January, 2016

Opinion

Tesco And The GCA Report: Policies That Seem To Harm Suppliers May Harm Tesco Most Of All

There is a new investigative report by the UK’s Groceries Code Adjudicator out on Tesco. The many investigations of Tesco remind me of an Internal Revenue Service (IRS) investigation that took place many years ago on the Hunts Point Market, New York’s main produce market, when this columnist was just a boy. The IRS had got wind that there was a lot of cash business done on the market and that owners were pocketing cash and not paying their taxes. So armed teams showed up one morning at the largest wholesalers – of which my family was one – seized records and began interrogating employees. The IRS commenced an audit of several years of our company’s taxes.

It was disruptive to our business, of course, but after a few weeks of intensive investigation, we were given a clean bill of health, our records were returned and the audit closed with “no changes”. The agents assigned figured they must have been wrong about all the untaxed income and went on to other things.

In reality, they were 100% correct about the cash sales and unreported income. The problem was that they didn’t know enough about the business to know how to effectively investigate and who to investigate. In Hunts Point, the largest firms, such as that owned by my family, had lots of employees accepting cash. Very often the owners worked mostly days, while the trading was mostly happening at night, so the owners of the larger firms were more concerned about being ripped off by their own employees than they were concerned about the IRS taking its share.

So our family business, and other large wholesalers, had elaborate systems to make sure that all cash was accounted for. We had cashiers 24 hours a day to make sure no salesperson ever accepted cash. We had cameras, daily inventory reconciliations and other controls.

If the IRS was actually going to catch unreported income, it needed to audit not the largest firms but the firms where the owner was on the loading dock, doing the sale himself and putting the cash in his pocket.

Equally, all of the investigations of Tesco, whether this latest by the Groceries Code Adjudicator, those related to profit overstatement, or the investigations by the Serious Fraud Office and Financial Conduct Authority, could well suffer from not having enough inside knowledge of the business and industry to even know where to begin their investigations.

Tesco has advised its suppliers to be 100% honest in answering all enquiries made by the authorities. That is different, though, than asking suppliers to be aggressive in helping the authorities ask the right questions. Without the aggressive intervention of suppliers and without hiring industry experts and veterans of Tesco and its supply base to assist with these investigations, it can be expected that much that could be known will never be known.

Everything that was reported about Tesco in the GCA report happens all the time in America – the big difference being that it is typically a more voluntary agreement; indeed, for those suppliers in a position to cooperate, one could call it a business opportunity.

For example, an important focus of the GCA report is that Tesco would demand payments from suppliers to meet its own financial targets:

Some suppliers reported that what set Tesco apart from other retailers was the pressure it put on suppliers at the end of a financial quarter, half-year or full-year to close a JBP [Joint Business Plan] to the margin projected in that JBP. I have seen internal Tesco documentation which suggests that Tesco purposely over-estimated the margin gap on one supplier’s account in order to meet a wider category target, and the supplier was told that this gap needed to be closed.

Although margin goals were entirely aspirational, not legally binding and not in the control of suppliers as Tesco sets the retail price, Tesco allegedly tried to put the pressure on suppliers to come up with money:

In the January 2014 internal training material, Tesco also set out how buyers should respond if suppliers resisted requests for payment to close percentage margin targets. The document recommends that buyers tell suppliers that the “aspirations have always been understood by us and treated by us as commitments that should be honoured”.

I have also seen internal Tesco correspondence suggesting that suppliers should be held to their JBP margin percentage target even where sales were lower than those envisaged in their JBP. The correspondence listed possible ways to achieve half-year targets which included “Holding suppliers to JBP margin % even when sales adverse to joint plan”.

In the States, a category manager who is sweating it out making his quarterly profit numbers might turn to his major supplier and explain the problem. The supplier might give a credit and save the buyer from this difficult situation, and the supplier comes out the hero. Indeed, many suppliers have said they have bailed out buyers, but that, though not required and a short-term profit hit, was the best investment they ever made. They report they sometimes kept the business for decades more or got a little extra on price because of the loyalty that one-time sacrifice engendered. It wasn’t a corporate matter though, it was personal. The buyer got bailed out and never forgot who had his back. Sometimes that buyer was thanking the vendor with business from two jobs later in his professional life.

But just as one can only be virtuous if given a chance to sin, so to, if Tesco just asserts the right to these things and demands them from suppliers, then the suppliers can’t get any benefit out of cooperating.

