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Edited Transcript of TSCO.L earnings conference call or presentation 2-Oct-19 1:30pm GMT

Half Year 2020 Tesco PLC Earnings Debt Investor Update Call

Hertfordshire Oct 3, 2019 (Thomson StreetEvents) -- Edited Transcript of Tesco PLC earnings conference call or presentation Wednesday, October 2, 2019 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Alan Stewart

Tesco PLC - CFO

* Lynda Heywood

Tesco PLC - Group Treasurer

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Conference Call Participants

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* Rebecca Clements

Fidelity International - Analyst

* Graham Gillis

Commerzbank - Analyst

* Dominic Waniki

Citigroup - Analyst

* Kyle Curran

AIG - Analyst

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Presentation

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Operator [1]

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Hello and welcome to the Tesco Debt Investor call. (Operator Instructions). And just to remind you, this conference call is being recorded. Today I am pleased to present Alan Stewart, CFO, and Lynda Heywood, Group Treasurer. Please go ahead with your meeting.

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Alan Stewart, Tesco PLC - CFO [2]

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Good afternoon, everybody, and thank you for your time. I thought I'd start just by covering the succession announcement which we put out this morning, which is that Dave Lewis has decided that he will step down as Group CEO of Tesco. He is on a notice period which takes him through the results next year and sometime in the summer next year he will step down.

His successor has been announced as well. His name is Ken Murphy and in the announcement on details not only of his background but also what the Board was looking for in looking for a successor to Dave.

So, a very personal decision. Dave has been very clear that he has no job that he's going to, there's nobody that he's talking to about a possible job. And what he needs and wants is space and time to think about that having continued and will continue to work right through the last day he's in the business. So, happy to take any questions on that if there are any, but we'll now move to the results.

Starting on the operating profit, we look at the business in three ways. And the way that we think about this is driving cash profitability, driving the cash flow from that cash profitability and then the financial discipline that we bring to the business. I will look at cash profitability and cash flow and then hand over to Linda who will cover the financial discipline section of the presentation.

So, in the six months we delivered a significant improvement in operating profit, up 25.4% to GBP1.406 billion. This includes a strong increase in operating profit in the UK in ROI, up GBP240 million to GBP1.085 billion, driven by an improved produced mix and our cost saving progress. You will remember that these are the elements that we've been focusing on throughout the turnaround and they continue to be the way that we drive an improvement in profitability in our business.

The year-on-year comparison also benefits from last year the inclusion of Tesco Direct operating losses, about GBP23 million, and also last year booker transaction costs of GBP22 million. But even without those the year-on-year progress is very significant.

In Central Europe, the underlying profit improvement of 1.3% was held back by the disruptive impact of the very significant business transformation we are undertaking in that part of the market. We also took in the segment a GBP30 million provision in respect of historic VAT liabilities in the half.

And in Asia, operating profit of GBP171 million was GBP60 million higher year-on-year. This included the effect of renegotiating promotional investment from suppliers which, you'll remember, held back last year's first-half numbers as we went through this process, as well as an acceleration of our cost savings numbers. So, strong performance across the business.

And then the bank, touching on this, was down slightly as a result of some investment in insurance product and also some of the treatment of what's an industry-wide treatment of so-called persistent debt.

If we turn now to the next slide which covers the Group income statement, Group sales of GBP28.3 billion were up 0.1%. Operating profit I've already covered, and the margin at 4.41% -- this is on and IFRS 16 and including booker basis -- is up 87 basis points year-on-year. Our JV and associate contribution of GBP10 million was decreased year-on-year reflecting a reduced contribution from Gain Land, our associate in China.

Net finance costs decreased by 13.1% primarily due to the lower levels of interest-bearing debt following the further debt maturities and the bond tenders which Lynda will cover later on. That led to our adjusted profit before tax increasing just under 50% to GBP1.03 billion for the half, which led to an increased tax charge as you'd expect. And as a result, our diluted earnings per share increased by 49.8% year-on-year to 8.17 pence.

