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Edited Transcript of TSCO.L earnings conference call or presentation 10-Apr-19 1:30pm GMT

Full Year 2019 Tesco PLC Earnings Debt Investor Update Call

Hertfordshire Apr 11, 2019 (Thomson StreetEvents) -- Edited Transcript of Tesco PLC earnings conference call or presentation Wednesday, April 10, 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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* Kieren Santoni

BNP Paribas - Analyst

* Brian Giffney

Neuberger Berman - Analyst

* Conner Curran

AIG - Analyst

* Katerina Ferrera

Morgan Stanley - 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 begin your meeting.

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Alan Stewart, Tesco PLC - CFO [2]

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Great. Thank you very much and good afternoon, everybody. And thank you for taking the time to get a little bit more behind our results for the year ended February 2018. As usual, and I'm on the first page of the deck, I will begin with the performance of the group. And I am pleased to say we delivered broad-based improvements across the whole of the business. Our momentum in sales growth has continued, up 11.5% at actual exchange rates with 2018/2019 representing our third full year of sales growth for the group. Our results include 51 weeks of Booker as we completed the merger right at the start of the financial year on March 5, 2018.

Once again we delivered strong profit growth, up 34% year on year to GBP2.206 billion representing a full-year group margin of 3.45%. Excluding Booker and synergies, our group margin was 3.79% for the second half, putting us well within the range that we -- of ambition that we set ourselves. Our retail operating cash flow was GBP2.502 billion. This reflects a strong improvement in underlying cash profitability. However, our year-on-year progress was held back by approximately GBP490 million of working capital timing impacts which we'll cover later on in the presentation.

Reflecting our confidence in the ongoing cash generation, we are proposing to pay a final dividend of 4.1p per share taking the full-year dividend to 5.7p per share, which is up 92.3% year on year. Again, we will come back to that later.

If we now move to the segmental performance. This year I have included a slide showing our performance across all parts of the business but on a single slide. I'm pleased with the performance from each region with all areas on an improved trajectory since our last update in October.

If we briefly focus on the UK and ROI segment, we've seen strong like-for-like sales growth of 2.9% as we completed the rollout of our new exclusively at Tesco own brand range; and in the fourth quarter, our sales outperformed the market. Our operating profit was up 45% at actual exchange rates to GBP1.537 billion. This includes the consolidation of Booker and also reflects good progress on our cost savings program and our continued focus on more sustainable and profitable ranges. These numbers also include the impact of the decision to close Tesco Direct earlier this year.

We saw a benefit of GBP52 million from a change in Clubcard accounting estimates. We delivered GBP79 million of Booker synergies in the year and are on track to deliver our target of around GBP200 million per annum by the end of year 3. We now expect integration costs of between GBP50 million and GBP75 million over the three years, lower than the GBP145 million that we originally expected.

Our Central Europe operating profit, before exceptional items, was GBP186 million, up 56.3% year on year at actual exchange rates. We are improving the quality of our business by focusing on more sustainable product categories as well as reducing operating costs across the region as we simplify the store service model. We closed 62 lossmaking stores in Poland during the year and made a small profit there in the second half.

As you know, in the first half, our Asia operating profit was impacted by the combined effect of sales deleverage, price investment and the renegotiation of promotional investments in Thailand. I am pleased to say the second-half performance has improved significantly and we've been able to recover our operating margin more fully and quickly than we had anticipated at the half-year.

And then, finally, in respect to the bank, we saw a good growth in operating profit, partly helped by a one-off timing impact as we renewed an insurance contract which added GBP13 million to our operating profit. That's as a result of the introduction of IFRS 15. But, more importantly, on the balance sheet side, our lending growth, particularly in the secured, was strong; and modest growth in the unsecured.

Insurance market and the mortgage market remain extremely competitive, but we are focused on sustainable customer relationships which we can then view to build the strength of the business in the long-term.