The extent of the margin payments to Tesco was sometimes large:

The amounts requested by Tesco in order to maintain its margin were often significant, for example:

(a) I have received evidence that a number of suppliers made margin payments to Tesco of over £1 million;

(b) I reviewed internal Tesco correspondence noting that a supplier had paid over £800,000 in margin maintenance for a half-year period; and

(c) I am aware of one example when a seven-figure sum was unilaterally deducted from the supplier in order to meet a JBP margin target.

It is, of course, possible that these are huge suppliers and they bent to pressure and paid these fees because they feared being delisted. But it is also entirely possible that there was a quid pro quo and that the suppliers made the payments in exchange for commitments by the buyers to accept higher prices or give the vendors proportional opportunities that normally would be paid for.

It is not at all certain that the GCA has its pulse on the market close enough to catch these sorts of transactions, yet they are very important. If a public company, such as Tesco, induces a supplier to reduce its costs in one quarter so as to meet a financial target, with costs being transferred to another quarter, that is defrauding stockholders.

Even if there is no explicit quid pro quo, if there is an understanding that in the end Tesco will make sure the supplier is OK, there could be legal issues that the Serious Fraud Office might investigate. We raised some of these questions in relationship to Tesco’s acquisition of UK supplier transplants that it had encouraged to open in the USA in conjunction with the Fresh & Easy rollout in a piece in the Perishable Pundit titled: Tesco Puts Up “Tens of Millions” And Purchases British Transplants Wild Rocket And 2 Sisters Foods — Was A Secret Promise Made To Make The British Suppliers Whole? Did This Constitute Fraud Against Its Own Shareholders?

Some of the GCA report is unclear. For example, the report states:

I have received internal Tesco emails which encouraged Tesco staff to seek agreement from suppliers to the deferral of payments due to them in order temporarily to help Tesco margin.

It is not obvious what this means. If suppliers are not paid in a timely way, voluntarily or involuntarily, that has no effect on Tesco’s margins. Tesco is not on a cash accounting system, so it accrues whatever is owed, regardless of when it actually pays that bill.

The report details many other situations when Tesco made life difficult for suppliers – for example, if a payment was due, instead of just sending a cheque to the supplier, Tesco buyers would try to hold the money by negotiating its use for a promotion, etc.

Yet in total, despite the press claiming the report as a major indictment of Tesco, the report was a kind of thin gruel. Tesco is an enormous operation, which means it does a lot right and a lot wrong every day, and if this is the worst they can find about Tesco’s practices, Tesco is not really doing such terrible things to suppliers.

The more interesting thing revealed in this report is what Tesco is doing to itself, and in this report we can easily see three keys to Tesco’s problems:

First, justified or unjustified, if Tesco is sometimes demanding large payments from suppliers that were not contemplated in the original agreement, or if Tesco is not paying as agreed for product or other payments due, this does not just hurt suppliers, it hurts Tesco. Smaller companies, unable to handle these issues, won’t sell to Tesco, so the consequences of Tesco’s demands is that Tesco constrains its own supply chain and it can only buy from those willing and able to withstand the vagaries of such a relationship.

This means that Tesco doesn’t always have access to the best product and that it doesn’t have as many suppliers competing for its business, which would ultimately lead to less satisfied consumers and higher prices paid for goods.

Second, the report reveals an obsession with meeting margin goals when, of course, the important goal is total profitability, not high margin. In this obsession, one gets a hint of why Tesco has had so much difficulty in competing with the hard discounters. If everyone is focused on margin, then a low margin line that increases total sales and profits by attracting discount-oriented shoppers will fail because it will be de-emphasised in store, since it will be reducing overall margin.

Third, what this report reveals is all too many people at Tesco are working on financial trickery rather than effective procurement, marketing and merchandising.

Right now Tesco is focused on the PR impact of this report and promising to improve supplier relationships. Yet Tesco’s future depends on it drawing different lessons from the report:

  1. To be a reliable buyer who uses its financial resources to pay promptly and reliably so as to attract the broadest possible range of vendors.

  2. To focus on total profitability – not look to increase margins but to make more money.

  3. To keep executive talent focused on core success strategies: effective procurement, marketing and merchandising. Nobody should be looking to plump up earnings through financial manipulation.

If it reads these messages between the lines of the report, Tesco will find this public shaming to be the start of a successful future.

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