Beleaguered Tesco’s (TSCO) third profit warning in as many months has rocked confidence in its turnaround and corporate governance alike. Given heightened risks, we retain our bearish stance  (see Agenda, 4 Sep).

In a shock update (22 Sep), Britain’s biggest retailer warned interim profits may have been overstated by £250 million at the time of its previous profit warning (29 Aug). New CEO Dave Lewis said ‘we have uncovered a serious issue and have responded accordingly’ and four senior directors have been suspended until a Deloitte-led investigation completes.

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Last month Tesco said first-half trading profits would be 31% lower year-on-year at £1.1 billion, while also cutting full-year profits guidance, again, to between £2.4 billion and £2.5 billion. That implied a 28% annual slump against a backcloth of continuing market share loss to discounters Aldi and Lidl, as demonstrated by the latest Kantar Worldpanel data (23 Sep).

Agenda - TSCO - Sep 14

The overstatement in the UK food business is ‘principally due to the accelerated recognition of commercial income and delayed accrual of costs’, though Cantor Fitzgerald Europe argues this was a deliberate policy to maintain trading margins at a time of falling sales and rising costs. Lewis has pushed back the interim results from 1 October to the 23rd. Without a finance director since Laurie McIlwee’s April resignation, Tesco has parachuted in former Marks & Spencer (MKS) numbers man Alan Stewart early too.

Shore Capital writes: ‘These are serious times for Tesco and its shareholders. We are flabbergasted by this development and have no choice but to put our hold stance, which we only went up to through Mr. Lewis’ appointment, under review.’

With a 165p price target, Espirito Santo argues that ‘with some prices 38% more expensive (ESIB estimate) than Aldi, questionable pricing architecture and higher levels of salt and sugar in some fresh products alongside an ailing non-food business, we believe that Tesco could eventually generate zero profits in the UK – the extent of the risks to us remain large and uncertain.’

Governance failure

The £250 million profit overstatement at Tesco is a reminder that corporate governance should be at the top of every investor’s agenda. It is easy to dismiss so-called ‘soft’ considerations like business culture and accounting policy amid the focus on the ‘hard’ facts of profit and loss until a scandal like this one emerges to leave investors out of pocket. Shore Capital’s frank assessment cuts right to the heart of the issue: ‘This development may raise, indeed must raise, much more fundamental questions over the chairman’s position and the nature, composition and extent of the board, which to our minds has been lopsided between executives and non-executive directors for far too long.’ We ran a three part series on governance in the magazine in 2013 (FeatureShares, 18 Apr ‘13, 25 Apr ‘13, 2 May ‘13); we regularly look at the issue in our Fight for your Rights section; and will continue to a keep a close eye on this essential topic. (TS)

Issue Date: 29 Sep 2014