Overall, the group delivered like-for-like sales growth of 1.4% and operating profit of GBP2.206 million, up 34%.

If we now turn to the sources and uses of cash, this is the usual waterfall that represents how we think about cash within the business. We've generated GBP3.1 billion of cash from retail operations, up GBP579 million on last year, excluding working capital. I've then split the working capital outflow of GBP302 million into 2 components -- an in-year timing impact of GBP349 million; and an underlying inflow of GBP37 million. I will come back to these on the next slide.

Our exceptional cash items resulted in an outflow of GBP237 million. Around half of this related to restructuring costs. Also included are onerous lease payments and the final payment under the shareholder compensation scheme. Overall, this leads to a retail operating cash flow of GBP2.502 billion.

We spent CapEx of GBP1.126 billion, in line with our guidance. Net interest and tax costs amounted to GBP585 million. We paid less interest year on year due to lower levels of debt, partly offset by the timing of the coupon repayment on our largest sterling-denominated bond. Tax payments of GBP302 million were higher than last year as our profitability improved.

Our net property transactions cash, at GBP149 million, includes GBP285 million proceeds from property sales across the group, including the disposal of a site in Kennington, three retail sites in Central Europe, and two Booker properties. The proceeds were offset by 3 property buybacks in the UK totaling GBP136 million. The net impact of acquisitions, disposals, and dividends received was GBP112 million. As a reminder, this excludes the GBP747 million total cost of combining with Booker, which of course is reflected in our net indebtedness.

Finally, our commitment to offset any dilution to satisfy new share issuance for share schemes resulted in net cash outflow of GBP146 million this year, in line with our guidance, and with the bulk of the outflow occurring in the first half. Overall, this leads to retail free cash flow of GBP906 million.

Turning to the next slide, which shows our retail operating cash movement year on year. If we look at it, as I've mentioned, we've delivered a strong increase in underlying cash profitability of GBP579 million. This progress has been held back by around GBP490 million of working capital timing impact which split into 2 elements. First, this year's working capital net outflow includes payments of GBP139 million which were delayed from the last financial year following the administration of Palmer and Harvey. And then we did highlight these, this time last year. Together with the corresponding benefit from last year as we pay this money this year, this creates a GBP278 million year-on-year timing impact.

Secondly, there's a further GBP210 million arising at the end of the financial year. The majority of this relates to the implementation of a new general ledger system in the UK and ROI which went live in November, a few months later than originally planned, and which temporarily delayed the collection of some receivables into the beginning of the 2019-2020 financial year.

In addition to safeguard availability and service levels for customers at a time of political uncertainty, we de-prioritized some ongoing working capital initiatives. In the prior year, we also saw a particularly high inflow of GBP354 million from working capital initiatives, and this level of incremental initiatives has not been repeated again this year. Over the last 3 years, we've generated around GBP570 million from working capital improvements; or, put another way, around GBP200 million per year.

In the current year, we expect the GBP210 million timing impact from the end of 2018-2019 to reverse. And we will also maintain our focus on generating sustainable improvement in working capital. These movements resulted in a total retail operating cash flow of GBP2.502 billion, down GBP271 million year on year.

Our proposed final dividend of 4.1p per share will be paid on June 21, subject of course to the approval of shareholders at the AGM. This will result in a cash cost of around GBP400 million payable in the current year. The full-year dividend, as I said, is 5.77p and is up 92.3% and reflects the Board's continuing improvement and the confidence in the future cash generation and the underlying continued improvement in performance. I'm also pleased to confirm that we are now expecting to reach a dividend cover of 2 times earnings in the current financial year. That is on a post-IFRS 16 basis.

I will now hand over to Lynda.

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Lynda Heywood, Tesco PLC - Group Treasurer [3]

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Now I'm looking at balance sheet progress. Looking at net debt, we've seen an increase of GBP238 million after a cash outflow of GBP766 million relating to our combination with Booker. Our lease commitments were down GBP292 million on an underlying basis, and up GBP68 million when we include the GBP360 million additional Booker operating leases that we took on.