Over the last 12 months we delivered our operating profit margin within the range that we originally set out of 3.5% to 4% at 3.73%. So, we are well within this range. And this is of course on a pre-IFRS 16 and excluding booker basis. We achieved this target six months ahead of plan and going forward all of our reporting will be on an IFRS 16 basis only.

If we turn into the next slide, the sources and uses of cash, I've shared this way of looking at our business many times and it represents how we think about sources and uses of cash in the business. It now reflects our updated free cash flow definition including repayments of obligations under the leases as required under IFRS 16. I am going to call out the most notable items starting with GBP2.1 billion cash from retail operations.

We generated a net working capital inflow of GBP114 million. This improvement principally reflects the full recovery of the GBP210 million timing impact which we spoke about at our preliminary results in April. This has been offset by the impact from lower stock purchases as we reposition our business in Central Europe, which is a timing difference, and the phasing of initiatives in the UK, which are weighted towards the second half.

Exceptional cash items were an outflow of GBP116 million driven predominantly by restructuring payments. Our cash CapEx totaled GBP389 million, and a bit more detail on this will be later in the presentation. Net interest and tax payments of GBP529 include an increase in cash tax of GBP30 million and a GBP61 million reduction in cash interest payable. We generated property proceeds of GBP65 million across the UK ROI in Central Europe and used GBP89 million to buy back Blandford and Chesterfield stores in the UK.

We also have made a commitment to offset any dilution in respect of new share issuance for share schemes which resulted in the cash outflow of GBP52 million in the half. We expect the full-year cash impact to be around GBP150 million, as previously indicated. And finally, the repayment of obligations under leases drove an outflow of GBP325 million which overall led to retail free cash flow of GBP814 million, up 105% year-on-year.

And if we turn to the next slide, a little bit more color on this strong increase in free cash flow. Increasing profit of GBP307 million is the biggest driver. And in addition, year-on-year working capital inflow was GBP126 million higher. As I have said before, the other elements such as property proceeds, market share purchases can be quite lumpy. And in the half these net to a net GBP16 million outflow. Overall free cash flow generation increased by GBP417 million when compared with last year.

If we turn now to capital expenditure, in the UK and ROI, our spend relates to the maintenance of our stores in addition to five new convenience stores openings and the building of a temporary replacement store in Kennington, London. Year-on-year CapEx has increased by GBP25 million related to the work we are doing to simplify operations in store in the UK segment.

In Central Europe we continued our broader program to address unproductive selling space. And in Asia we opened a further four new stores in Thailand and one new store in Malaysia. We saw a lower CapEx spend in Asia year-on-year reflecting a short pause at the beginning of the period, while we refined our store costs and operating models as we outlined at our recent Capital Markets Day.

For the full year we now expect capital expenditures to be no more than GBP1.1 billion, reflecting our continued strong capital discipline. Going forward I continue to expect to see our annual spend remaining within the range of GBP1.1 billion to GBP1.4 billion. And we are also pleased to be able to open new stores within the strict payback period we now apply.

On the next slide a little bit more color on property proceeds. We continue to unlock value from our property portfolio and consider it an important driver of value creation in the Group. We disposed of 50 small sites in the half generating proceeds of GBP65 million. In addition, we have agreed to the sale of a further 23 sites in Central Europe with aggregate proceeds of GBP145 million due to be received in the second quarter of this financial year and in the year beyond that.

I will now hand over to Lynda who will talk about financial discipline.

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Lynda Heywood, Tesco PLC - Group Treasurer [3]

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So, moving to our balance sheet progress, with the adoption of IFRS 16 our net debt definition includes lease liability. Since year-end total indebtedness has reduced by GBP0.9 billion to GBP14.7 billion primarily from a GBP0.5 billion reduction in underlying net debt. There was also a GBP0.2 billion reduction in lease liabilities and an equivalent reduction in the pension deficit from GBP2.3 billion at the end of the full year to GBP2.1 billion at the end of the half.

