The Role of the Finance Management at Tesco Plc and Sainsburys Plc - Case Study Example

Financing Decision: Case of Tesco and Sainsbury’s This essay is on the role of the finance management at Tesco plc and Sainsbury’s plc, the two largest grocery retailers in the UK, and the factors of influence exerted by the financial environment in their financing decisions, including the range of resources available within that environment. The essay has three parts. The first part is a general introduction on the two companies, the industry where they compete, and the common business environment where they operate. The second part explains in compares and contrasts in greater detail the financing decisions in each of these two companies using publicly available financial information. The third part summarises the key points on the role of financial management at these two companies, highlighting its importance and the practical applications of financial management theory. Part One: UK’s Grocery Retailing Industry The UK’s grocery retailing industry had total sales of £120 billion in 2005 growing at roughly 4% per year and account for almost half total retail sales of £246 billion. 65% of industry sales are food and drinks not consumed at the point of sale. The remainder of sales are non-food grocery items like toothpaste, soap, health and beauty products and non-grocery items such as electrical goods, fuel, and house wares. 75% of sales are made in supermarkets and superstores owned by large multiple supermarket chains, with the remainder consisting of sales at small convenience and traditional retail stores accounting for a decreasing 7% of total sales (Defra, 2006, p. 1-2). Amongst the latter are stores that stock a range of specialist products such as newsagents selling confectionary, tobacco, and newspapers, specialist grocers, food specialists such as chain stores of bakers, butchers, and health food shops, and independent specialist retailers. The industry captures 13.1% of total household expenditures, which is expected to increase as these giants widen their business to include non-traditional products and services such as banking, health care, and mobile phones. Some 1.2 million people, 5% of UK’s workforce, are employed in over 102,000 stores all over the nation (Defra, 2006, p. 3). The size, visibility, and influence of grocery retailers have made them the focus of much attention and controversy. Their economic power, key industry trends and characteristics, and the nature of competition amongst the different grocery retailers have profound economic, social, and environmental impact on the UK. This is why the sector is highly regulated by the UK government and, more often than not, is the target of civil society groups that want their say in the pricing and the sourcing of goods and services, the location of shops, the employment opportunities, their accessibility to disadvantaged social groups, and the health and safety standards of what they sell, amongst many other things. The industry is dominated by the so-called Top Four: Tesco, Asda-WalMart, Sainsbury’s, and Morrisons, all of which are publicly-listed UK companies that grew organically at a steady rate in the last three decades. Tesco has the largest market share at 33%, followed by Sainsbury’s and Asda, acquired by US-based Wal-Mart in 1999, each with around 16%, and Morrisons, which acquired Safeway in 2003, with 11%. The remainder of the market is distributed amongst smaller competitors such as Somerfield, Waitrose, other Multiples, Co-ops, and independent retailers. Profit margins are thin and range between 2% and 6%. Thus, profits are determined mainly by sales volume (Defra, 2006, p. 7-8). Table 1 summarises the Top Four’s management and financial performance. Part Two: Financial Management at Tesco and Sainsbury’s Tesco is currently the largest grocery retailer in the UK and was founded in 1927. J. Sainsbury plc owns Sainsbury’s Supermarkets (hereafter Sainsbury’s), currently the UK’s third largest retailer, and was founded in 1869. Sainsbury’s was the nation’s biggest supermarket and undisputed market leader, but a series of strategic missteps allowed Tesco to catch up in 1995. Sainsbury’s and Asda, whose combined sales are less than Tesco’s, are fighting for second place. The grocery retailing market is described as mature, characterised by a stable population with a limited growth rate of food consumption even though trends vary between food types with the change in demographics (increasing number of single-person households) and customer preferences (increasing awareness of health issues), decreasing food expenditure patterns (more people are eating out), and tight government-drafted planning restrictions that limit new stores. Grocery retailers compete for market share by varying the prices and range of goods sold and the quality of customer service rendered at the point of sales. They also diversify into non-grocery products and services, shift to premium products, enlarge existing stores, and open high-street convenience stores to generate increased sales volumes and higher margins. Given the intense nature of business competition and their closeness to consumers, grocery retailers are doing all they can to manage their supply chains better, improving the sophistication of their sales information, distribution, and