Did Tesco Cook its Books?

A profit warning on Aug. 29, three days before its new chief executive Dave Lewis joined, had overstated expected first half profit by 250 million pounds or 23 percent. This implies a class period of less than one month.

Tesco’s error was discovered by a “commercial manager”, Lewis told reporters, who informed the firm's legal counsel on Friday when he discovered it during preparations for the forthcoming first half results. Tesco's interim results have now been pushed back from Oct. 1 to Oct. 23. Deloitte and Freshfields are to undertake review of issues. Four senior executives were almost immediately put on leave.

Exactly what happened is not clear. “People familiar” with the matter said the company had been overly ambitious when predicting the sales of products in its UK food business. This in turn reduced the cash rebates Tesco receives from suppliers who pay out when certain volumes are achieved. They also said Tesco had mis-reported in its accounts the costs of “waste”, which is out of date food, and “shrinkage”, which is stolen or unaccounted for product.

Analysts questioned the board’s scrutiny of the profit warning and numbers put out by Tesco on Aug. 29, asking why that process had not revealed this latest issue.

That August 29th alert had forecast trading profit for the six months ending Aug. 23 to be in the region of 1.1 billion pounds. The new forecast of 850 million pounds means group trading profit has nearly halved from the 1.6 billion pounds Tesco recorded in the comparable period last year.

Cantor Fitzgerald analyst Mike Dennis said he had questioned last year how Tesco was supporting a 5.2 percent UK trading margin with falling sales and rising costs, drawing attention to a note he published in October entitled: “It's just an illusion.”

“In November 2013, in a morning comment titled A desperate move? and in October 2013 we published a research note entitled “It’s just an illusion”. In both we questioned how Tesco was supporting 5.2% UK trading margins with falling sales and rising costs.

“We believed Tesco had been overstating its UK commercial gross profit by £200m+ per annum, via deducting monies from suppliers’ trading accounts or extending payment dates without notice. Below is a copy of part of that update.

“How can Tesco make up for the £500m lower UK incremental sales in cost cutting when costs are rising? Logically it is not possible to say UK margins are on track, in our view. Surely we should be expecting a £100m+ UK profit downgrade. The answer is Tesco is again demanding/taking money from suppliers trading accounts.” Mike Dennis, Cantor Fitzgerald

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Other analysts expect more to come in the way of adjustments:

“The issues are due to “accelerated recognition of commercial income and delayed accrual of costs”. This is effectively timing issues, bringing income forward from future periods and delaying costs to those future periods.

“One example in which this could happen is ‘Tesco commercial director of department X is short his profit target; he/she discusses with supplier bringing forward a big promotion, funded by supplier; in return Tesco commits to doing three more new product launches in the

next reporting period.’

“If this is the kind of manipulation that happens, then Dave Lewis as a past supplier may have had good prior insight into it.

“This is the stretching of the accounts we have referred to before. Eventually these would have to catch up with them, but the poor trading results will have made it harder to hide these issues.” Bruno Monteyen, Bernstein

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“Tesco also states that some of the £250m difference is a matter of intra-year timing – in other words an element of the £250m trading profit shortfall is more properly allocated to half-two and will therefore not affect the full-year outcome.

“However, although details are lacking, it seems that this is not the explanation for the full £250m – so there is a clear implication that Tesco’s previous full-year trading profit guidance of £2.4bn to 2.5bn needs to be reduced.

“Tesco makes no comment about the level of adjustment that might be needed to full-year guidance so we cannot necessarily assume that the maximum change required is £250m.

“Tesco comments that this issue was uncovered in relation to the UK food business – it is trying to establish whether these problems have an impact beyond the core division. It does not mention any reason to be concerned but - as mentioned earlier - this situation has only just come to light so it would be wise not to rule anything out. James Anstead, Barclays

During the week of October 13th three more senior employees were asked to step aside: The prior suspensions included the, chief executive of its British business, and the commercial director. The three new executives were in charge of parts of Tesco’s British food business: the impulse-purchase unit; wines and spirits; and convenience-store operations.

The company has said it will provide an update of its investigation on October 23. The U.K. Financial Conduct Authority is also investigating the “accounting error.” Previously the Financial Reporting Council said that it is monitoring Tesco's situation following the discovery of the accounting error. However, the regulator said while it doesn't have powers to monitor or require the restatement of unaudited trading statements, the Financial Reporting Review Panel can require a company to restate its financial statements. The FRC also has the power to discipline accountants for misconduct.

We suspect there is a pretty good case now for a one month class, but as investigations continue we would expect a restatement going back a couple of years…maybe more. There certainly will be an ADR case, but the big pension funds all bought in London.

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Any purchasers of Tesco ADRs may contact Hagens Berman Partner Reed Kathrein, who is leading the firm’s investigation, by calling (510) 725-3000, emailing TSCDY@hbsslaw.com or visiting http://hb-securities.com/investigations/TSCDY. Currently it appears the investors who purchased on or after August 29, 2014 may have damages. Yet we expect that because of the nature of the error, it is likely that revenues have been overstated for a longer period of time.