Strong asset performance including in our LDI portfolio, together with some improvement in actuarial factors and our deficit payments more than offset the change seen in the scheme liabilities from the falling corporate bond yields.

Moving on to our debt capital markets activity, this slide details the actions we have taken in the half with the Euro 2019 bond repaid at maturity and the concurrent tender and 400 million sterling new issue launched in April. The sterling bond was the first issued by Tesco in 10 years and allows us to place a new benchmark having targeted so much of our existing sterling curve with our liability management exercises.

Looking at our debt metrics, these further improved since the end of last year and we continue to make good progress towards our total indebtedness target range with an improvement in the ratio to 3.2 times. Our fixed charge cover has also improved [to] 3.2 times and is now above our threshold target. Both metrics are now calculated on an IFRS 16 basis.

On liquidity, we continue to have a strong liquidity position with GBP1.7 billion of cash and short-term investments and GBP3 billion of committed facilities. We have proven access to both the euro and sterling markets in the last year having issued off our ENTN program. Our proportion of debt held in sterling has increased in the half with the repayment of the Euro 2019, which was held at a net investment hedge against our euro denominated businesses.

Our credit ratings have changed since April and we are pleased to say that we've regained a further investment grade rating from Moody's and a positive outlook from S&P.

So, to summarize our financials for the half, we have a more profitable sales mix in all of our markets. We are already ahead of our full-year cost savings target and see many more opportunities to improve cost-effectiveness of our business. Our margin target has been achieved six months ahead of plan and we have delivered a strong cash profit improvement and generated significantly higher free cash flow. Finally, we returned to the sterling bond market with a GBP400 million benchmark issued in May.

I will now hand back to Alan who will talk about growth, innovation and enabling technology.

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Alan Stewart, Tesco PLC - CFO [4]

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Thanks, Lynda. As we move from the turnaround, which, as you'll remember, had the six strategic drivers, we've been very clear and set out our capital allocation framework. But equally, we are now looking at the business and will continue to look at the business in terms of the elements that we are talking about here, which is the growth, the innovation and the enabling technology for that.

So, if we turn to the first slide, we believe having delivered the turnaround we are well positioned for sustainable, profitable growth. And you can see we've rebuilt the operating profit. We've set out at our capital markets day -- and this is available on the website -- some of the untapped value opportunities. And today we've given more color on where we will be focusing in respect of some of those in the near future. And the focus is all about delivery in terms of growth, innovation and enabling technology agenda.

Turning to innovation product, this sets out a number of the areas where we have focused. The one that we particularly highlighted today was packaging and plant, and this is an area of the market where we really believe that we've been leaders.

A few years ago we launched our Wicked Kitchen and we today also announced that we've launched plant food as a range alongside that. And by the end of the year we will have 300 products, some brands alongside that, delivering a very, very strong offer in this fast-growing part of the market. Very happy to talk about any of the other innovation areas we set out on that.

In terms of the enabling technology, the cost efficiency is a key part of our business. And for us technology is not only about some of the elements we've also spoke about today including an investment in a business called Trigo, which will help us with understanding and developing frictionless shopping for customers. We are also focused on technology for cost efficiency reasons.

We have what we believe is one of the best ways of looking at weather forecasting in the business and we continue to use technology to improve that. The improvements we've made across the country and across the business in how we use weather to determine demand have led to a 6.7% improvement in our fresh sales forecast accuracy, which serves customers better and also means that we have less waste in stores.

And we saved around GBP40 million from stock control as part of this as well and our Pay+ app, which is the way that you can digitally pay and earn Clubcard points at the same time, has seen an 18% increase in transactions.

So, we run the business and set out very clearly -- whilst the targets we set out were specific as regards to margin, cost savings and cash generation, they were always within the framework of improving cash profitability, generating free cash flow, increasing EPS and, at the heart of everything, increasing customer satisfaction. And as you can see, all of these metrics were delivered and delivered well in the first half.

