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Tesco tumbles on probe into overstated profits

Tesco tumbles on probe into overstated profits

Shares in Tesco (TSCO) have tumbled after the supermarket said it had overstated its expected first-half profits by £250 million.

Tesco has suspended four senior directors and appointed Deloitte to undertake a 'comprehensive review' of its accounts. Shares in the supermarket fell 7.7% to 211.9p.

'We have uncovered a serious issue and have responded accordingly,' said chief executive Dave Lewis in a statement to the market. 'The chairman and I have acted quickly to establish a comprehensive independent investigation.

'The board, my colleagues, our customers and I expect Tesco to operate with integrity and transparency and we will take decisive action as the results of the investigation become clear.'

He said a 'significant' element of the overstatement was linked to timing issues, with income recognised too quickly in the guidance, and costs delayed.

Lewis said in a conference call this morning the profit overstatement was brought to his attention by a whistleblower on Friday afternoon. The supermarket had said it expected profits of £1.1 billion for the six months to 23 August.

Tesco will report back on progress of the investigation when it issues its interim results on 23 October, rescheduled from 1 October.

Tesco shares have lost a third of their value over the course of a torrid 2014 for the company, which issued a profit warning in July and last month slashed its half-year dividend, as it brought in Lewis a month earlier than planned to replace Phil Clarke.

Fund managers cling on

Contrarian investor Alastair Mundy (pictured), who holds Tesco in his Investec UK Special Situations, Investec Cautious Managed and Temple Bar (TMPL) investment trust, said the shock announcement should prompt the supermarket to refocus on its core capabilities.

'We think this is good as it probably brings forward mass simplification of the group - i.e. selling things like [garden centre chain] Dobbies, closing things like [TV streaming business] Blinkbox and focusing 100% on how to take on the discounters,' he said.

'We think a focused price war on where discounters make their money is a likely outcome - it won't be pretty but [I] still believe Tesco has got more chance than most of coming out on top.'

Hawksmoor's Jim Wood-Smith meanwhile described the revelation as a 'shocker' but said it had not swayed his long-term conviction about the stock.

'Shareholders have every right to feel extremely aggrieved,' he said. 'Tesco has extraordinary potential, but it may take longer to break free of its legacy issues than I had hoped. We are getting close to the bottom and I have even more confidence that the current opprobium towards Tesco will prove to be a fantastic opportunity. In time.'

Analyst angst

Shore Capital analysts Clive Black and Darren Shirley, who had rated Tesco a 'hold', placed their recommendation under review. 'These are serious times for Tesco and its shareholders,' they said. '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.'

Marc Kimsey, senior trader at Accendo Markets, added: 'Tesco is no longer a viable investment. Traders are clearing the books of all holdings and reallocating funds in sector peers. The last two years have tested investors' patience but with the dividend being cut back and today's revelation, justification to hold is non-existent.'

Espirito Santo analyst Rickin Thakrar cut his fair value price for the stock to 165p from 190p and reiterated the investment bank's view that Tesco's UK profits could evaporate. 'With some prices 38% more expensive than Aldi, questionable pricing architecture and higher levels of salt and sugar in some fresh products alongside an ailing non-food business, we believe Tesco could eventually generate zero profits in the UK - the extent of the risks to us remain large and uncertain.'

Jefferies analysts said today's share price falls appeared 'a fair reflection ahead of a more complete picture'.

'This is unlikely to be systematic, in our view,' the said. 'We suspect this is a relatively new issue at Tesco, rather than a small practice affecting the business over a number of years (one of the personnel allegedly suspended was appointed to his senior role in January 2013).'

'Value trap' warnings

Investors have been fleeing Tesco this year after its dismal performance, but Mundy and Wood-Smith are not the only fund managers to have retained the supermarket on hopes it will be able to turn around performance. Citywire Selection pick Schroder Income Maximiser, run by Thomas See, has the stock as a top 10 holding, while Citywire AA-rated Clive Beagles and James Lowen, manager of the Citywire Selection star pick JOHCM UK Equity Income fund, are also investors.

But while some contrarians have been investing in Tesco as the shares have fallen, others, such as Citywire A-rated Jeremy Lang (pictured), manager of the Ardevora UK Income fund, have deemed the supermarket a value trap.

'The issue for Tesco, as well as for similar chains, is it tries to do everything: cheap food, expensive food, clothes, toys - but it ends up doing nothing particularly well,' he said last month. 'Our interpretation of how management is behaving through its balance sheet and investment decisions is that it is in a state of denial.' 

Citywire A-rated Terry Smith, manager of the Fundsmith Equity fund, meanwhile outlined in the Financial Times earlier this month his reasons for shunning the stock. He pointed to the company's declining return on capital employed, even during Terry Leahy's tenure as chief executive, over which time the shares performed strongly.

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