Tesco, what went wrong?

tesco Image copyright Getty Images

Apologies, but this is going to be a longer blog. Maybe "mega-blog" would be a better description.

I have spent the last few weeks speaking to many people who are closely involved in Tesco - or were.

I have also spoken to analysts and commentators to build as rounded a picture as possible of a retail business that has lost 50% of its market value in a year.

I'll just repeat that. Has lost 50% of its market value in a year.

Now, a share price that drops by 50% may not mean very much to the shopper in the street.

Until he or she realises that Tesco's profits and dividends - slashed by the retailer - make a vital contribution to all of our pension funds. The business is also one of Britain's largest corporate tax payers.

If too many major British businesses fail, then that not only means bad news for UK Plc and, in this case, the supply of groceries - it also means bad news for our savings and the government's tax income.

Tomorrow, Tesco will reveal its latest results. Sales and profits are likely to be down again.

Grim enough. But these are also the restating of the results Tesco was meant to release last month - until it stumbled across a £250m accounting problem in its profit forecasts.

I'll just repeat that. A £250m accounting problem in its profit forecasts.

It doesn't just rain for Tesco. It pours, then it hails, then there's a bit of sleet and snow thrown in.

For a business that was predicting it would make £1.1bn profits for the first half of this year, a mis-statement of £250m is a significant number. So significant that a series of former executives from the business I have spoken to simply don't believe it.

They say it is likely that Tesco will announce a lower figure tomorrow.

That is just a wrinkle. If you cannot trust a business's accounts, then there is not much left to trust.

Tesco insists that the numbers it reveals tomorrow will be accurate. It will also attempt to explain what went so horribly wrong.

That will come as a relief to investors who have told me they are astonished that there has been such a Horlicks at Tesco.

Image caption Tesco's share price has fallen by 50% in a year

They are voting with their wallets. Since the announcement that Tesco could have been booking profits from suppliers before costs - flattering Tesco's bottom line - the retailer's share price has fallen by 10%.

Warren Buffett is the highest-profile seller, saying his 4.1% investment stake in Tesco was a "huge mistake" which has cost him £465m in a year. This is a man who runs an investment fund - Berkshire Hathaway - so successful and popular it costs £200,000 to buy one top-graded share.

Tesco has announced its own inquiry into the accounting crisis, led by Deloitte and Freshfields. The Financial Conduct Authority has also started an official investigation.

The Financial Reporting Council and the Serious Fraud Office are also maintaining a "watching brief".

Eight senior executives have been asked to "step aside" while the inquiry continues, though no blame has been attached to any of them.

This is one of the biggest corporate messes of the year. How Tesco responds ahead of the key "golden quarter" for all retailers - Christmas - will be key.

'Find me £30m'

The first Dave Lewis, Tesco's new chief executive, and Sir Richard Broadbent, the chairman, knew about the problem in Tesco's accounts was on Friday, 19 September.

Mr Lewis and Sir Richard were given a file by Tesco's general counsel, Adrian Morris. He had been handed it by a lawyer - who had been given it by a senior member of the finance team.

Such a convoluted process - using a company's legal department to raise concerns rather than going direct to executives or the board - is thought by some to reveal a business where trust is not much evident.

The file highlighted worrying discrepancies between when profits were accounted for from deals with suppliers and when costs were paid.

I am told by one senior figure very close to Tesco that the "whistle blower" had become concerned that the numbers he was being sent on supplier income did not have the "full documentation that I needed".

Was someone trying to cover something up?

At its simplest it appears that profits were "booked" early - ie moved into the first half of the year.

Image copyright Getty Images

At the same time, expenditure on costs associated with the deals was delayed.

Now, this can be done in any number of ways, some of which may have been used by Tesco.

Suppliers pay retailers for promotions that could mean more of their product being sold.

Payments can be made for better positions on shelves, for visibility on "plinths" at the end of aisles where customers are more likely to see products, or for two-for-one offers.

One senior figure in the grocery industry said there was evidence across the sector that payments are sometimes taken unilaterally from suppliers.

The payments may be disputed later, and a refund or new agreement made later in the second half of the year. By then, the original payment has been taken as revenue.

Targets, therefore, have notionally been hit.

In an era of rising sales and increasing amounts of money going through the tills, moving profits forward can later easily be disguised, cloaked by increasing revenues in the second half of the year. Any issues in the first six months are "traded away".