I mentioned that we continue to run the business under the capital allocation framework that we set out. And Lynda has spoken about the debt metrics and the targets. And as we can see, we are very, very close to achieving the start of the range of the EBITDA multiple and we are within the range on the other one.

These allocation framework is the way we look at the business. We will always reinvest and look at customers first. We have said our indebtedness to EBITDA ratio and that is a critical and important part of our capital discipline. We want to, and this year will, increase the dividend to a 50% payout ratio.

We will always look at inorganic growth opportunities. Today we announced a small one through our book of business. For a nominal consideration we bought a business -- the assets and operations of a business which will give us a very important food delivery profile across the country, GBP1.1 billion of sales currently. Loss making, but it's in the classic Charles Wilson way of building businesses, buying them and improving profitability and we would look forward to working the same approach on this acquisition.

And then finally, and if appropriate, within that allocation framework we may well get to a point where we'll talk to shareholders about returning surplus cash.

So in summary, and before I open it up to questions, we've delivered every element of our turnaround plan. We are celebrating 100 years of great value with customers this year. Many of you I'm sure will have seen that. We will continue to focus on that through the balance of the year.

Very importantly across this half, customer satisfaction improved across all measures and channels. And this is particularly in respect of the UK business and we've seen a very strong customer response to what we are doing. And we've seen switching gains in our business from all of our competitors in the first six months of the year in respect of the -- exclusively our Tesco products.

We've seen a strong increase in profitability, significant improvement in cash generation, and we are positioned well for profitable growth in the years ahead. Very happy to open it up to questions now.

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Questions and Answers

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Operator [1]

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(Operator Instructions). Rebecca Clements, Fidelity International.

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Rebecca Clements, Fidelity International - Analyst [2]

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Just two quick questions from me. The first one is and I think you were asked something similar to this this morning, but just to be clear. Would you be willing to have your leverage multiple hovering at 3 times or a bit above that, i.e. not been consistently below 3 times, and still participate in allocation priorities three through five, the dividend inorganic growth and return cash to shareholders? That's my first question.

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Alan Stewart, Tesco PLC - CFO [3]

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Yes, certainly. Well look, way that I answered this morning, which when asked it slightly differently but the same question I think really was -- is how I will answer now. We've set out the range and that range has both got the threshold and a floor which we spoke about last year at the 2.5 times. I think for us the important thing is first and foremost always to look at the opportunity in the business.

But equally in -- I'm not targeting and we're not targeting a particular point in that range. The important thing is should we ever get to the position that we are, and we've been very clear on our payout ratio and we expect to achieve that this year.

That would always generate surplus cash because, almost by definition, we are paying out only half of what we are earning. Cash and EPS pretty much on the way that we look at them run hand-in-hand. So we are always generating surplus cash anyway having paid the dividend.

The important thing once we are in the range is not that where we are in it, but that it's as we look forward can we see a stable position and do we expect to stay within that range? And that's the way we are looking at it and that's the way we think about all of these things. The allocation framework has been well received by the market and it's important that we, once we get to the range that we set, that we demonstrate a commitment to that range.

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Rebecca Clements, Fidelity International - Analyst [4]

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Okay, so maybe put another way, if you were sitting at 3 times but you were looking out to next year and you weren't comfortable that you were going to remain at 3 times based on what the outlook was, that would make you more conservative in looking at the other capital priorities below that -- below your debt target leverage targets? Is that a right way to look at it?

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Alan Stewart, Tesco PLC - CFO [5]

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Yes, I come back to -- it is, Rebecca. I don't think it is about where we sit in the range particularly; it's about how do we feel about the business. Just as the dividend is a sign of confidence -- it reflects what we've done, but it's also always a sign of confidence from the Board. And as we look forward we always have to factor in what we think about the future.

But we would hope and expect that we would be growing the business and increasing EPS which therefore creates cash given the way we look at the business is something which we'll always be targeting. But yes, we will always take into account the future as well as where we are.