Our pension deficit reduced from GBP2.7 billion to GBP2.3 billion with continued deficit contributions and a strong asset performance over the period. As a result, our total indebtedness reduced by GBP84 million to GBP12.2 billion.

This slide is reported on a pre-IFRS 16 basis. We start reporting on an IFRS 16 basis in this financial year. And we will be issuing the full 2018-2019 financial statements on an IFRS 16 basis on Monday, 29 April.

Looking at our debt metrics, we've made continue progress on the balance sheet with both our key metrics crossing the threshold levels. Our total indebtedness ratio has reduced to 2.8 times from 3.3 times last year. And our fixed charge cover has increased to 3.2 times from 2.7 times. As a reminder, these are reported on a pre-IFRS 16 basis. We've also confirmed today that we intend to operate with a total indebtedness ratio between a range of 3 times and 2.5 times which will be measured on an IFRS 16 basis. We expect fixed charge cover to remain at around 3 times going forward.

In the debt capital markets, we've repaid a further GBP1.2 billion of debt through the year, bringing the total debt repaid or prepaid since 2017 to GBP4 billion. We have run two liability management exercises in the year between them buying back GBP1.2 billion of debt and generating annual interest savings of around GBP50 million. We also issued a five-year, GBP750 million Eurobond at a coupon of 1.375%. This is our first bond for 4 years and was well received by the market. Overall, our capital markets activity has driven a reduction in annualized interest of nearly GBP100 million which represents 43% saving in finance costs.

On slide 10 we give you -- we can show you our gross debt position and outstanding bonds by currency. It shows the progress on gross debt which -- and how we've reduced it over the 3 years as we continue to pay down our bonds. The percentage of debt issued in or swapped to sterling has remained fairly stable at around 75%.

For our liquidity position, we ended the year with nearly GBP2 billion of cash and liquid investments, which, together with GBP3 billion of committed facilities that were undrawn at year-end, underpin the group's strong liquidity position. The debt maturity profile highlights the balance in our portfolio as well as the bonds that we have prepaid through our liability management exercises. As you can see, we continue to target bonds with high coupon rates to maximize the return. The chart also highlights, in blue, the bonds that we issued in October.

Moving to slide 12, just as we confirm our credit rating for reference; but noting that in FY 2018-2019, we were upgraded to investment grade with Fitch and took a positive outlook by Moody's.

So just to summarize the year just gone, we have met or are about to meet the vast majority of our medium-term targets. Sales grew by 11.5% and we saw a significant year-on-year increase in operating profit of 34%. We delivered a second-half margin of 3.79% for the group, excluding Booker. Our Booker Joining Forces program delivered GBP79 million of synergies in the year. And we now expect the integration costs over the 3 years to total GBP50 million to GBP75 million. We delivered retail operating cash flow of GBP2.5 billion, as our underlying improvement in cash profitability was impacted by working capital timing, including decisions we made in the second half.

We made further substantial progress in our cost-saving program ,leaving us firmly on track to deliver our GBP1.5 billion of cost-savings target. We continued to reduce total indebtedness and we strengthened our debt metrics, reaching our threshold targets. Finally, our proposed dividend and confirmation that we intend to reach 2 times dividend cover in the current year once again demonstrates the Board's confidence in our ongoing recovery.

I will now hand back to Alan.

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Alan Stewart, Tesco PLC - CFO [4]

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Thanks, Lynda. So we are now, as we reach towards the end of our turnaround and we can see we delivered the vast majority of the goals we set ourselves, I'd just like to remind you of the 6 strategic drivers which we've used to focus on that turnaround. These are ones which we used internally really since the early days of 2014-2015, February 2015; and we spoke about them more publicly in 2016.

