Will the Tesco turnaround plan maximise shareholder wealth?

The assumed primary objective or sole guiding principle in a shareholder owned company is shareholder wealth maximisation, that is, to act in a way which is in the best interests of its owners (Loderer et al, 2010). In my opinion this is perfectly logical given the fact that shareholders have incomplete contracts and so bear the risk that something could go wrong within the company and for this they should be rewarded. However, considering Tesco's situation over the past few months it appears they have most definitely not been following this principle. In September it was unveiled that the supermarket giant had overstated profits for the period by £263m (Financial Times, 2014). By doing this, clearly, they are not acting in the best interests of their shareholders, but what drove the executives to do this?

Agency theory is the assumption that the interests of the agents (the executives) and the interests of the owners (the shareholders) deviate from one another (Hill, 1992). Therefore there is a separation between ownership and control. This can result in managers making decisions for their own benefit to maximise their own utility rather than acting in the best interests of the shareholders by making decisions which create value. It could be argued that the executives at Tesco manipulated profits with the desire of gaining their bonuses or because they were under pressure to appear to be doing a good job and have 'rising' profits after a bumpy, poor performing couple of years. Either way, it destroyed shareholder value as shares crashed to an 11-year low and the end of year dividend was scrapped following the announcement. Clearly this overstatement was not made with shareholder wealth maximisation in mind and demonstrates how there is significant scope to destroy shareholder value through the agency problem.

But are the executives the only ones to blame? Tesco announced that at the time there was no CFO appointed after their current officer had resigned and was not due to start until December. It could be argued that the company was not being run correctly and there are potentially governance issues as well as auditor problems. However Jensen (2010) suggests that the problem lies with governments by not effectively setting rules and regulations for companies to follow to avoid these issues (Jensen, 2010), therefore suggesting Tesco are not the only ones to blame. 

So what are Tesco's plans to turn the company around and generate shareholder value?

It is only now that we are beginning to see the real effects this has had on Tesco and what they are planning to do to regain investor confidence and steps they are taking to create value.

In January, Dave Lewis, the companies CEO of five months was presented with the challenge of turning Tesco around. Lewis revealed plans to 'beef-up' their corporate finance department who will concentrate on investment opportunities, portfolio reviews and disposals in order to strengthen the balance sheet (Financial Times, 2015). Following this, plans were announced to make cost cuts of £250m which will begin by closing 43 unprofitable stores and cancelling plans for 49 new stores. Is this creating long-term shareholder value? Arguably not as they are not investing in the future of the organisation and new store openings are vital to the success of supermarkets. However I believe it is likely that shareholders will recognise that this is the only option available to Tesco given September's events and the generally poor performance of the company. Closing the unprofitable stores is an action consistent with point three of the value action pentagon which suggests that one way to create value is to divest assets from operations with a negative performance spread in order to utilise this capital more efficiently elsewhere (Arnold, 2013). This will allow capital which was previously tied up in unprofitable stores to be employed more productively. A further example of how Tesco is doing this comes after the announcement that they are closing their e-book selling service after posting a pre-tax loss of £2m on sales of just £70,000 in 2013. This business appears to have been a value-destroyer from the start for the company. Whilst they have been unable to find a buyer for this business, it further demonstrates how the company is making decisions to prevent any further damage as capital which would usually been spent within these units can now be invested more efficiently elsewhere.

However it was announced today (3rd February 2015) that Tesco are paying out £2.2m in severance pay to the former chief executive and finance director (BBC, 2015). The company suspended the payments while the scandal was investigated, however after seeking legal advice it was made clear that Tesco cannot withhold these payments. This is a further dent in shareholder value as a result of the scandal where otherwise the money could have been efficiently invested within the business to maximise shareholder returns.