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Rebecca Clements, Fidelity International - Analyst [6]

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Okay and then kind of a segue to that, would you say that you are approaching your capital framework a bit more conservatively just in light of -- I mean nobody knows what's going to happen this next month with Brexit for sure. But does that make you a bit more cautious or conservative just to give yourself wiggle room for the next sort of 12 months in case we have a hard Brexit or a lot of upheaval?

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Alan Stewart, Tesco PLC - CFO [7]

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All I can say is there is uncertainty. We are all aware there is uncertainty. We'll see where we end up in April and we'll see what the world looks like in April when we get to that.

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Operator [8]

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[Graham Gillis], [Commerzbank].

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Graham Gillis, Commerzbank - Analyst [9]

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Good afternoon and a great set of results. Well done. Just wanted to touch on the bank. I know you mentioned it. I know it has been slimmed down. It looks quite small, so what are the benefits it brings to the wider business?

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Alan Stewart, Tesco PLC - CFO [10]

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Yes, well look, we made -- under Gerry's leadership as the new CEO in the bank, a strategic review was undertaken and the decision was made really looking at through the lens of Tesco customers, whether the mortgage business was something which really served Tesco customers and Tesco retail customers in the best possible way.

And after a number of years of operation that business, combined with pressure from the -- in the UK market, but there were 23,000 customers. It was sold through intermediaries. It wasn't something which sat naturally with Tesco retail customers, and so the decision was made to exit it and to sell the 3.7 billion book.

What -- the benefits the bank brings to Tesco's customers is the opportunity to bring financial product and banking and money, which is very, very important to all of our customers, together with telephones and shopping. And that's a really important part of the equation.

If I wanted to think about it in Fs, we've got food, finance, phone and I could add fuel as well as a fourth one. Now I am misspelling phone obviously and getting to that, but those are four Fs, which really from a customer perspective are really important.

And if you look at what we've announced today in terms of Clubcard Plus, we are really for the first time bringing that potential into customers. So the Clubcard Plus offer, which we will launch later in the year, we've shown how it has GBP7.99 subscription per month. What we we'll be offering customers is two free -- two savings per month from big shops, they can choose the shops, 10% savings.

There will be some permanent 10% savings on the number of Tesco branded products whether it is Go Cook, whether it is Fox & Ivy, whether it is F&F. And in addition, you will be able to get double points on the phone and, if you choose to and are acceptable from the bank's credit perspective, you'll be able to get free foreign exchange transactions.

So, for the first time the bank is bringing products which are relevant to Tesco retail customers and we're able to do that in one way. So, the focus of the bank is very much being the bank for people who shop at Tesco.

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Graham Gillis, Commerzbank - Analyst [11]

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That's really great. Thanks for the update. I appreciate it.

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Operator [12]

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(Operator Instructions). [Dominic Waniki], Citigroup.

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Dominic Waniki, Citigroup - Analyst [13]

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This is [Dominic Waniki] from Citigroup. Just a quick question, I was wondering if you would consider further liability management exercises in order to optimize the cost of debt.

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Alan Stewart, Tesco PLC - CFO [14]

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I'll ask Lynda.

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Lynda Heywood, Tesco PLC - Group Treasurer [15]

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I think (inaudible) talked about it. Yes, we would consider further exercises if it made economic sense and was likely to reduce our interest cost.

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Dominic Waniki, Citigroup - Analyst [16]

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And would you think that now this is possible or -- because you have done this type of exercises in the past.

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Lynda Heywood, Tesco PLC - Group Treasurer [17]

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We have. All I would say is that we would look at each opportunity on a case-by-case basis and assess the economics of it and the likely execution whether we're likely to get good execution. So we look at each one on a case-by-case basis.

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Dominic Waniki, Citigroup - Analyst [18]

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Sure, thank you.

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Operator [19]

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[Kyle Curran], AIG.