The brand performance has been very strong. In the full presentation today, we spoke about the improvement in sentiment, as measured externally on us as a brand, from a trust perspective. And from the low point in 2014, we are now right up against the others in the sector. And this is, as a high level, the highest it's been since 2011.

We've made great progress on reducing the operating costs: GBP532 million achieved in the year, and well on track for the target. We generated GBP8.6 billion of cash from operations. If we adjust against our target of GBP9 billion, if we adjust for the GBP210 million that we've just spoken about, we were really within GBP200 million of the overall GBP9 billion target over the 3 years. We've used the mix to improve the underlying profitability in the business. And we continue to use this as a basis for making decisions about range, about channels, and about where and how we serve our customers.

And, finally, we've generated more than GBP1 billion -- GBP1.7 billion -- from property disposals and from property realizations in the -- over the last 4 years. We've increased the freehold percentage on an underlying like-for-like basis before the inclusion of 183 Booker leasehold properties from a 43% freehold to -- 41% freehold to 53% on pre-held within the group. We've brought a number of innovations and continue to look at innovation across the business.

If we then begin to look ahead and see what's coming next, we have a number of opportunities. The 4 years, though, from a financial perspective, in 2014-2015 -- and these numbers are just at the disposal of [careers], so they're really the shape of the business as we've been running it for most of the last period -- our sales have grown from GBP49.3 billion to, including Booker, GBP56.9 billion.

The profit in the first year that we joined the business and began the turnaround was GBP1 [billion], and we actually met a loss in the UK business in that second half of the year. The group made a profit of GBP1 billion. And we've delivered GBP2.2 billion in the year just ended. And the margin in that first year was 0.8%; and as we've said, 3.8% in the second half of this year against the 0.8% in the second half of 2014; or, including Booker, 3.96%. So strong margin performance which is now, we believe, pretty well in line with industry, if not the best in the industry as we look at it now in the markets in which we operate.

And we've continued to -- on the next slide we have reshaped the portfolio. We've brought Booker in. And we've made a number of disposals, including Homeplus, which is the Korean business; Kipa, the turkey business; and a number of other smaller businesses disposed of or moved out of the business.

Total indebtedness has dropped from GBP22 billion in February 2015 to GBP12 billion at February 2019. And this is something we're really proud of and pleased with. If we look at it from a colleagues and supplier perspective, we've improved the measures which our colleagues are -- we use the great place to work as a metric; and it has moved from 70% to 83% despite significant change in our business. And our supplier perspective has moved from 55% positive to 81% positive. And we've won 3 external awards over the last 3 years from suppliers.

If we then move to the framework on which we've been running the business, this really has remained consistent. And whilst initially, on the left-hand side, we chose to express it through some external targets which gave the market and interested parties ways to look at how we were going to achieve the turnaround -- be it margin, be it cost savings of GBP1.5 billion, or be it cash generation of GBP9 billion -- the underlying philosophy which is now the way that we're going to be looking at the business, is one focused on cash profitability -- on customer satisfaction primarily, and first and foremost. It is at the heart of everything we do.

We will are focused on cash profitability, free cash flow, including the right level of capital investment with returns evaluated through a rigorous framework; and enlarging our EPS. And that's a framework which we've been using to run the business, and that's the way we will continue to run the business going forward.

And if we then look to how we will think about our allocation of capital, we felt it really useful really to talk about this, albeit if you looked at and listened to our presentation over recent years, I think you could probably have drawn up most of this yourself.

First and foremost, we will reinvest in the business and the customer offer in order to remain relevant to our customers. We then are clear that the leverage that we want to achieve and maintain -- and this is on a post-IFRS 16 basis -- is in the range of 3 to 2.5 times total indebtedness to EBITDA. We then will grow the dividend to the circa 2 times cover which today we said we expect to achieve in the current financial year. And then we will maintain this at about a 50% payout ratio going forward.

