the expected dividend payout due to cash flow difficulties. Tesco in fact did this back in 2014.

The other way to return cash to shareholders is through share buybacks. Now, this isn’t technically returning cash as cash doesn’t go into shareholders’ pockets like it does with dividends. But companies use cash to buyback their own shares, resulting in a lower share count and a higher share price - which benefits shareholders. This article here from Investopedia explains the calculations behind share buybacks very nicely.

Something to note here is that for most companies, and Tesco is no different, buyback policy is a lot less structured than dividend policy. Buybacks are seen as an additional tool to reward shareholders if business is doing well. However, if management start to feel that things are turning bleak, they’ll most likely stop the buyback whilst doing everything to protect the dividend. In October 2021, Tesco announced a share buyback program of £500m, which was then increased by £750m in April 2022. Will Tesco continue with buybacks after this current program is finished… who knows!

Invest Cash Back Into The Business

Tesco as we said earlier is no Amazon. However, it does need to invest some cash back into its business. Whilst it’s not so much for topline growth, Tesco’s investments are to do with making their operations leaner and taking costs out of the business. Remember, increasing profits doesn’t just come from growing your sales but also by reducing your costs.

One area Tesco has been exploring in a bid to improve efficiencies and reduce costs has been automation in warehouses. In early 2020, Tesco partnered with Swisslog, the Swiss tech company, to enable the roll out of automated robots in their warehouses across the UK. How does this reduce costs? Well, instead of paying a Tesco worker £20-25k a year to pick and package products in the warehouse for 8 hours a day, why not use a robot that can do the same tasks… but for 24 hours a day!

Swisslog’s tech is already used by giants such as Pepsi and Coca-Cola. And the UK player, Ocado, also uses it in its fulfilment centres in the UK. For such a mature company like Tesco, automation is one of the key avenues the company is turning to in a bid to increase operational efficiency and drive margin expansion.

The other way Tesco is reducing costs is through increased ownership. We looked at this in the ‘What Are Their Costs’ section. However, what we didn’t fully touch on is that this strategy of increased ownership requires a lot of cash. People aren’t going to just hand over their properties to Tesco for free! In the Tesco 2022 annual report, the company states that £37m was spent to buy back one Tesco Extra store in Bury. And a further £43m was spent to buy out a partner and gain full control of 11 stores. That’s £80m spent on purchasing the ownership rights of stores!

Keep Cash On The Balance Sheet

This final strategy is the most boring option! And it often receives the most flak from shareholders. But just keeping cash on the balance sheet is a very important option for management. Why?

Well for one thing, the future is uncertain. How many of us expected that in March 2020 a global pandemic would arrive and change the way individuals and businesses operate? What if you as a business had no revenues coming in (because all your stores were closed) and because of that you didn’t have the cash to pay off your debts? You may have to go into administration and this is unfortunately what has happened to several large retailers over the last couple of years.

Another more positive reason why management may choose to keep cash on the balance sheet is because of strategic initiatives that may take place in the future. For instance, the company may be eyeing up a potential target company to acquire, and so beefing up their cash holdings would mean they need less debt to complete the acquisition. An example of this was the Amazon acquisition of Whole Foods. The e-commerce giant bought the supermarket chain in 2017 for $13.7bn… ALL IN CASH.

For a list of companies that are sitting on the biggest piles of cash, read this article. Some of the numbers are mind-blowing!

23rd Feb 2023

Nigel Jacob CFA