stock control systems for both own-label and private-label goods. In effect, the industry’s competitors are the gatekeepers of a sophisticated consumer base and reward those companies that can best meet consumer demands. The complex combinations of these unique features that characterise the industry give financial management a highly important role because in a mature market where growth potential is tightly controlled by government regulations, customer demands for the highest quality goods and services at the lowest possible prices or at the highest value to the customer, and increasing public criticism against grocery retailers’ growing economic power, the managements of these firms are subjected to intense internal and external pressure to squeeze and generate both shareholder growth and customer value from the business. This task seems to be very contradictory because it demands that the business maximises profits and increases shareholder value, raises prices and/or cuts down costs, without affecting product or service quality. How Tesco and Sainsbury’s grew year by year reflects their financial management acumen. Tesco plc Tesco’s revenues are growing at an average rate of 8.7% or almost £3 billion yearly in an industry that is growing by only 4%. This shows that it is gaining market share at the expense of smaller stores that are closing down because these cannot compete with Tesco’s ability to sell goods at much lower prices given their economies of scale. The company is also grabbing market share from other large grocery retailers such as Sainsbury’s that are still paying for their management mistakes committed in the past. Tables 2 and 3 contain Tesco’s summary financials including income statement, balance sheet and cash flow for the period ending 28 February 2006 in comparison with 2005. The highlights of Tesco’s financial performance are discussed next. Group sales increased 17% from £33.8 to £39.4 billion, which includes international sales that grew by 41% to £10.5 billion. Operating profit increased by the same rate of 17% from £1.95 to £2.28 billion, which shows that cost of sales and administrative expenses were held at a stable rate of 2.1% (in fact, administrative expenses as a percentage of sales even dropped slightly). This means that additional sales were generated by the company without an increase in the overhead expenditures, which is a sign of management efficiency. Profit for the period grew from £1.35 to £1.58 billion or 17% which includes a finance income of £114 million which increased 10% or £11 million over 2005. Although the finance costs also increased at a lower rate (2.5%) to £241 million, mostly from interest payments and financial charges, the impact on profits from good financial management was positive as the year’s financial “losses” decreased from £132 million in 2005 to £127 million in 2006. Tesco generated net cash of £165 million from strong cash flow from operating activities, which generated £3.4 billion in cash. After interest payments, taxes, dividends, and other financing activities, the company was able to invest £1.96 billion (up from £1.5 billion in 2005). Its net debt was unchanged except for IAS accounting procedures at £4.5 billion, which is 48% of stockholders equity. By controlling costs and increasing productivity, Tesco was able to absorb significant cost increases arising from higher oil-related costs and increases in local business taxes (the effective tax rate rose from 28.5% in 2005 to 29% in 2006). Tesco was able to keep operating margins almost unchanged and increase net profits with a corresponding growth of shareholder value, allowing the company to increase earnings per share to 19.92p-20.30p (from 17.30p-17.52p in 2005) and give shareholders a full-year dividend of 8.63p per share in 2006 (7.56p in 2005). Tesco’s Total Shareholder Return (TSR) is stronger against a comparator group of its retail competitors in the UK (Tesco, 2006, p. 46). What all these findings show (Table 8.2) is that Tesco was able to grow its sales revenues, control costs in an environment of high economic uncertainty, manage revenues in various European and Asian currencies, limit debt whilst increasing investments for future growth, pay higher taxes despite a large increase in sales and profits by using cash generated from operations to pay debts, and to give dividends. Competent financial management allowed Tesco to do all these in an industry characterised by intense competition where the company had to find ways to bring down prices by passing cost savings to customers, and where it had to learn to manage a diversity of products sourced from and sold in the UK, Europe and Asia. Sainsbury’s plc Sainsbury’s has the distinction of being the oldest grocer in the UK and the largest in terms of sales, until 1995 when a steadily growing competitor (Tesco) matched and then overtook it. Whilst Tesco plodded along, growing each year, Sainsbury’s experimented with all sorts of formulas and in 2002-2003 decided to revamp its supply chain, strategic planning, and marketing functions with disastrous results. Store shelves ran out of products that the marketing group promoted at the same time that purchasers ordered products that customers never wanted to buy (Sainsbury’s, 2004, p.4). Sales and profits collapsed, allowing Asda to overtake