Tesco's hunger for land ends in tears

Britain's biggest retailer is known for stocking everything from sausages to sweaters. But according to one seasoned retail executive Tesco has added another item to its range: "A new size of kitchen sink: double extra large".

This was the view among some analysts and retailers of the £7bn of writedowns and charges, primarily for its sprawling store estate, announced by Tesco on Wednesday. They pushed the supermarket to a pre-tax loss of £6.4bn - the biggest in its near 100-year history.

By far the biggest element of the writedowns was the £4.7bn of charges for the change in the value of Tesco's property. Of this, £925m was for projects that Tesco would no longer develop. This followed its decision in January to shelve 49 store developments.

But the magnitude of the writedown has led some to question whether the impairments have been overdone.

Dave Lewis, the new chief executive of Tesco, acknowledged the scale of the impairment. "It's a big number," he said on Wednesday. "We would not diminish how significant it is."

The decision to ditch store projects is a reversal of Tesco's previous policy under which it was the most aggressive of the UK supermarkets in hoovering up as much land as possible. This was to either build stores itself or prevent rivals from doing so. The land grab reached its peak under former chief executive Sir Terry Leahy.

Tesco's land bank came under investigation eight years ago by the Competition Commission. Ultimately, Tesco won the antitrust authority's broad support.

However, Tesco was identified at the time of the probe as having a land bank of 185 sites - 4.5m sq ft of new space - that it could develop without getting permission from government regulators. For much of the past decade Britain's big supermarkets engaged in a vicious "race for space", as they sought to build stores at an unprecedented rate.

About £3.8bn of Tesco's £4.7bn property writedown was for stores that were still trading. Of this, about £2.3bn was for UK supermarkets.

The charge for ditched UK projects is not Tesco's first. Two years ago the company took an £800m hit after it identified 170 schemes that would not go ahead as it sought to scale back the construction of large supermarkets.

When it comes to existing stores, according to people familiar with the situation, for accounting purposes the value of an asset must be greater than its future cash flows adjusted for the time value of money. If this is not the case, then an impairment must be made.

There is no doubt that conditions in the UK have deteriorated for the big four supermarkets. Britain's grocers are under pressure from consumers moving away from big weekly shops at out of town superstores, and the rise of the no-frills discounters, Aldi and Lidl. Unlike the big four, the German discounters are continuing to expand aggressively.

Mr Lewis estimated that Tesco's UK business made a loss of £30m-£40m in the six months to the end of February. In the year to February 2014, the UK business made a trading profit of £2.2bn.

But one institutional investor said there appeared to have been a huge swing in the auditor's opinion of what was deemed to be a true and fair value of the store portfolio.

"I struggle to see that there has been such a big shift in the economic climate over the year to warrant such a big swing in the numbers," he said.

The Financial Reporting Council's audit quality review teams should look at the variation between the auditor's opinion last year and this year, he added.

The UK accountancy watchdog said at the end of last year it was investigating Tesco's accounts, and that would encompass the quality of the audits.

"We will only know if the writedown was excessive next year," the investor said.

Reducing the value of Tesco's property will mean that it will pay a lower depreciation bill in the next few years, flattering profits as Mr Lewis seeks to rebuild the business.

Analysts estimate that the benefit could be about £100m a year, not insignificant for a group that made almost £1bn of underlying trading profit in the year to February 2015.

And there is another reason why Mr Lewis might want to get the profits down. The company is talking to shareholders about putting in place a new long-term incentive scheme, and this will now start from a particularly low base.

Mr Lewis insisted that taking an axe to the balance sheet was driven by nothing more than the reality of the situation Tesco finds itself in - both difficult conditions in the market and its own poor performance. "There is nothing more than good objective thought gone into that," he said.

According to one person familiar with Tesco's thinking, the retailer has taken a "conservative" view, assuming no rapid recovery. But the board had performed a "sense check" on the magnitude of the problem.

They added that if there was a rapid bounce back, then values would be adjusted back upwards accordingly. And, if profits were flattered by a lower depreciation charge, any benefit would be reinvested back into the business in the form of better prices, service or availability for customers.

But not all analysts are convinced that Tesco has reached the end of its balance sheet adjustments.

According to Mike Dennis, analyst at Cantor Fitzgerald, Tesco still needs to close another 200 of its largest stores, which could mean further charges.

Tesco may yet need to stock a bigger kitchen sink.

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