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Is the accounting scandal a bottom in pessimism towards Tesco?

CMC Markets

22nd October 2014: Tesco the UK’s largest supermarket, issued its first profit-warning in 2012 for twenty years. Fast-forward to 2014 and several quarters of declining revenue and market share caused Chief Executive Philip Clarke to lose his job. No sooner had new CEO Dave Lewis settled in, that Tesco went from stalling into a tailspin, when it was revealed the company had overstated its half-year profit guidance by £250m. The Financial Conduct Authority has initiated a full-scale investigation into the profit overstatement and its investigation will be a weight around the neck of Tesco shares until completed. With a new scandal erupting in South Korea with respect of the illegal sales of customer data, the problems seem to be piling up for new CEO, Dave Lewis. He can only hope to win back investor confidence with his own investigation into the UK scandal, using Deloitte and the law firm Freshfields to offer a clear explanation on why the profit misstatement happened and why it won’t happen again. Hopes of a sale of the Korean operations could well draw a line under that particular problem. Tesco’s share price is down 46% year to date, having lost over 20% since the accounting scandal broke. Investors are already pricing in the worst so if it turns out that the loss is a lot more than £250m and/or it is deliberate fraud, then Lewis would be better off having Tesco come clean while the share price is down. If properly handled, the accounting scandal could mark the turning point for Tesco. Olympus, the Japanese camera-maker was at the centre of the biggest corporate accounting scandal in Japanese history. Olympus stock plunged 80% in two months from October 2011 when the news broke but despite multiple regulatory investigations, never looked back and is now at its highest since 2007. In fact, Dave Lewis would do well to throw the kitchen sink at reforms in most areas of the business. More changes in personnel at the management and board level would increase confidence that more of the same is not on the cards. Tesco has slashed dividends. The dividend cut is a good sign management appreciate the scale of the problem; the funds can build the kind of war chest needed to turn Tesco around. The problem is that shareholders will be left with a distinctly lower yield and without a key reason to maintain their holding. Tesco in the last few years has sacrificed return on capital employed for expansion, even running loss-making operations like Fresh and Easy in US. The recent release of a tablet to compete with the likes of Apple is too far from its core business and epitomises where Tesco is going wrong. If Samsung is finding the tablet market tricky, Tesco might be advised to stay clear. Peripheral business ventures including overseas stores, the online video streaming service Blinkbox as well as Dunnhumby, which runs the supermarket’s club card marketing business should get the chop if they are not generating sufficient margins. That extra cash can be a buffer against future dividend cuts. It’s well known that Tesco as well as Sainsbury’s and Morrisons are facing stiff competition from Aldi and Lidl. Aldi and Lidl have had stores in the UK for two decades but became a lot more ubiquitous in the last few years when more cash-conscious consumers sought out cheaper alternatives to major supermarkets during the recession. Studies have shown that the majority of customers have not shifted one hundred per cent of their shopping from Tesco to Aldi, rather just started shopping at both as well as using other sources including shopping online. Consumption habits have changed so there is no going back for Tesco; the company needs to adapt through the use of online shopping, convenience stores and perhaps different brands with different pricing models. Tesco’s shares are down heavily thanks to the profit misstatement; this normally might bring on speculation of a take-over bid. The risk associated with acquiring one of the UK’s biggest retailers with possibly more disgrace to be unearthed would likely be too much for most potential buyers. The accounting scandal should mark the bottom in pessimism for one of the UK’s pre-eminent businesses as it did for Olympus in Japan. But to do this Tesco need to change the management dynamic, secure the dividend and streamline their business into core, complimentary services that give customers the kind of diversity in price and service they now expect from their grocer.

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