it. However, three years later by 2006, Sainsbury’s was back on track and jockeying with Asda for the second place position in the grocery retailing industry. Although its sales were by then less than half of Tesco’s, the road back to profitability although full of challenges was by now more certain. Tables 5 to 7 show Sainsbury’s financial statements for the year ending 2006. Aside from the important role that the new charismatic CEO Justin King played in the turnaround, much was contributed by the financial management team led by Roger Matthews who was the CFO until 2005. From the annual reports, it could be seen that financial management saved the company from bigger losses and allowed it to turn around by 2006 despite the efforts of the management team to squeeze costs and efficiencies to fatten the bottom line, as it forgot to talk to the customer (the function of then-CEO Peter Davis). Sainsbury’s entered into an outsourcing agreement with a consulting firm that was poorly implemented, which also contributed to the company’s troubles (Sainsbury’s, 2004, p. 22). Table 8.1 shows sales were flat at £17.1 billion since 2001, collapsing to £15.4 billion in 2004 before recovering slightly to £16 billion in 2005. Operating income went from £625 million in 2001 to a loss of £167 million in 2005. Were it not for asset sales that brought down current liabilities, it would have been more difficult for the company to recover in 2005. A decrease in the cost of goods sold, additional cash flows generated from the group’s banking operations, and controlling the effects of currency rates fluctuations could all be attributed to good financial management. Good financial management prepared Sainsbury’s for the new management that fixed the marketing and purchasing functions and supply chain management. When sales increased by 2006, profitability came back, and Sainsbury’s was able to resume its growth strategies (Figure 2). Part Three: Conclusions The grocery retailing industry is highly competitive and challenging because it is subjected to intense pressures from shareholders, customers, suppliers, the general public and government regulators. As shown by the experiences of Tesco and Sainsbury’s, managing in this turbulent environment is not easy. The forces that act on the company demand financial expertise to meet profit targets, manage free cash flow, create shareholder value, offer low prices for customers, satisfy suppliers, raise funds from the credit markets, manage fluctuations in exchange rates, and balance corporate growth. These companies have amongst their most valuable assets a group of competent financial managers who made the right financial decisions that enabled Tesco to grow with stability and helped Sainsbury recover from management blunders that threatened its long-term future. Bibliography Brealey, R.A. and Myers, S.C. (2003) Principles of corporate finance, 7th Ed. New York: McGraw-Hill. Brigham, E. F. and Davies, P.R. (2004) Intermediate Financial Management, 8th Ed. London: Thompson. Defra/UK Department for Environment, Food, and Rural Affairs (2006, May) Economic note on UK grocery retailing. London: Defra Food and Drink Economics Branch-Analysis and Cap Strategy Directorate. FAME (2006) University of Birmingham eLibrary database. Retrieved 5 November 2007, from: http://fame.bvdep.com/version-200745/cgi/ IGD/Institute for Grocery Distribution (2005) Grocery retailing. London: IGD. Morrisons (2006). Annual report and financial statements 2006. Bradford: Wm Morrison Supermarkets plc. OFT/Office for Fair Trade (2006) The grocery market: OFT’s reasons for making a reference to the Competition Commission. London: OFT. Pike, R. and Neale, B. (2003) Corporate finance and investment: decisions and strategies, 4th Ed. New York: Prentice Hall. Sainsbury’s (2006) Annual review and summary financial statements 2006. Holborn: J. Sainsbury plc. Sainsbury’s (2007) What we did this year: Annual review and financial statements 2007. Holborn: J. Sainsbury plc. Tesco plc (2006) “Inside Tesco.” Annual Report 2006. Hertfordshire: Tesco plc. Tables and Figures Table 1: Financial Performance of Top Four (Sources: Annual Reports 2001 to 2005)   Tesco Sainsbury’s Asda Morrisons Annual Turnover (£ mn) 33,974 15,409 14,318 12,116 4-year Annual Growth 8.7% -2.0% 6.7% 41.8% Net Income (£ mn) 1,366 61 495 206 Net Margin 2004 4.02% 0.40% 3.46% 1.70% 4-year Net Margins 3.67% 1.86% 4.13% 3.46% Employees 273,024 96,200 145,134 134,337 Sales/Employee (£) 124,436 160,177 98,654 90,191 Net Income/Employ (£) 5,003 634 3,411 1,533 Table 2: Tesco Income Statement (Source: Tesco, 2006, p. 45) Table 3: Tesco Balance Sheet (Source: Tesco, 2006, p. 46) Table 4: Tesco Cash Flow Statement (Source: Tesco, 2006, p. 46) Figure 1: Total Shareholder Return (TSR) for Tesco plc (Source: Tesco, 2006, p. 46) Table 5: Sainsbury’s Income Statement (Source: Sainsbury’s, 2006, p. 52) Table 6: Sainsbury’s Balance Sheet (Source: Sainsbury’s, 2006, p. 54) Table 7: Sainsbury’s Cash Flow (Source: Sainsbury’s, 2006, p. 55) Table 8.1: Comparing Financial Results Tesco vs. Sainsbury’s (Source: FAME, 2007) SAINSBURY’S SAINSBURY’S KEY RATIOS Table 8.2: Comparing Financial Results Tesco vs. Sainsbury’s (Source: FAME, 2007) TESCO TESCO KEY RATIOS Figure 2: Total Shareholder Return (TSR) for Sainsbury’s (Source: Sainsbury’s, 2007, p. 40) Read More