There is no immediate change to our £3 fair value estimate or our Standard stewardship equity ratings for Tesco (TSCO) following the announcement that the company had identified a £250 million overstatement of its expected trading profit for the first half of the year, which it estimated as £1.1 billion on August 29.
Management attributed the overstatement to accelerated recognition of commercial income and delayed accrual of costs. CEO Dave Lewis has confirmed that four Tesco employees have been asked to step aside while tax advisor Deloitte, but not current auditor PwC, and Tesco's external legal advisors Freshfields review the issue. Management also noted that it is also working to establish the extent of these issues and the impact that they might have on full-year trading profits, which the company previously forecast at between £2.4 billion and £ 2.5 billion.
Until we have greater visibility as to whether the overstatement was isolated to the six-month period ended August 2014, we aren't planning to make material changes to our model. A GBP 250 million reduction to our current full-year trading profit assumptions would only have a minor impact on the long-term cash flow assumptions underpinning our fair value estimate. However, if the accounting issues prove to be more severe than management has disclosed or stem from a lack of corporate oversight, there could be more meaningful changes to our valuation assumptions or our stewardship ratings.
Although shares appear undervalued based on our long-term discounted cash flow model, which assumes a gradual return to low-single-digit revenue growth and normalized trading margins in the low to mid-4% range, we believe investors must have higher risk tolerances and longer investment horizons given the timeframe needed to better position this no-moat company to better compete with discounters Aldi and Lidl in the U.K., high-end grocer Waitrose, and ongoing customer migration to the convenience and online channels.