We will continue to look at inorganic growth opportunities, if as and when they arrive. We will always do that through the rigor of returning returns which are above our cost of capital and which pay back in a reasonable timeframe, given the amount that we would be spending. And then, finally, within all of those four, if there is surplus cash available, we will return that to shareholders in a way which will be appropriate, whether it is share buyback or special dividend.

So that's the capital allocation framework, and that's the way that we are be looking at the business. We're not going to be having margin targets going forward. We are very clear that we can achieve what we've said. But we are not going to be running the business, and we never have, off margin targets; neither will we be publicly putting out targets. The capital allocation framework is the way that we intend to operate and run the business.

So, finally, before opening this up to questions, we have delivered a full year which is ahead of expectations. We have seen a significant increase in profitability. We have made strong progress against our strategic drivers. And in the second half, we achieved a margin which is already well within the ambition range, even before Booker. And Booker is additive on top of that.

We are in a 100th anniversary year. We will focus on celebrating 100 years of great value for our customers. And we will use that as an opportunity to continue to show what it is that makes Tesco a great place for them to put their trust into, and to do their shopping.

And then, finally, we've set out our clear priorities for allocating capital, including the target leverage range.

Very happy now to throw it open to questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions). [Kieren Santoni], BNP Paribas.

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Kieren Santoni, BNP Paribas - Analyst [2]

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Congratulations on the great results on the full-year progress. I just wanted to touch upon the new leverage ratio which is now adjusted leverage under the IFRS 16 method between 2.5 and 3 times. Has this been discussed with the agencies. And if so, where do you see your weighting, should you achieve this?

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Alan Stewart, Tesco PLC - CFO [3]

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Lynda, Do you want to --?

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Lynda Heywood, Tesco PLC - Group Treasurer [4]

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So we are in ongoing discussions with the agencies, I think it's fair to say. We saw this level as a -- representing an efficient place for us to be in terms of our capital structure, and gives us a strong balance sheet. We don't publicly map that to any particular rating. And that's obviously, as we've said before, a decision for the agencies to make. But having said that, we would expect this range to be in the investment-grade space.

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Alan Stewart, Tesco PLC - CFO [5]

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If I could just add to that, what we've -- if you go to chart 8 in terms of the improving debt metrics. What we've shown on there, the second shorter line is the metrics measured on an IFRS 16 basis. And clearly whilst previously we'd set out a threshold, and we've now put in a range below that. So the 3 was the threshold, the 2.5 is below. On one level, this could be viewed as a more prudent test, given that the current line is above where we were before. But we haven't had those discussions, and we will be having them shortly with the agencies.

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Kieren Santoni, BNP Paribas - Analyst [6]

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Okay, just to follow-up, that's nearly a turn worth of deleveraging under the old target, so that's a pretty strong commitment to de-lever. I'm surprised the agency, whether -- I mean, S&P -- hasn't been more receptive to your deleveraging. Is there any particular reason why?

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Alan Stewart, Tesco PLC - CFO [7]

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You'd have to ask them.

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Lynda Heywood, Tesco PLC - Group Treasurer [8]

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Yes. That's not something we can comment on.

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Kieren Santoni, BNP Paribas - Analyst [9]

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Okay. And just a final question, just on Brexit. I know it's a hypothetical question. But should there be a no-deal Brexit, what do you think the impact would be for Tesco?

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Alan Stewart, Tesco PLC - CFO [10]

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I think certainly what we've -- I don't know; and I don't know what the outcome will be of that. And in that sense, I think the uncertainty is as much you know as much as I do. When we've looked at this before, nothing has changed in terms of the potential impact on us, or indeed on anybody operating in the UK market. The challenges were around the free movement of people, the free movement of goods, and Ireland. Those were the 3 challenges which were identified before Brexit even began the negotiations, and post- the referendum. That remains the case.