Whilst some may argue that Tesco are beginning to turn their current situation around, I was shocked when I came across the below graph (Figure 1). The graph shows an increase in Tesco's EPS – great for shareholders right? WRONG. It shows that whilst EPS is rising, more capital is being employed to achieve this at ever lower returns suggesting that returns on new investments were inadequate and in most cases possibly negative. Whilst it only shows up until 2011, looking at the general trend over those 13 years I believe it is unlikely to have changed considerably. This is clearly destroying shareholder value as the capital is not being invested efficiently and is a further example of agency theory as the company is not acting in the best interests of the shareholders. It also demonstrates how one figure can make it appear that a company is performing well whilst on further investigation other figures suggest otherwise. This is why many academics acknowledge that shareholders should not solely rely on EPS to determine a company's performance as it does not always show the true picture (Rappaport, 2006).

Figure 1: Tesco's EPS and ROCE 1998-2011 (Financial Times, 2014)

 

Figure 2: Tesco PLC Share Price (London Stock Exchange, 2015)

Although it has been a very bumpy past few months for Tesco and its shareholders, looking at the company's share price (figure 2) it appears the market is regaining some confidence - shares jumped by 20% in January after the "turnaround" plan was announced. I believe the only way is up for Tesco and given the plans they have revealed, I think they are focusing on turning the company around and creating value for shareholders in the process to some extent. I think it is also worth noting that the other three supermarkets, which along with Tesco are referred to as the "big four", are also delaying expansion plans with some even closing stores. Whilst I believe Tesco is without doubt in the worst position I believe investors will gain some comfort knowing that competitors are struggling too. Nevertheless the ROCE figure over past years provides significant worry. It will be interesting to see how Tesco performs over the coming year and what further actions they take and whether they are ones which truly maximise shareholder wealth.

References

Arnold, G. (2013). Corporate financial management. (5th ed.). Harlow: Pearson
 

BBC (2015). Tesco's ex-boss and finance officer to share £2m payout. Retrieved 3rd February 2015, from http://www.bbc.co.uk/news/business-31122025
 

BBC (2015). Tesco to close 43 stores despite better Christmas sales. Retrieved 3rd February 2015, from http://www.bbc.co.uk/news/business-30712762
 

Financial Times (2014). How investors ignored the warning signs at Tesco. Retrieved 4th February 2015, from http://www.ft.com/cms/s/0/8f866d16-3280-11e4-93c6-00144feabdc0.html?siteedition=uk#axzz3QiBvu91J
 

Financial Times (2014). Tesco reveals it overstated first-half results by £250m. Retrieved 3rd February 2015, from http://www.ft.com/cms/s/0/67fb8db4-421e-11e4-9818-00144feabdc0.html#axzz3QiBvu91J
 

Financial Times (2015). Tesco to beef up corporate finance department. Retrieved 3rd February 2015, from http://www.ft.com/cms/s/0/07ed51ec-a31b-11e4-bbef-00144feab7de.html?siteedition=uk#axzz3QiBvu91J
 

Financial Times (2015). Tesco to close ebook-selling service. Retrieved 3rd February 2015, from http://www.ft.com/cms/s/0/48e6c4b4-a567-11e4-ad35-00144feab7de.html#axzz3QiBvu91J
 

Hill, C. W. L. (1992). Stakeholder-agency theory. Journal of Management Studies, 29(2), 131-154. doi:10.1111/j.1467-6486.1992.tb00657.x

Loderer, C., Roth, L., Waelchli, U., & Joerg, P. (2010). Shareholder value: Principles, declarations, and actions. Financial Management, 39(1), 5-32. doi:10.1111/j.1755-053X.2009.01064.x

London Stock Exchange (2015). TSCO TESCO PLC ORD 5P. Retrieved 3rd February 2015, from http://www.londonstockexchange.com/exchange/prices-and-markets/stocks/summary/company-summary.html?fourWayKey=GB0008847096GBGBXSET0

Rappaport, A. (2006). 10 ways to create shareholder value. Harvard Business Review, 84(9), 66-77. Retrieved from http://web.b.ebscohost.com