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Tesco implodes

If you thought things couldn't get much worse for supermarket chain Tesco (TSCO), think again
September 23, 2014

Tesco (TSCO) is really in a pickle. If you thought things couldn't get much worse for the blighted supermarket, think again. Following a string of profit warnings and the decision to slash the half-year dividend by 75 per cent, it has now emerged that the UK's biggest grocer has been engaged in what can only be described as unorthodox accounting practices to mask weak trading.

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The new management team, headed up by former Unilever (ULVR) executive 'drastic' Dave Lewis (a name earned after restructuring Unilever UK in 2007), announced that guidance issued by Tesco at the end of August had overstated half-year trading profit expectations to the tune of £250m, due to some creative accounting in the UK food business. That means profit will now come in at £850m, down from the £1.1bn expected by the markets and nearly half of the £1.6bn reported last year. Mike Dennis, a retail analyst at Cantor Fitzgerald, says this implies profit at Tesco UK could be down by as much as 55 per cent to £500m on sales of £21bn, equating to a UK trading margin of 2.3 per cent, down 280 basis points year on year. "The read across is that Tesco may now have to sell assets across its UK and overseas portfolio to pay for its behaviour," he warns.

In a statement, Tesco said the error was "principally due to the accelerated recognition of commercial income and delayed accrual of costs. Some of this impact includes in-year timing differences".

So, what on earth does "accelerated commercial income" and "delayed accrual of costs" actually mean? We asked the same question. Mr Dennis reckons Tesco has been "acting inappropriately towards its suppliers", by targeting their trading accounts in a "well organised" fashion for years. He believes Tesco was paying suppliers for the cost of goods, but for less than the cost price agreed, with the aim of keeping as much cash as possible. If the supplier objected and no agreement was reached, Tesco would repay the sum, but much later. That means the timing of such repayments could artificially book additional cash profit as 100 per cent trading profit, only to be repaid in a future trading period. "This is not at all an accounting issue, but more a behavioural issue instilled by previous management into the trading and commercial teams to maintain stable UK trading. The point is that this was a well-known practice within Tesco and we believe it had been going on for at least a year and became more desperate as sales fell further," he said.

In response to the revelations, the shares have taken a hammering as analysts have slashed profit forecasts. David McCarthy at HSBC cut his pre-tax profit forecast for the current financial year by 14 per cent. He also suspects Tesco of artificially hiding a rapid fall in gross margin and pushing costs into next year that should be carried this year. "Whether these are cash costs or non-cash is unknown at this stage. Investing in Tesco is investing in the unknown and is high risk," he said, adding that a rights issue was "not out of the question".

The accounting error raises the question of whether more such irregularities might be unearthed in the next few months. It's certainly possible. We've previously pointed out that Tesco's guidance has grown increasingly unreliable and now it appears the real underlying level of profitability is anyone's guess. The news has led to the suspension of four senior executives, including UK managing director Chris Bush, while Marks & Spencer (MKS) has generously released finance director Alan Stewart early so that he can get to work at Tesco straight away.

For The Trader Nicole Elliott's views on the Tesco share price, click here.