Why the Tesco story is part of a bigger UK retailing picture

Following today's news that the Serious Fraud Office (SFO) is moving in on the Tesco £263m auditing 'black hole', I suspect that several people I know and like will be feeling quite apprehensive at the prospect of some serious official questioning. There is something in this story - from what has emerged so far - that's rather reminiscent of the scandal that surrounded the British parliamentary expenses system a few years ago. But the numbers are, of course, bigger this time. 

In both cases, a group of people knew at least part of what was going on - and knew that others in the loop knew - but no one was talking. In the Westminster scandal, members of parliament annually pocketed thousands of pounds to cover payments for which they were absolutely not eligible. This is precisely what Tesco is accused of doing: asking suppliers for money that should only have been payable if sales of their products had been greater than they actually were. In technical terms, the accusation is that the retailer was 'bringing forward rebates': or, as an accountant might say 'claiming profits that have not yet been made'. Which sounds to me rather like the classic Israeli military term, 'pre-emptive retaliation'. 

Getting sales projections wrong is not very difficult; quite the reverse. But at Tesco, it looks as though it was happening on an industrial scale, and over several years. Profits are believed to have been overstated by £118m in the first half of 2014, by £70m in the 2013-2014 financial year and by £75m prior to that. Given the limited number of suppliers big enough to make these kinds of payments and with whom supermarkets have close relationships, it is more than likely that the retailer will have made a number of visits to the same well. (Wine-focused readers should note that as I mentioned previously, it is very likely that wine suppliers will only have been contributing in the same way - and at relatively smaller levels - as much bigger companies such as Coca Cola, Unilever and Procter & Gamble).

The SFO investigation will take a long while: the numbers are big and the stakes high. But while the wheels grind small and slow, there are bound to be increasing discussions over the nature and desirability of the 'commercial income' that lies at the heart of this saga. Some readers of own little piece may have gained the impression that I prefer the German discounter model of net sales in which the payments only ever go from retailer to supplier and not vice versa.

Far from it. In fact, I entirely understand the logic of suppliers contributing to retailers financially in the context of a strategy to build sales - and ultimately profitability - of a brand. 

The Tesco Wine Fairs are a brilliant example of how this can work at its best, with thousands of consumers being introduced to new and unfamiliar products and potentially being turned not only into customers but also unpaid brand ambassadors. Tesco's extraordinarily widely distributed wine magazine is another useful role model for others to follow. Efforts like these should be at the heart of the Joint Business Plans (JBPs) about which so much has been heard.

The JBP sounds like a very good idea. What's not to like? Well, actually, as several respondents to the piece have made clear, rather a lot. First, it naturally favours the trend towards small numbers of big retailers trading with small numbers of big suppliers. A JBP makes no sense when applied to smaller producers and importers. As Angela Mount, former wine buyer at the now-closed UK retailer Somerfield said in a recent Harpers piece, she was almost obliged to work with companies with the "most lucrative promotional strategies and marketing money". Her employers told her to "Get the brands listed who are going to give us money..."

Second, even when signed between grown ups, a JBP can be a very unequal arrangement.

In theory, the plan is supposed to represent a strategy that suits both sides of the equation.The supplier agrees a price at which they are happy to sell their wine and the retailer calculates the retail prices that give them the margins they require. If all goes well, the wine sells at the predicted rate and price and everybody is delighted. If all goes very well, the supplier will be super-delighted to share some of his extra income with the retailer who facilitated it.

Unfortunately, all does not always go well. The retailer has the power to change those retail prices as and when they please. And for whatever reason. Obviously, this might be because of the wine enjoying a slower than planned rate of sale. On the other hand, it might actually be flying off the shelves, but this very popularity might lead the retailer to want to offer it to their customers as an attractive bargain.

Obviously, reducing the price reduces the retailer margin, allowing it to reclaim its lost profit from the supplier as a rebate. These are the kinds of occasions when Mount might have had to make an uncomfortable call: "I know we did that deal but I now need another £15,000 from you."

In other words, rather like the UK being fined by the EU for having the fastest-recovering economy in Europe, wine producers can be penalised by their customers for making a product consumers enjoy drinking and believe to be good value. Suppliers can of course walk away from the table when the play gets too rough, but the world is full of wine and plenty of companies ready to adapt their modus operandi to the UK model. Like a Victorian schoolboy who keeps a book ready to stick down the back of his trousers in case of a beating from the teacher, they hold a cash reserve with which to fund retailers' unexpected calls for cash.

