Will the Tesco turnaround plan create long term shareholder value?

Maximising shareholder value is fundamentally maximising shareholders purchasing power, which implies that the ultimate measure of a company’s success is the extent to which it enriches shareholders. This is seen by increasing a company’s share price over the long term and through paying out dividends. Jensen and Meckling (1973) argued that the singular goal of a company should be to maximise the return to shareholders. Similarly, Arnold (2013) states Value Based Management is a managerial approach in which the primary purpose is long term shareholder wealth maximisation. However, in comparison, Arnold (2013) brings together the way in which shares are valued by investors, with the strategy of the firm, its organisational capabilities and the finance function. Based on the recent revelations of Tesco’s poor performance, in this blog I will highlight the flaws in Tesco's previous strategy and how the concepts proposed by Arnold (2013) underpins the turnaround plans for Tesco. 

In my opinion, if investors are using indicators such as Earnings Per Share (EPS) to assess the performance of a company, and form expectations as to how the company is likely to perform in the future, it is by no surprise that management feel the need to focus their attentions on the future rather than what really matters; their current position and their stakeholders. With such an emphasis on EPS, unsurprisingly in 2009, Tesco announced in its annual reports ‘the best way of enhancing shareholder value is to grow earnings while maintaining a sustainable level of Return on Capital Employed’ (ROCE). The results on the other hand were very different (see Figure 1).

If Tesco truly believed in their strategy, then why do the results illustrate a decreasing ROCE and a rapidly increasing EPS? Research suggests that there was inadequate cash to both invest and pay out dividends; however this problem was covered by the proceeds of the sale of fixed assets.This example demonstrates that it is possible for a company to generate a rising EPS at the same time as it is employing increasing capital at inadequate rates of return. In other words, Tesco was destroying shareholder value as it was increasing its earnings (Financial Times, 2015).

Figure 1 – Tesco: the Leahy Years (Financial Times, 2014)

This unsustainable resource of cash led to Tesco borrowing the money, demonstrating that they lacked one of the main elements of shareholder value creation – finance. Furthermore, in 2014, the BBC News reported that Tesco had predicted profits of £1.1 billion for the first half of 2014. However, due to accounting errors there had been a £250 million overestimation in its forecasts. As this news hit the headlines in September 2014, shares plunged to an 11-year low, closing at 202.75p, and then continued to fall overnight hitting a trough of 191.08p - see figure 2. This rapid decrease in share price illustrates that the market was of semi-strong efficiency (Fama, 1970), as the news was rationally being integrated into the public domain as it hit the headlines. 

Figure 2 - Share Price of Tesco during September 2014

More recently, Denning (2012) argued that pursuing the goal of maximising shareholders value produces less shareholder value than a specific focus on delighting the customer. His research concluded that shareholder value is a result, not a strategy. Denning explained that in order to rescue companies from bad habits, a phase stage is required whereby it rethinks the very basis of a corporation and the way the business is conducted. If you take care of your customers, shareholders will be drawn. With a focus on customers, there is an opportunity to build a brand for the long term rather than to exploit short term opportunities. This theory was support by the research carried out by Hillman & Keim (2001), which concluded that stakeholder management leads to improved shareholder value creation. Working for customers produces focus and motivation for organisations – enter Dave Lewis!

In order to increase long term prospects, Dave Lewis has recently been appointed the new Chief Executive of Tesco, who is determined to give Tesco a ‘cultural cold bath’ by implementing back-to-basic strategies, which supports the research of Denning and Hillman. He plans to get Tesco back to what it does best: selling a wide range of items at low prices. The previous Chief Executive’s first error was promising investors that he could sustain an operating margin of 5.2% in the U.K (The Guardian, 2015). Lewis has made no medium-term financial pledges because restoring competitiveness is his top priority. He is also ensuring that short term profits associate with an increase in the long term value of the company. In creating a clear strategy to support long term prospects, he has planned to close 43 unprofitable stores, cut back on new store openings and seek to rationalise the business by cancelling dividends and ending the company’s defined benefit pension scheme, which has a deficit of £3.4 billion (The Guardian, 2015). In the past, Tesco’s product range has arguably become over diversified, resulting in a decline in profits. Lewis has planned to sell the Tesco Broadband and movie streaming service Blinkbox to TalkTalk for an undisclosed sum. In addition, to help implement the changes, a new UK Operations Director (arrival from Halfords) and Finance Director (M&S) have also been appointed. By employing three external candidates for top management roles, I believe this will introduce a fresh perspective into the business whilst also bringing much needed experience, knowledge and a wider skill set, which in turn will strengthen the organisations capabilities of fulfilling Lewis’ Tesco Turnaround vision.