But when sales are falling - as they have been for a number of quarters at Tesco - then moving profits forward starts to cause problems.

"When the business is under strain, you will get found out," one Tesco source told me.

It was reported over the weekend that wrongdoing by a small number of employees had been found by Tesco's internal inquiries.

The details of such behaviour may seem remarkable to the outside world.

But speaking to former senior employees at Tesco, that ignores the febrile and aggressive attitude within retailing, which is a highly competitive market.

The arrival of the discounters Aldi and Lidl - which have both eaten into Tesco's market share (down from 30.2% to 28.8% according to Kantar Worldpanel data) - only exacerbated the push for the earlier taking of revenues and profits.

Image copyright PA

One former senior Tesco executive who was head of a large number of supply chains told me that as the end of each half year approached, heads of division would put out a call.

"'Find me £30m' would be the message," the former executive told me. "That would cascade down to the buyers and they would demand more and more from suppliers."

It seems that, as Tesco's trading position deteriorated, actions became more and more desperate.

Bruno Monteyne, senior research analyst at Sanford Bernstein and himself someone who used to work at Tesco, puts it like this: "As a retailer you always have long-term relationships with suppliers - and in any long-term relationship you have give and take, much like a marriage.

"Clearly while everything was going well, suppliers wanted to work with Tesco and Tesco asked for things back.

"But because Tesco has been under three or four years of substantial profits pressure it has been pulling the bed cover over to its side a bit more - and it got more and more unbalanced."

The new CEO Dave Lewis has written to suppliers saying that "integrity" has to be at the heart of everything the business does. Part of this is about culture change.

"I expect Tesco to act with integrity and transparency at all times," Mr Lewis said in the letter to thousands of the businesses' suppliers.

"Our values are what we stand for and we will live those values in all that we do for Tesco. It is in times of challenge that our values are tested, and I want to reassure you that we will live our values fully at this challenging time.

"Our relationships with our suppliers are critical. They form the bedrock of the service we provide to our customers."

Pledges on "integrity" are one thing. Sorting out a £250m accounting mis-statement is quite another.

One central question is whether there was evidence of any major accounting problems before this year.

On that, as with so many issues connected to Tesco, accounts differ.

Senior figures close to the business told me there was no evidence earlier in the year of any problems.

In 2013, Tesco actually tripled the number of checks it did on supplier accounts, a move I understand satisfied the company's auditors PwC ahead of their audit of that year's accounts.

The issue of commercial income - that's payment to suppliers - had been raised by PwC.

"The committee notes that commercial income was an area of focus for the external auditors based on their assessment of gross risks," the annual report says, referring to Tesco's audit committee.

Ken Hanna, the chairman of that committee, was satisfied the risks had been dealt with by the extra checks.

Image copyright PA

One source said the business was under more pressure because of declining sales, but it was seen as a time for more vigilance, not less.

"What's worse than a profit warning?" my source said. "Well, going to prison for fraud."

At present Deloitte and Freshfields are focusing on this financial year. But many would find it remarkable if the inquiries do not uncover more widespread problems.

If the accounting problems hit Tesco's international businesses, then all sorts of horrors could come to light.

One major investor in Tesco pointed me towards an analyst note from 2010 which talked of "aggressive accounting" at the retailer.

You can read my original blog on that here.

Tesco sources say the issues raised by the note were not concerned with commercial income and were of a far lower magnitude than the problems of this year.

They suggest that the 2014 accounting problem is unique.

'Where's the chairman?'

The role of chairman Sir Richard Broadbent during Tesco's travails has faced criticism from some investors.

There was a point during the middle of year when Tesco had neither a chief executive nor a chief financial officer.

A little careless, many said, to say the least.

It also raised significant questions about how the board approached succession planning.

The board has faced further criticism for a lack of retail experience. On that, there have been some improvements, as I've written about here.

Image copyright Getty Images
Image caption Tesco became the biggest retailer in the UK under the leadership of Sir Terry Leahy

Sir Richard also appeared to be unsighted as to whether Laurie McIlwee, the former chief financial officer, was actually working for Tesco when the accounting problems came to light.

He wasn't - Mr McIlwee left the business in early April. Tesco was obliged to publish a clarification on that matter.

Possible evidence that the accounting problems are limited to this summer could include the fact that Mr McIlwee has not been called by those undertaking the inquiries, despite making himself available.