The point to be stressed is that nothing I have just described necessarily fits into the remit of the SFO enquiry. In other words, as long as the retailer keeps its accounts correctly, it will be breaking no rules. Whether this is all a Good Thing is a matter of opinion.

Tesco: the giant canary in the mine

'Commercial income' like 'collateral damage' is one of those attractively anodyne expressions that hides a decidedly unpleasant reality. In the UK, even some of the most sophisticated members of the business community have only just been introduced to this term that neatly covers all the cash that retailers extract from their suppliers rather than from the more expected source: their customers. 

In the US, where accounts have to reveal the origin of how businesses make their money, the credit rating agency Fitch suggests that almost all of retailers' profits - 8% of the cost of goods - now come directly from suppliers. The UK situation may be even more dramatic. If chartered accountant Duncan Smith of Moore Stephens Food Advisory Group's comments in this BBC piece are to be believed, the big four British supermarkets make £5bn in this way every year - more than their total combined pre-tax profits.

Although the reasons for doing so just now are glaringly obvious, it is far too easy to focus all of our attention on Tesco. Yes, from what we have read, there seems to be little question that Britain's biggest chain played fast and loose with the facts of if and when supplier contributions would be made, but if we set the timings aside, Tesco was far from the only attendee at this orgy. Waitrose, every middle class Brit's favourite shop (when they aren't slumming it at Lidl), also has a price list from which suppliers can choose how to make their contributions and so, apart from the pesky German discounters, does almost everybody else. 

The commercial income Tesco will have got from its Beer, Wine & Spirits department will have been significant, but readers of this article will probably somewhat overestimate the contribution derived from wine companies to the gaping hole in the retailer's projections. To provide some context, the total value of UK retail wine sales is only around twice the £2.8bn spent on cheese in 2014. However, when it comes to providing commercial income, wine will have significantly overperformed when compared to those dairy counters. Cheese is essentially unbranded; half of what we eat is cheddar of some kind, much of it sold under the retailer's own brand and bought from a small number of suppliers. So there aren't as many arms to twist. 

Wine companies in the UK have peculiarly twistable arms, given the relative impossibility of building substantial sales for a brand without passing through the shelves of the big retail chains that control around three quarters of the market. Volumes can be moved through the German discounters, but at low margins and usually under those discounters' own labels. By contrast, the more fragmented nature of the US market - and its size - allow producers who so desire, to sidestep the biggest chains altogether. 

And this is where the most important difference between the markets comes into play. In the US, wine companies have the potential to run their own marketing campaigns and to build and sustain the value of their brands. Under the UK system, they are hit with a double whammy: almost every penny of spare cash is sucked up by retailers who then regularly reduce perceived brand value by cyclical deep discounting. (Heavy price cuts are a feature of the US market too but they are less regular and predictable; when you see a product at a low price, you are more likely to grab it now for fear of never catching that bargain again). A very few, very strong, global brands such as Hardy's and Concha y Toro can buck this trend and run effective campaigns of their own, but they are the glaring exceptions to the rule.

The days when Masters of Wine travelled the world cleverly snapping up bargains wherever they found them are long gone. Today, every sale involves negotiators and quite possibly notorious Joint Business Plans which have much in common with the old days when teachers administering beatings straightfacedly told their unfortunate victims that "This will hurt me more than it hurts you". 

This may not have made the UK a particularly pleasant environment to work in - at least for suppliers who complain about having to deal with serial unexpected requests for additional cash - but, until recently, it seemed to work pretty well for anyone holding shares in the biggest chains. (And, let's face it, there are plenty of shareholders in other sectors who lose little sleep over the contributions supplier-abuse make to their dividends).

But the climate in Britain may really be changing. There are farmer-friendly parliamentarians who had a nibble at this issue a couple of years ago and seem ready to take a much deeper bite this time, and German role models who daily demonstrate that there is another way to play the retail game. A fresh parliamentary enquiry would have no reason to limit its interest to Tesco.

Quite how easy it would be for an entire national retail system to alter its diet, however, is another question...

Why Tesco's woes are raising a cheer in Germany

A small - or possibly fairly sizeable - bomb may be about to explode in the heart of UK retailing. In the wake of the revelation that Tesco, the country's biggest grocer, had overstated its latest profit warning by a cool £250m and the reported suspension of several of its top executives, there is a strong likelihood that the company may have to face some very tough questioning. And so may some of its competitors.

Adrian Bailey, Chair of the UK parliamentary Business Committee has been quoted - in International Business Times - as saying that "We may well as a committee want to look at this. Not just at Tesco but at what is going on in the retail industry and in the relationship with the suppliers to see if the issues we came across two years ago are still there."

