Wednesday 26 October 2016

Drastic Dave's Tesco turmoil

Tesco - Britain and Ireland's biggest retailer - is in turmoil. It's announced record losses of £6.4bn with sales at its Irish arm falling by 6.3pc. New boss Dave Lewis has his work cut out if he is to turn Tesco around

Published 26/04/2015 | 02:30

EVERY LITTLE HELPS: Trading profits at Tesco’s European operations fell by almost a third to £164m last year
EVERY LITTLE HELPS: Trading profits at Tesco’s European operations fell by almost a third to £164m last year

Mr Lewis has been serving up a seemingly endless diet of bad news about the company to investors ever since he took over as Tesco chief executive last September.

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He was barely a wet day in the job when Tesco revealed on September 22 that it had overstated previous profits by £250m. Several senior executives were suspended and the UK Serious Fraud Office announced an investigation into the affair.

Tesco issued an unscheduled trading update on December 9 and shocked investors when it revealed that trading (pre-interest) profits would be just £1.4bn for the 12 months to the end of February 2015 - down from the €3.3bn trading profit recorded the previous year.

Then on January 8, Lewis scrapped Tesco's final dividend and shut 43 profitable stores in the UK. Surely things couldn't get any worse for Tesco?

Well, last week they did.

Tesco published its annual results for the year to the end of February. In the results Tesco unveiled a massive £7bn of one-off charges, including a £4.7bn write-down in the value of its stores and other property assets, leaving the group with a massive pre-tax loss of £6.4bn - the largest loss ever recorded by a UK retailer and one of the largest in British corporate history.

Just for good measure, Tesco's net borrowings and operating lease commitments now stand at a towering £17.8bn - almost 13 times its annual trading profits - and the deficit in its pension fund has hit £3.8bn.

Tesco's Irish operations haven't been spared. Sales at Tesco Ireland fell by 6.3pc to €2.56bn. In recent years Tesco's market share here has tumbled from 28.2pc in March 2012 to just 24.7pc in March 2015 and it has now been knocked off the top spot in the grocery market for the first time in decades by Musgrave's SuperValu franchise.

It would also appear that some of the problems identified by Mr Lewis in Tesco's UK business have spread to Ireland.

The vast bulk of the profit overstatement at Tesco seems to have involved payments received from suppliers who wanted their products more prominently displayed and promoted in its stores. Tesco had already set aside £145m in its half-year results to deal with this matter. This provision was raised to £208m (an increase of £63m) in the full-year results. While the results statement isn't explicit, it would appear that most of this increase came from Tesco's Irish operations.

When we put this to Tesco Ireland, a spokesperson said: "The additional amount related to income in the Irish business".

Curiouser and curiouser.

It used to be so different. When former CEO Sir Terry Leahy stepped down in March 2011 after 14 years in charge, it seemed as if Tesco could do no wrong. It was the undisputed market leader on both sides of the Irish Sea and it had apparently mastered the difficult retailing trick of successful overseas expansion with operations in Central Europe, the Far East and the US.

So where did it all go wrong for Tesco and what can be done to sort out the mess?

With the benefit of hindsight, it is now clear that Sir Terry timed his exit perfectly. Even as he was departing, weighed down with praise for his apparent success in transforming Tesco from an also-ran into the largest food retailer in the UK, and the third-largest food retailer in world, serious problems were emerging at the company.

The much-ballyhooed US expansion, Fresh and Easy, turned into an unmitigated disaster with Tesco pulling the plug in 2013. The total cost to Tesco of the Fresh and Easy fiasco has been put at £2bn.

Some of Tesco's other overseas off-shoots have also had their problems. Tesco exited the Japanese market in 2012 and folded its Chinese subsidiary into 20pc-owned joint venture the following year. Now there are reports that Tesco may offload some or all of its Central European subsidiaries.

