It’s not every day a company the size of Tesco – the UK’s biggest retailer – gets taken to task over its accounting policies — but it happened on Wednesday.
Citigroup reckons the supermarket giant has a more aggressive policy than its peers with regard to:
Revenue Recognition - were the IFRIC 13 standard included in Tesco’s 1Q10/11, LFL growth would have been c-0.4%, not +0.1% as reported. We find the sales evolution of International in FY09/10 odd. Fuel sales within International have been material).
Depreciation - Apply Morrison standards and Tesco would pay c15 per cent more.
Property profit allocation – These should not be in underlying earnings, in our view.
Capitalised interest expense – The main reason why Tesco’s P&L interest is consistently lower than its cash interest expense is Tesco’s capitalised interest policy. Tesco capitalised interest is equivalent to 27bp of sales last year: for Costco, another high growth freehold operator, it was 1bp, and for Wal-Mart 2bp
Pension accounting – Include the IFRS standard in underlying earnings with Morrison’s rate of return assumptions and Tesco would have had £64m lower PBT last year
and also;
Leases and customer loyalty programmes – Why should we be excluding these items from underlying earnings at Tesco, but including them at other chains?
Now, we must state quite clearly that this DOES NOT MEAN there is anything wrong with Tesco’s accounting policies. However, Citi does say that the impact of these increasingly strident policies means that its pointless comparing Tesco’s profits with those of J Sainsbury and Wm Morrison.
As such Citi analyst Alastair Johnston has recalibrated Tesco P&L account and the results are very interesting.
Here, for example, is the Alternative Tesco P&L:
If we make the seven adjustments listed above, [revenue recognition etc] some of which are just readjustments back to IAS accounting standards, then it is possible to propose an ‘Alternative’ PBT for Tesco, which would have been £2,601m in FY09/10. The £3,395m underlying PBT Tesco reported is 30% higher than our Alternative number.
Assuming a similar underlying tax rate, Johnston reckons the Alternative P&L suggests and Alternative EPS figure for 2009/10 of 24.2p. To put that figure in contact, the underlying EPS defined by Tesco for that period was 31.7p says Johnston. As such he has lowered his target price on Tesco to 350p a share, advising clients to sell.
However, the biggest danger according to Citi is that Tesco’s accounting policies, and management’s desire to be a “10-percenter” in terms of earnings growth, are influencing corporate strategy.
As Johnston continues (emphasis ours):
Tesco’s accounting has a growth bias, we think. As long as the company is ramping up growth, it can keep capitalised interest at a high level, thereby taking an immediate cash cost and spreading over an extended period and, in the process, reducing the present value of the cost. The same applies to its aggressive depreciation policy. On top of this, we wonder whether considerations about profit growth are influencing how many, and which, property assets Tesco decides to sell each year
Many investors seem to like the “visibility” Tesco offers on its earnings. The UK EBIT margin always tracks around the 6% level regardless of the impact of petrol sales (dilutive), sales-and-leasebacks (dilutive), non-food growth (accretive), IFRS (which should have cut it significantly), or other factors. Despite huge LFL swings in international markets in 2009, the trading profit margin was remarkably stable. At every results presentation, management pronounce that every division is ‘on track’ even when, like the US, they have visibly come off the rails, in our opinion. As we argue in this report, the P&L Tesco presents to analysts, owners and potential owners of the business is increasingly divorced from its operational realities, we think. This sort of “visibility” on numbers gives us no comfort: Tesco may look like it is moving forward, but we are not inclined to take appearances at face value.
Ouch.
Plenty for incoming chief executive Philip Clarke to chew on, although doubtless Tesco will say that all these points have been raised and dealt with before.
Ayway, Lots more on Tesco’s accounting policies in the usual place.
Update: 16.45 (GMT). Tesco responds.
There is nothing untoward with our accounting as Citigroup’s report acknowledges. We report in line with statutory guidelines and the accounts are externally audited. The issues discussed in the report have been gone over many times before and do not detract from our strong performance over the last year.
Related links:
Like-for-like at Tesco – FT Alphaville
Leahy to step down as Tesco chief – FT Alphaville