According to 2012 House of Commons documents "In April 2008 the Competition Commission completed an enquiry of the UK grocery market, following long-running concerns that the four major chains exploited their market power to put undue pressure on suppliers and to compete unfairly with smaller retailers. Although, in the Commission’s view, the country’s supermarkets were delivering a ‘good deal for consumers’, it concluded “the transfer of excessive risk and unexpected costs by grocery retailers to their suppliers through various supply chain practices if unchecked will have an adverse effect on investment and innovation in the supply chain, and ultimately on consumers.” 

There are very few wine suppliers who would say that Britain's supermarkets no longer apply 'undue pressure' on the companies with whom they deal. Indeed most freely admit that they would greatly prefer to sell to the German discounters Aldi and Lidl, than their UK counterparts. As one said to me recently "The discounters drive a hard bargain but you know precisely where you are with them. They buy what they say they are going to buy, for the price they agree to pay".

Consumers also increasingly appreciate the way the discounters do business. Lidl is seeing annual growth of 18% in the UK, while at Aldi, the figure is 30%. Tesco, by contrast, is slipping backwards at a rate of 4.5%

Most analysis of the differences between the discounters and the established UK retailers have reasonably focused on the former chains' smaller outlets, more limited ranges and service levels - and lower margins. What few have mentioned is the fundamental philosophical gap between working practices of the two groups. The discounters, despite their size, are little different from any corner shop or market trader: they buy stuff and then sell what they have bought. Compare this with the model now applied by Britain's biggest supermarket chains - including the middle class darling Waitrose, and you might be looking at two sets of political parties, so wide is the difference between them. Coopbury, Asdrose and Morisco et al rely for part - often a big part - of their income on a wide range of payments that have little or nothing to do with the simple business of buying and selling. Some of these payments are more voluntary than others.

It was to handle the involuntary ones that a Grocery Code was established last year, along with a Grocery Code Adjudicator (CCA) in order, in the words of Farmer's Weekly magazine, 'to tackle unfair supermarket buying practices'. According to a July 2014 report in that same publication, last June's  GCA annual conference revealed that "80% of suppliers had experienced an issue with a retailer, but only 23% would consider giving evidence. Fear of retailer retribution prevented 58% of respondents from raising issues, while 40% worried the GCA would be unable to do anything."

Where the GCA has been involved, it has actually proved to be effective. Tesco apparently 'retracted requests for shelf-positioning payments' after evidence was brought to the GCA, while 'The Co-operative stopped asking suppliers to “compensate” it under joint business agreements' after the adjudicator was informed. Uncovering these practices was not easy, however. It apparently involved 'forensic auditing (retailers trawling communications to find ways to claim money from suppliers)'. Following the recent revelations, it seems fair to imagine that Tesco is about to be the target of rather a lot more forensic auditing.

Successful GCA-mediated cases are rare because, as Graham Ruddick wrote in yesterday's Daily Telegraph, "Many suppliers are too scared to speak out against a larger retailer for fear of being delisted or replaced by a rival, so they suffer in silence and agree to the unreasonable demands being placed on them."

Ruddick lists a set of recent instances that serve as an indictment of the way retailing in general is conducted in the UK, and the regularity with which retailers renegociate deals they have already agreed. In 2013, "Debenhams demanded a one-off fee - a rebate - from suppliers worth 2.5pc of its outstanding payments and said it would apply a 2.5pc discount to orders it had already agreed with suppliers" while, general retailers Argos and houseware specialists Homebase "applied a 2pc rebate to future orders". John Lewis, parent to Waitrose and every Briton's model retailer, "told suppliers last year they would be subject to a rebate of up to 5.25pc on annual sales". In May, motoring accessory retailer Halfords sought to fund a £100m turnaround plan with help from one-off payments by its suppliers amounting to up to 10% of the cost of their annual sales to the retailer. In another Farmers Weekly article, readers are warned against retailers tracking their - the farmers' - profits and using them as a basis for rebate demands they want to levy. In another context, this would sound very like the kind of protection racket operated by the Mafia.

The law has a way of dealing with gangs who threaten businesses with violence as a means of exacting cash, but it also sanctions businesses who abuse their employees. A boss can't simply demand that his workers hand over a percentage of their agreed wage in return for a - still uncertain - measure of job security.

Whether or not the world's wine suppliers will ultimately benefit from the fallout from the Great Tesco Profit Warning Scandal of 2014 remains to be seen, but I'll bet that a couple of German retailers are already raising a glass or two of celebratory good-but-very-inexpensive Sekt.