Trading profits at Tesco's European operations fell by almost a third to £164m last year. These include businesses in Poland, the Czech Republic, Slovakia, Hungary, Turkey and Ireland. Most analysts reckon that if Tesco Ireland were excluded, Tesco's European operations made little if any profits last year. Things are looking particularly ropey for Tesco in Hungary and Turkey.

Turns out overseas expansion isn't as easy as it looks.

Tesco's problems in Europe have inevitably led to calls from investors that some or all of these businesses, including perhaps even its still profitable Irish operation, should be sold. Tesco Ireland is giving nothing away merely stating that: "Tesco Group said it would review the whole business and we're not commenting on speculation relating to various parts of the business".

The company might have been able to weather the botched overseas expansion if its core UK operations hadn't been going to hell in a handbasket at the same time. Tesco has been hit hard by the German discounters in the UK and Ireland. Aldi and Lidl now have a combined 9pc market share in the UK and almost 17pc in Ireland. The discounters' gains seem to have come disproportionately at Tesco's expense. As has been the case in Ireland, Tesco's UK market share has also been falling and now stands at 28.4pc, down from almost 31pc when Sir Terry quit four years ago.

The rise of the discounters and the post-2007 economic recession seems to have permanently altered consumers' shopping habits. They have shifted from the traditional weekly or fortnightly "big shop", where one filled up the boot at an out-of-town superstore, to "little and often", where consumers opt for lower-value shopping trips every few days.

While "little and often" suits the discounters down to the ground, it has serious implications for Tesco's huge superstores. Even after the closures announced in January, one-third of its retail floor space is concentrated in stores of 60,000 sqft or more with a further one-quarter being in stores of between 40,000 and 60,000 sqft. By comparison the average size of an Aldi or Lidl store is less than 15,000 sqft.

Which of course begs the question: did the January closures go far enough?

Cantor FitzGerald retail analyst Mike Dennis doesn't think so. He calculates that Tesco has up to 2.7 million sqft of uneconomic floor space in the UK and that it should close a further 200 of its remaining 900 full-size stores. Meanwhile Tesco Ireland has escaped the axe, at least for now, with no stores closing in this country.

It mightn't be a good idea to bet on this happy state of affairs continuing indefinitely, with a spokesperson merely saying that: "We have no specific plans to close any stores in Ireland."

With the benefit of hindsight it could be argued that Tesco has been victim of the abnormally low interest rates we have enjoyed for most of the past 15 years. With its cost of capital being so low, the quality of Tesco's investment decision-making inevitably suffered.

Would Tesco have green-lighted as many of those superstores if it had been paying more for its capital? Even worse, this excess of cheap capital seems to have encouraged Tesco to take its eye off the retail ball with its shops increasingly being seen by consumers as dowdy - and expensive.

So where does Tesco go from here? While things are undoubtedly bad, it would be a mistake to exaggerate Tesco's problems.

Tesco still retains deep strengths, particularly in its core UK market. It possesses a superb logistics system and, thanks to its Clubcard loyalty card programme, the ability to gather information on its customers that remains the envy of its peers. If it can spruce up its shops there is no reason why a slimmed-down Tesco can't remain a formidable competitor for many years to come.

But it will be a long, slow and expensive process. Tesco now finds itself in a position not dissimilar to that of the big DIY chains a decade ago. Like Tesco, they had bet the future on out-of-town superstores - many which were surplus to requirements when the market changed.

In an interview which he gave after stepping down as CEO of Kingfisher, which owns B&Q, late last year, Sir Ian Cheshire warned the UK food retailers to prepare for a long, hard slog as they tried to adjust their store portfolios to meet the new market realities. Tied in to 35-year leases signed at the peak of the boom, it took B&Q five years to cut its floorspace by 20pc. Food retailers such as Tesco can expect a similar experience.

Mr Lewis, who earned the nickname of 'Drastic Dave' in his previous career at Unilever, has his work cut out for him.

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