I think that the impacts are ones which potentially impact customers as regards the free movement of goods, particularly fresh goods. But we and everybody that we've talked to, including government, are determined that whatever happens we don't impact that free movement.

From a customer sentiment perspective, we've seen absolutely nothing that we can discern in terms of changed customer behavior in the run-up to where we are. Clearly, there is uncertainty and customer feedback. If we look at [GfK], if you look at a number of other metrics is concern over the uncertainty. Nothing that we can see from a consumer behavioral perspective.

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Operator [11]

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Jack (technical difficulty) Barclays.

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Unidentified Analyst [12]

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I was just wondering if you could put a timeline on the deleveraging trajectory. Is this target going to be reached in the next year? Or are we looking at 2 years? Any clarity would be much appreciated.

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Alan Stewart, Tesco PLC - CFO [13]

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No, no, Jack. Look, I fully understand the question. We had it from the equity side as well earlier on today. We haven't put a timeline on it. I think the things that -- when we look at it, the 2 elements of moving the metric are the cash that we are generating through the EBITDA, and the improvements in EBITDA. Clearly, equally, the total indebtedness is something which moves it. And if both of those are moving in the same direction positively, the deleverage happens quite quickly. We haven't put a specific timeline on it.

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Operator [14]

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Brian Giffney, Neuberger Berman.

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Brian Giffney, Neuberger Berman - Analyst [15]

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Just a quick question. I think I know the answer from your comments about capital allocation. But looking at gross leverage and specifically the quantum of gross debt, what are your thoughts about directionally? Are you expecting to pay down debt as it matures this year? Or it a case of we should be expecting a refinancing so you won't necessarily see a reduction in the gross debt number?

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Lynda Heywood, Tesco PLC - Group Treasurer [16]

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We've got two bonds that are maturing this year that we would expect to be repaying. I think than we are obviously wanting to reach this leverage target before we then go to the next stage. So you've seen from the slide that Alan referred you to just now that we're not quite at the metrics yet. Things evolve as and when we get to that target range which is clearly our first priority currently.

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Alan Stewart, Tesco PLC - CFO [17]

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Sorry, the other thing I would add to Lynda's comment is that as we look forward -- and the chart on page 11 really shows that we do think about maturity. We think about when bonds come up for maturity. And as we saw last year, we did issue into one of the [gaps] in our forward profile of potential maturities. And that is something which we increased; and you think about as we get pretty close to or even when we get within the target -- the range that we set ourselves.

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Operator [18]

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(Operator Instructions). [Conner Curran], AIG.

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Conner Curran, AIG - Analyst [19]

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I just wanted to ask about your view on the potential for -- if we got a down trading sort of environment, be it driven by a disruptive Brexit or just an ordinary consumer assession, how do you think you are positioned for such an environment in terms of the relaunching of the range as you've done. And maybe are price differentials on some of the key items from discounters how do you think you'd be positioned for down trading environment now compared to going back a few years ago?

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Alan Stewart, Tesco PLC - CFO [20]

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Yes; and thanks. I think it's a good question. In terms of our price positioning, which is an important part of it, we really have made significant progress on our price positioning. Whether that is against the others in the big 4 and traditionally the ASDA has been the benchmark against which others have measured, we had operated at quite a high -- 5% to 6% premium to that, going back a few years.

We are now operating very comfortably at around 102%, so 2% premium; which, over time, we've shown that that's something which customers are prepared to, and indeed value, given the greater range and the greater service they get from a Tesco. Against the -- and then against the others in the market. Again we're very comfortable with our positioning.

But the second element which is really important is the focus we've been putting on not only the exclusively at Tesco brands, which are about 400 SKUs in which we will expand as the course of over the next year based on customer feedback and customer demand, not significant expansion. But they are really clear and important part of defining the price positioning particularly against the newer entrants, the German retailers, whose price positioning has been significantly lower than the traditional supermarkets. We are encouraged and very encouraged by what we see from that.