Many investors believe Sir Richard will leave as chairman once the initial investigations have been completed.

Some would like to see a big retail hitter like Archie Norman, the chairman of ITV and the former chief executive of Asda, take over.

Mr Norman, as far as I am aware, has not yet been contacted. Presumably the conversation would be something like: "Hi, Archie, now about this poisoned chalice..."

A juggernaut with the wheels coming off

At the heart of all this is, of course, the fact that customers appear to have fallen out of love with Tesco.

This was the store that under Sir Terry Leahy, the chief executive before Philip Clarke, became the largest retailer in the UK.

It also expanded across the globe.

The problem was that its slogan Every Little Helps morphed, according to many critics, into Every Little Helps Tesco.

One of the funniest-ever Matt cartoons in The Telegraph pictures an elderly couple sitting on the sofa with a Tesco Express, complete with special offers, sitting proudly in the corner of the sitting room.

Tescopoly was a new game we could all play as the retailer's lorries thundered around the country and its shops opened on every High Street.

The customers flooded in and the profits went up and up. The share price flirted with £5 in the autumn of 2007. It is now languishing around £1.80.

When did it start going wrong?

When he took over, Mr Clarke said that Tesco had been "running too hot" under Sir Terry, suggesting that the retailer had lost focus on the core retailing principles - best prices, highest quality and stores that people like shopping in.

Mr Clarke famously pulled Tesco out of "the space race", halting the expansion of hyper-stores and instead focusing on a different strategy of making Tesco "all things to all people" with a strong digital bent.

The new Amazon, he explained privately. Though, of course, as one source told me, Amazon did not make profits like Tesco made profits.

Under Mr Clarke, Tesco bought posh coffee shops, restaurants and digital businesses as it expanded the services it thought customers would be interested in.

The launch of Tesco's own tablet, the Hudl, proved very successful - giving Tesco an automatic way of influencing how people shopped online.

There were many who disagreed with Mr Clarke's approach. Allies of Sir Terry say that Mr Clarke allowed Tesco to lose its reputation as the cheapest of the "Big Four" retailers, a crown it lost to Asda.

Customers followed with their feet, deserting for competitors.

Image copyright EPA

When it came to tackling the exodus, sources say there was a major split among the executives over Tesco's strategy. Some wanted the retailer to open more discount-style stores under the "One Stop" brand.

I am told Mr Clarke disagreed, saying that a store refreshment programme was delivering results.

Critics are not convinced. Rewards for being a Club Card holder were cut back (a mistake, according to one source, given the cards' popularity with customers) and an exodus of senior staff including Mr McIlwee, Richard Brasher, head of the UK business, Tim Mason, head of the US, and Andrew Higginson, another former chief financial officer, left the retailer struggling internally.

One figure close to what might be regarded as the "old Leahy team", told me: "To be honest I feel most sorry for the staff who work in the stores and operations who deserved better from their board, both executive and non-executive.

"At its core the UK business is a great company and despite a huge drain of talent, when Tesco focuses on the customer and regains its determination to do the right things it has the potential to rebound."

That rebound, if it comes, is likely to be lengthy and expensive.

David McCarthy, a leading retail analyst with HSBC, said a turnaround could cost as much £3bn.

"Terry built a fantastic business in Tesco, there is no question about that and there was a relentless focus on the consumer," Mr McCarthy told the BBC.

"But five, six, seven years ago the focus seemed to shift more towards a mantra of Tesco does not miss its numbers and in that mantra, the consumer does not feature."

The consumer needs to feature now. Most believe Tesco will cut prices again and look to improve its widely criticised stores.

Recent marketing campaigns, including a voucher for £5 off a £40 shop, appear to have arrested the sales decline to an extent.

The four-week figures for retail sales from Kantar - privately shared with the retailers and seen by the BBC - show that Tesco sales are down 1.5% year-on-year over the last month, compared to Sainsbury's (down 4%) and Morrisons (down 4.6%).

Of course, short term figures are heavily skewed by marketing pushes. The Kantar 12-week comparison released yesterday revealed Tesco's sales down over 3% in the last three months compared to last year.

Many believe that Tesco should move away from vouchers and one-off price promotions and win back customers with lower prices across all its ranges.

The accounting problems may be dreadful. But the real test for Mr Lewis will be getting customers back through the door. Remember, there are only 63 shopping days to Christmas.

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