Based on the new plans, Tesco is set to report a rise in profit next year of 2%, followed by an increase of 23% in the following financial year (Yahoo Finance, 2015). If achieved, this will demonstrate a strong growth, which should change the markets view on the company and lead to a higher share price over the medium term. The results published by The Financial Times on 8^th January 2015, illustrates that shareholders are feeling optimistic about the turnaround plan as share price has increased by 15% since December (The Guardian, 2015).

I believe this turnaround plan demonstrates the strong connection between the three elements of creating shareholder value. A clear strategy, implemented by the correct people can drive success, which in turn will increase shareholder value. The proposed plans by Dave Lewis already look to deliver strong results based on the recent increase in share price - see figure 3.

 Figure 3 -  Tescos share price December 2014 - March 2015

References

Arnold, G. (2013) Corporate Financial Management. 5^th Edition.

BBC (2014). Tesco, what went wrong? Retrieved from http://www.bbc.co.uk/news/business-29716885  

Forbes (2015) How investors ignored the warning signs. Retrieved from http://www.ft.com/cms/s/0/8f866d16-3280-11e4-93c6-00144feabdc0.html#axzz3QVXabBEG

Forbes (2015) Maximising shareholder value is the dumbest idea in the world. Retrieved from http://www.forbes.com/sites/stevedenning/2011/11/28/maximizing-shareholder-value-the-dumbest-idea-in-the-world/

Hillman, A. J., & Keim, G. D. (2001). Shareholder value, stakeholder management, and social issues: what's the bottom line?. Strategic management journal, 22(2), 125-139.

Stephen Denning (2012), “From maximising shareholder value to delighting the customers”, Strategy and Leadership, Vol. 40 Iss 3 pp. 12-16. Permanent link to this document: http://dx.doi.org/10.1108/10878571211221167

The Financial Times (2014) What exactly do we mean by shareholder value? Retrieved from http://www.ft.com/cms/s/0/463abec2-9721-11e4-845a-00144feabdc0.html#axzz3QVXabBEG  

The Guardian (2015) Investors buy Tesco’s turnaround plan. But will its customers? Retrieved from http://www.theguardian.com/business/2015/jan/11/tesco-investors-buy-turnaround-plan-persuade-customerss  

The Guardian (2015) Tesco chief unveils dramatic shakeup at troubled supermarket. Retrieved from

http://www.theguardian.com/business/2015/jan/08/tesco-chief-unveils-dramatic-shake-up-troubled-supermarket

The Guardian (2015) Tesco turnaround plan: prices cut, stores to close – business liveblog. Retrieved from http://www.theguardian.com/business/live/2015/jan/08/tesco-turnaround-plan-halfords-ceo-sales-blinkbox-business-live

Yahoo Finance (2015) 5 reasons to buy Tesco Plc right now. Retrieved from https://uk.finance.yahoo.com/news/5-reasons-buy-tesco-plc-090511582.html

Figure 1 - Data retrieved from http://www.ft.com/cms/s/0/463abec2-9721-11e4-845a-00144feabdc0.html#axzz3QVXabBEG 

Figure 2 - Data retrieved from http://www.hl.co.uk/shares/shares-search-results/t/tesco-plc-ordinary-5p/share-charts

Figure 3 - Hargreves Lansdown (2015) Tesco Share Price. Retrieved from http://www.hl.co.uk/shares/shares-search-results/t/tesco-plc-ordinary-5p/share-charts