So -- and on top of that, we've relaunched the 10,000 SKUs which in the Tesco brands whether it's Tesco or Tesco Finest. And we've, over the course of the last 4 years, we've actually done 15,607 new SKUs which we've reformulated, repackaged, and re-presented to customers. It's a huge focus on customer range and giving customers what they want.

I think the final thing I'd say in response to your question is that what Tesco has shown over time through periods of slowdown and recession and consumers coming under pressure, what Tesco has done with all but one exception in focusing on the customer Tesco has emerged stronger after that downturn than entering the downturn. And the only exception to that was post-2008 when Tesco focused on the margin, and rather than giving customers what they needed which was great prices at a time when they were themselves under pressure.

So we are in a much better position, I think, than we have been. We are in the best we've been, certainly in the time we've been here, and we are ready and willing to follow customers where they need to go.

However, having said that, customers today -- and you read this in the economic metrics -- wage and price inflation is running at higher than underlying inflation. And so people do have more money in the pockets today than they had a year ago. And that seems to be the expectation going forward is that we see inflation at about 2.5% and it feels as if wages are running and starting higher than that. So looks as if customers are getting a little bit more money in their pocket. But I think we're very well placed and certainly the best place we have been in the past 4.5 years, should that circumstance you are asking about come to pass.

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Conner Curran, AIG - Analyst [21]

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Great. Do you quote any differential versus the German discounters in the same way you quote for [ASDA], or is that something you cannot compare as easily?

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Alan Stewart, Tesco PLC - CFO [22]

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Well, the way we look at it is that the -- on those 400 SKUs -- and again I can't give you an update here on those 400 SKUs which are the ones which are particularly and specifically directed as against those products and those retailers because that is the comparisons that customers make -- we are absolutely price competitive.

And back in October last year, we showed a basket of goods. You may recall this slide. We had our price of goods, we then had competitor A and competitor L, the same products, and we were cheaper than them. We did that comparison last week on the same basket as against the same products against the same competitors, and we continue to be cheaper than them. So on the prices where customers really see the comparison and feel the value and make the equation, that's where we are price competitive. And it's against that customer feedback that we are expanding these 400 SKUs over the next period. Because customers have said, we see this; we value it; we would like to have a bit more of it. That's what they are heading.

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Conner Curran, AIG - Analyst [23]

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Just on the online numbers, I think sales growth is about 2.8% in the year. Just wondering if that's -- it seems like a slower rate of growth for online. Are there any reasons behind that? Or is it just a more mature market and business? And then if you have anything on the profitability associated with the online business currently.

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Alan Stewart, Tesco PLC - CFO [24]

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Yes. So the way that we have looked at the online business for certainly a number of years now, 3 years at least, is that we will focus on giving customers the choices that they want -- whether it's delivered to your home, whether it is a click-and collect, whether it is a convenience store, or whether it's a large store; and in which case, you are making the effort to go to that store and choose the product yourself.

We will do that in a way which we think reflects the economics and customer choice. But what we are not going to be doing is subsidizing one channel at the expense of another. So we withdrew a number of the sales-driving but ultimately value-destroying activities which were pushing customers from one channel into another. So what we are seeing in terms of the online growth is a natural demand driven by customers and customer preference.

We have -- we're focused on loyalty as well. We have a subscription in terms of which we call Delivery Saver where customers can pay and get a free delivery, providing the basket is over a certain size. And if they don't use that in a quarter, then they will get a refund on what they haven't used. So it's a very customer friendly offer. And we've seen it well taken up more than 50% of our online customers are now on Delivery Saver.

And in terms of the specifics of -- we've also seen growth in customer numbers and growth in orders and basket size over the period, which is again not something which everybody in the industry is seeing.