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Kyle Curran, AIG - Analyst [20]

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Can I just ask you on the property strategy, you've brought in some cash from property transactions? You've also spent some money buying back stores. I just wondered whether you consider those just very much on a local market opportunity by opportunity basis. Or is there any guiding strategy or any freehold versus leasehold mix either in the whole UK estate or by types of store that you are trying to get to?

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Alan Stewart, Tesco PLC - CFO [21]

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Yes, look, it's a great question. If we go back five years, we were very clear that we felt that the mix of freehold and leasehold was not what we would want. And if we could get on economically advantageous terms to us stores that we previously owned and [had sold or] -- and leased back, if we could regain ownership of those then we would and we made very significant progress on that.

We've never had a target we still don't have a target. We continue to look at opportunities as they become available. The principles under which we look at buying back stores are pretty simple ones and they really start with, is this a store which we expect to trade from and to trade from profitably for a considerable period of time. If the answer to that is yes, next question is do we own it. And if the answer to that is no, then it falls into the potential funnel for stores we would be interested in owning.

Against that we then have to -- you need generally to have a willing seller and we would be, providing the price is right, a willing buyer. And the economics of those are ones which really are case-by-case and we would never be in the market to buy back stores at economics which weren't attractive to us.

I think fundamentally that remains the case. And having made very considerable progress, particularly in the UK, in buying back stores which we previously sold off and leased back, the opportunities are fewer now. And to a certain degree we were standing against ourselves in the market because we were signaling that we wanted to buy at the same time recognizing that we'd be having to pay for that.

But we've made good progress and, as we've seen in the half, we saw two. They tend to be more situationally specific now. Very often when we have sold a store on the first transfer subsequently we have a right of first refusal and that gives us an opportunity. Sometimes the circumstances of the owner are such that we get offered them. Being known to be in the market means that we are generally offered and are aware of what's happening anyway and sometimes we pass on stores.

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Kyle Curran, AIG - Analyst [22]

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That is clear, thank you. And then one on working capital, please. There was a big improvement obviously in this half and -- with a couple hundred million of a timing reversal which you guided to. I just wondered on a more run rate steady-state basis if there's any guidance you are giving on what the working capital should look like.

Is it fair to expect sort of a working capital inflow generally as the business grows? And is that a couple hundred (multiple speakers) over the last three years I think? Is it of that order again?

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Alan Stewart, Tesco PLC - CFO [23]

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Kyle what we've said and, again, we were clear on this as we set out what we thought through the turnaround. What we said was that we expected around GBP200 million per annum. A lot of it through the improvement in stock turn and the reduction of slow-moving stock in our store operations. We continue to see that and in the year that we are in we continue to see then around GBP200 million.

We will come back to it. We come back to our guidance every year. But on an underlying basis we expect this year to be around the GBP200 million. On top of that we had the GBP210 million outflow which was a timing difference over last year. So, we should expect some continued good working capital inflows through the second half of this year. And then in April we will come back, as we always do, to all of our guidance.

Sorry, the one thing I would add, Kyle, to that is as we grow the business the nature of food retailing has always been, or certainly for a long period of time, has been that it's a cash generative business because of the fast way in which we sell stock, particularly fresh food. That's -- we are receiving cash ahead of when we are paying suppliers.

We are very transparent on that. We are the only retailer who has published the payment terms across the different categories and -- but that's the way in which we do business. And naturally in a normal year we would expect as the business grows so we'd get some positive working capital.

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Operator [24]

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As there are no further questions I'll hand it back to the speakers.

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Alan Stewart, Tesco PLC - CFO [25]

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Great, thank you very much, everybody. As we've said, some news about succession, very well-planned, orderly. Dave will be here totally committed to the business through April next year and the full-year results. We have in Ken a very, very excellently placed replacement.

And more importantly, the underlying business is in strong shape. We've delivered every element of a turnaround plan. And we are really well set for continued progress in the business despite the challenging market that we are in. Thank you very much for your time and look forward to talking in six months' time.

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Operator [26]

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This now conclude our conference call. Thank you all for attending. You may now disconnect your lines.