31 Oct 2014 08:50am

Tesco: the store that wasn't there

Once lauded as a global success story, Tesco has fallen harder than most. Tim Philips asks why no one saw it coming

Tesco, we learn, is facing “the worst crisis in its 95-year history” and, to be fair, discovering your profits were overstated by £250m is a bad day at the office for any incoming chief executive.

In 1977 the founder and the chairman squared off against each other, brandishing weapons ripped from a wall-mounted Wilkinson Sword display

The mood at Tesco’s austere headquarters in Cheshunt – where, in the 1990s, staff made their own partitions out of old cardboard boxes because management was too thrifty to redecorate – can’t have improved when the company took delivery at the beginning of October of a new Gulfstream 550 corporate jet, valued at $50m. Awkward.

Having written books about Tesco (full disclosure: my co-authors were the chief executives of Tesco’s direct mail and data processing agencies at the time) and the ways in which successful businesses fail, I didn’t expect that the subject matter would overlap quite so soon, and quite so dramatically. But, when we look at the inglorious history of business failure, there are two lessons: long-run success is the exception in business, and that success often breeds failure.

To the first point, we can argue that this isn’t even the biggest crisis at Tesco in the last 40 years. In 1977, the board was so dysfunctional that the founder, Sir Jack Cohen, and the chairman, Leslie Porter (also his son-in-law), once squared off against each other, brandishing ceremonial weapons ripped from a wall-mounted Wilkinson Sword display. Tesco’s reputation for quality was so bad that a team of consultants brought in to save the business instead concluded that the company should change its name. Over the Silver Jubilee weekend in 1977, every Tesco store in the country was closed, stripped and completely refitted in a reboot that kick-started the recovery, and 35 years of consistent sales and profit growth.

Some of the problems at the time sound familiar: competition from discounters (Asda and Kwik Save); the wrong type of real estate (at that time, Tesco had too many small high-street units); dreary, dirty shops; confused, outdated strategy.

This time, chief executive Dave Lewis hasn’t closed every shop. He has, though, sent a memo to staff saying that this turnaround will require changes to culture, processes and brand proposition: in short, everything. But this is also a new type of crisis for Tesco. Its management in the 1970s might have been incompetent, but it wasn’t cooking the books.

Success brings the pressure to deliver a message of consistent success in financial reports, which undid WorldCom and Enron among others. As the economist Joseph Stiglitz wrote: “Capitalism needs accountants. If the firm could make up any old number, who would buy a share?” But we are accustomed to thinking of financial reporting as a set of rules, when often reporting is more art than science. Firms also use accountants to negotiate the wiggle room so that financial reports satisfy investors, and retail has more wiggle room than most sectors.

Even perfectly legal reporting practices can mask damaging truths, due to our tendency not to look too closely at success stories – the sort of faith in success that masked long-term underperformance in a company like GM. Fund manager Terry Smith, chief executive of Fundsmith LLP, points out that, in 14 of the last 18 years, Tesco’s free cash flow minus its dividend was a negative number. It covered the gap with borrowing. This predates competition from Aldi and Lidl, or the changes in shopping habits that have put pressure on profits in the short term. This is, in Smith’s words, “neither healthy nor sustainable”. It’s the responsibility of analysts to dig into these numbers, which are public. But there’s a line that many successful businesses cross when profit is under pressure. The temptation for many businesses in the past has been to wiggle just a little more each quarter until they are, effectively, making up the numbers.

One of the innovations that Tesco Clubcard introduced to the business was a much better reporting of how promotions and discounts were working. Tesco used this information as a bargaining tool for its suppliers, who pay supermarkets for promotions via a complex set of rebates and discounts. This has become a huge source of profit for all supermarkets, and also a temptation for managers who are under pressure to deliver their numbers. And so, according to Tesco, it has booked income before it was earned, and recognised costs later than they were incurred.
Whistleblowers into this type of misstatement are rarely believed until it is too late. WorldCom managed to overstate profits by $11bn; Enron hid $30bn of debt. In both cases, warning signs were consistently ignored because successful businesses just don’t do that sort of thing. But they do. Elizabeth Monrad, the former CFO of AIG, explained the need to keep building profit when the foundations are unsustainable or illegal: “These deals are a little bit like morphine. It’s very hard to come off them.”

The question that the Financial Conduct Authority will now ask of Tesco’s investigation into the misstatement of its profits: for how long were some of its managers hooked?

But this isn’t just a financial crisis, as Lewis recognises: another problem for successful businesses has been recognising when doing more of the same has ceased to be good strategy. Through the 1980s and 1990s, Tesco management created a giant machine to build its business remorselessly. Even the best strategies have a sell-by date, but senior management have built their careers on the existing strategy, and so fail to spot the first signs of failure. Jim Collins and Jerry Porras analysed 18 companies in their famous book Built to Last that they argued had cracked the secret of longevity. On the 10th anniversary of its publication, seven of the 18 had run into serious problems.

Tesco’s long-term strategy was founded on the idea that it could be all things to all people, and that it knew more about us than any other retailer: it was proud that the demographic of its customers was the same as the demographic of the UK. It used this to innovate: for example in 1998 it discovered the single product that was bought only by value-conscious shoppers (Tesco Value margarine, since you ask), and concentrated discounts on the products that those purchasers also bought. At the same time it was using carefully-targeted direct mail to woo its upmarket customers to a different aisle where the goods weren’t discounted.

But simultaneously being a luxury brand and a discounter, a convenience retailer and an out-of-town destination, even when you have 20 million customers a week, isn’t always sustainable: for example, analysts note that many discount-led convenience Tesco shops are dowdy, and a poor location for the Finest range when M&S and Waitrose are on the same street.

A final problem: successful companies often have too many of the wrong managers to fix a problem. Some of the scrappy Leahy-era Tesco culture that emphasised small gains based on a flat management structure (for example, the requirement that executives regularly work in the stores, recently re-emphasised by Lewis under the title “Feet on the Floor”) remains. But many of Tesco’s current managers know only an era when the giant retailer was unquestionably number one: the sort of company that would solve a problem by buying a Gulfstream jet.

Tim Phillips

Accountants, retailers, economists and business leaders dissect the Tesco crisis in Tesco: The view from the industry




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