In short, Tesco failed to adapt from the change from the space race competition to a competition based on differentiated retail offers. From 1995 to 2007, Tesco won the space, laying down more big stores, having the widest range and trying to appeal to every customer segment in every store. Since 2007 however the nature of competition has changed, we have moved from consumers having a choice of 2 stores per local market to 3 stores (with the most growth in discount: Aldi+Lidl; and quality: Waitrose+M&S Food); and with this there has been an increased need to differentiate.
However rather than differentiate and have a compelling offer for a particular segment of the market: Tesco tried to preserve earnings growth in three ways:
1. It raised supermarket prices faster than any competitor, this left a value vacuum that the discounters were only too willing to fill
2. It added more and more bolt-ons: both trying to replicate the space race wins in the UK in other countries (leading to tail-between-the-leg withdrawals from China, Japan and USA) and other avenues: Hudl, Giraffe, Blinkbox. Meaning less and less focus from senior management on the core (and it remained the core) UK estate
3. It began to stretch its accounts: there was a shift in costs from SG&A to depreciation implying more capitalised costs, it used break clauses to hide operating leases, it didn’t include the full underlying costs of its pension in its underlying earnings and upon the exit from China it did not take the necessary full right down (more recently this was partly rectified with an impairment). The recent accounting scandal shows there are perhaps more gremlins in its accounts used to stretch earnings during the downturn.
All the while its supermarket estate was losing out to Aldi, Waitrose etc, because it did not have an offer that promised either great prices or great quality and these options were now available on the doorstep for more and more consumers.
Was it an audit failure?
So far the only thing disclosed by Tesco is that their guidance for H1 profits was inflated. H1 accounts, let alone guidance, are not audited and therefore we cannot conclusively conclude there has been an audit failure at this stage.
However, in the Tesco annual report the risks related to commercial income were flagged both in the audit report and in the audit committee report (the latter almost by exception: stating that it wasn’t in fact a risk
“The committee notes that commercial income was an area of focus for the external auditors based on their assessment of gross risks. It is the Committee’s view that whilst commercial income is a significant income for the Group and involves an element of judgement, management operates an appropriate control environment which minimises risks in this area. As a result, the Committee does not consider that this is a significant issue for disclosure in its report”)
Despite these assurances and the auditors highlighting the issues, something clearly went wrong, whether it was just in H1 this year or was a more long standing issues we can’t yet say for sure.
Was it inevitable with so liitle leadership?
Not having a CFO will certainly not have helped as there would have been no one highlighting any finance issues up to the board level. The succession plan was not as good as was believed, as we had been led to expect that Lawrie McIlwee was assisting behind the scenes when in fact he has not been present since his resignation in April. Tesco originally would have been without a CFO and with only one executive board member for 8 months.
The succession plan was not as good as was believed, however, Tesco should be praised for the speed with which they have reacted to the bad news:
- Straight after the 2nd profit warning the CEO was parachuted in early
- After the account scandal broke, the CFO was parachuted in early.
Were senior executive rewards too focused on share price?
There may be some element of that, that as earnings growth began to slide (or become negative), there was a willingness to smooth out earnings (by taking certain judgements in accounts, there is always a fuzzy grey line when it comes to judgements on commercial income), hoping they would pick up eventually and the smoothing would fall out. Then as trading results got worse, any judgements became less grey and more black and white; leading to the eventual current issues.
Interestingly, I don’t think many in the city were focussed on the short term results for Tesco. They know they are going to be bad and the different between 45% down and 55% down would not be overly consequential. People assessing Tesco at present need to look at the long term profitability, where can it be in 5 years time in terms of market share and trading margin. We all know we are going down the valley at the moment, but it matters less what the height of the bottom of the ravine is and more what the eventual height of the mountain the other side.
Senior executives were not paid based on share price directly (although obviously they do have share options). We believe this was more about preserving certain other metrics, both internal (profitability of certain divisions) and external (eps growth etc.)
Bruno Monteyne, senior analyst in food retail at Sanford C Bernstein and a former Tesco executive