In terms of profitability, we are really comfortable with where the business is, having moved it from significantly investing in that sales line which customers didn't value, and we're very comfortable with where it is now. It isn't at the group operating margins, but it is no longer the significant lossmaking business that it was. And (inaudible) we can make money and we can see it as something which overall is contributing to that 3.8% margin in the business and 3% in the UK business.

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Operator [25]

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[Katerina Ferrera], Morgan Stanley.

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Katerina Ferrera, Morgan Stanley - Analyst [26]

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My question is again around the ratings. So I know you don't want to give any timeline, but I have to follow up on -- regarding this topic. The first one would be the fact that rating agencies look at gross debt, not net debt, as you do in calculating leverage metrics. So are you willing to reduce leverage in gross terms so that you meet the agency targets for IG status? So that would be my first question.

And the second one is when I look at peers like Carrefour or even Morrisons which is closer to home, they are all in the BBB category. Is this where you also aim to be? Or will you be reaching further out into the BBB+? And once again, I know you don't give a timeline around it; but if you could give us more or less how you aim to achieve, how you want to achieve that?

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Alan Stewart, Tesco PLC - CFO [27]

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Yes, Katerina; and certainly very happy to answer. In terms of the way we think about this is that we've always been clear that the rating itself is something which the agencies make the decision on. What we will do is we will operate the business in a way which we think is appropriate and gives us a capital structure which is stable, which gives us the ability to withstand some movements in the environment or in terms of customer behavior, and gives us the stable and sustainable business. And that's the way that's really being the way that we run it.

The specifics of the rating are for the agencies to decide. But what we've also felt I'm being clear on as we map our understanding of how they look at the business in terms of the hard financial metrics that that 3 times threshold which we put out are now putting a range on it of 2.5 to 3 times is one which we believe is consistent with the financial metrics which then lead to an investment grade rating. It's for them to decide.

Within the specifics we're very clear and comfortable bad that -- now clearly the rating agencies haven't seen IFRS 16 financials from any issuer yet. We've probably done as full a job as certainly we could do in giving the numbers for the last half-year; and at the end of this month we'll publish them for the full year that we just ended. But the discussions that we had with the rating agencies certainly indicated that the IFRS 16 impacts which we highlighted were ones which were certainly within the bound of expectations that they'd had.

So we will see how they react, and we'll see how they look at it. But -- and we will be comfortable operating within that range, and the capital allocation framework that we've set out. So for the agencies to decide, but we are very comfortable operating in that range that we have a capital structure in a position which will be stable for all stakeholders.

Lynda, I don't know if you want to add anything to that.

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Lynda Heywood, Tesco PLC - Group Treasurer [28]

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Not very much, actually. You did ask us about gross versus net debt. I mean, we are aware of all the metrics that the agencies use. And we decided -- and this is not new news -- but our total indebtedness ratio is the one that we think is the most appropriate one to look at. We think it's most appropriate to look at it on a post-IFRS 16 basis. And that's the one that we will continue to monitor publicly. Internally, of course, we monitor a range of metrics that reflect the range of metrics that the agencies look at.

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Operator [29]

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And that was our final question for today. I will hand the call back to the speakers. Please go ahead.

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Alan Stewart, Tesco PLC - CFO [30]

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Thank you very much, and thank you for your time and your questions. So we are pleased with the progress we've made in the year. We've delivered ahead of expectations, and we are well on track to delivering against the ambitions that we set out. We've made strong progress. We have a 100-year anniversary this year, which we will continue to focus on with our customers. And we are very clear in terms of the capital allocation that we set out, including the target leverage range.

And we look forward to talking to you again at the half-year. And obviously if things change during that, then there may be earlier discussions. We are having a Capital Markets Day on June 18. And if there is interest in attending that, the spaces are limited. But if there is interest, then please, through the website, register your interest and we will follow up with you. So thank you again for your time, and look forward to seeing you if not at the Capital Markets Day, then talking again in October.

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Operator [31]

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And this now concludes the conference call. Thank you all for attending. You may now disconnect your lines.