October 2, 2014 / 6:08 AM / in 3 years

Tesco's 250-million-pound black hole: Who was minding the shop?

LONDON (Reuters) - “Things are always unnoticed, until they’re noticed,” Tesco Chairman Richard Broadbent said when asked how Britain’s biggest retailer had failed to spot a 250 million pound ($410 million) sized hole in its first-half profits.

Shopping trolleys are seen at a Tesco Express in southwest London September 22, 2014. REUTERS/Luke MacGregor

It was an oversight that led to a 4 billion pound drop in Tesco’s TSCO.L market value and the suspension of four senior executives. The newly installed CEO called in forensic accountants and lawyers to find out what went wrong.

Whether conspiracy or cock-up, the scandal raises doubts over the management and financial oversight at Britain’s largest private sector employer, now in the midst of the gravest crisis in its 95-year history.

“That whole finance organization must be in a world of hurt given what has gone on. The rigor and analysis and the focus seems to have fallen away a little bit,” one former UK Tesco director told Reuters on condition of anonymity due to the sensitivity of the subject.

Tesco had once appeared unstoppable, boasting two decades of uninterrupted earnings growth as it bulldozed its way to dominance. Things began to go wrong in 2011.

It has now issued three profit warnings in two months with the latest causing the most alarm - the overstatement of its half-year profit forecast by 250 million pounds due to the early recognition of payments by suppliers and the pushing back of costs.

Investors, analysts and some former employees are questioning whether an aggressive culture influenced the way the company handled its finances - especially when trading slowed - and perhaps prevented staff from coming forward to warn that the numbers no longer stacked up.

Tesco has declined to comment on what may have happened until a review has been completed but chairman Broadbent has described it as “something completely out of the ordinary”.

The revelation has also sparked scrutiny of the upper echelons of the company. The senior executives who ran Tesco during its glory years of the 1990s and 2000s have all left and the board lacks retail experience.

“The chairman has been the leader of this organization that seems to have failed at every turn,” said David Herro of large Tesco investor Harris Associates.

Four former senior Tesco executives have told Reuters that during the 2011-2014 CEO tenure of Phil Clarke, he repeatedly clashed with directors, who found him reluctant to take advice. During that time four of the company’s most senior executives quit, taking a combined 109 years of experience with them.

Clarke has declined to comment on his management style but defenders of his record point out that he was battling the most difficult market conditions in decades.

The company’s head of digital told a conference this week Tesco was too big and complex to be run by “one general”.

WHO‘S IN CHARGE?

People outside the company have many questions - not least who has been signing off on profit forecasts in the last three months which turned out, quickly, to be wrong.

By the time the group issued the second of its recent profit warnings on August. 29, Clarke, a 40-year Tesco veteran, was technically still CEO but was working his notice while Laurie McIlwee, the firm’s chief financial officer since 2009, had quit on April 4. McIlwee declined to comment for this article.

“It seems unbelievable that a retailing colossus like Tesco should not have a full-time finance director,” said Adrian Bailey, head of parliament’s business committee.

Tesco’s finance function had been further weakened in June when Mike Iddon quit as Tesco’s group finance director, planning, treasury and tax.

Tesco says that after McIlwee’s resignation on April 4 it set up a group of senior finance personnel, reporting directly to Clarke. However the company has declined to say who was in that group and Clarke was himself working down his notice.

“What was the board’s scrutiny of the (second) profit warning (on Aug. 29) and numbers that they put out, because you would expect it to be extreme?” asked one retail audit committee chairman, in reference to the profit downgrade and 75 percent cut to Tesco’s interim dividend.

“If you’re a non-executive director and you’re being asked to put out those kind of profound numbers and you’ve got no finance director and you’ve got no CEO to stand beside them, how do you know they’re right?”

OVERLY AMBITIOUS

Tesco said the 250 million pound overstatement principally related to its supplier contracts within the food business of its UK division - its home market which generated 48.2 billion pounds of revenue in 2013-14.

People familiar with how Tesco operates said it had been overly ambitious when predicting sales. As they then slowed, the cash rebates paid out by suppliers as incentives also dropped.

Tesco has declined to comment but said it is investigating the accounts. New CEO Dave Lewis has told staff the firm’s culture needs to change.

The former UK Tesco director believes the accounting mistake could have come about due to the combination of a loss of experience in the finance department and the fact that the business is now shrinking.

“You had a business that used to be growing and had algorithms that worked,” the former director said. “When the business is flat to declining and you don’t really know how much you’re declining by, you can get that wrong very quickly.”

During two decades of uninterrupted growth Tesco had rarely made a mistake with its numbers - it issued its first profit warning in living memory in 2012 as the competition ramped up.

However, analysts and shareholders have more recently raised concerns that Clarke and his colleagues had instilled a more aggressive approach as pressure to revive the business increased.

Bernstein analyst Bruno Monteyne, who was previously a supply chain director of Tesco Asia, said managers - possibly under pressure to improve earnings - might have brought forward promotions and the right to book supplier rebates.

Tesco declined to comment.

Cantor analyst Mike Dennis, who last year questioned how the company could be maintaining its trading margin at a time of falling sales and rising costs, noted that staff had been incentivized via share schemes to maintain the measure.

PwC [PWC.UL] Tesco’s auditors since 1983, had highlighted the rebate issue in its 2013-14 report as an “area of focus” due to the “risk of manipulation”. Broadbent says Tesco’s finance function was “working well with considerable oversight”.

THIN ON TOP

Analysts and investors have pointed out that the board is now very thin on retail experience. Broadbent, chairman for almost three years, was a former public official and banker.

Others on the board have experience in telecoms, media, finance and cars, while Patrick Cescau, the board’s senior independent director, is a former chairman of Unilever ULVR.L, one of Tesco’s biggest suppliers.

“In a situation such as this, the buck stops at the board,” said Guy Jubb, head of governance and stewardship at Tesco investor Standard Life Investments.

Having drafted in the replacements for Clarke and McIlwee earlier than expected, the board now has two executive directors in the form of new CEO Lewis from Unilever and CFO Alan Stewart, formerly of Marks & Spencer MKS.L. Stewart was appointed during the time of former CEO Clarke.

Tesco declined to comment on the retail experience of its board, or on who was involved in the planning of the Aug. 29 statement. Trading statements do not have to be checked by an external accounting firm.

But the numbers are now being pored over.

A swathe of managers have had to hand in their laptops and phones as part of the internal probe and Britain’s Serious Fraud Office has said it is watching events closely.

The country’s financial regulator, the Financial Conduct Authority, has launched a full investigation and lawmakers are also considering whether to grill past and present executives over the error.

(story refiled to fix typo)

Additional reporting by Dominique Vidalon in Paris and Tom Bergin in London; editing by Janet McBride

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