In my last blog, Weighing up M&A, I talked about how the stock market’s initial reaction to takeover deals can often be a poor indicator of how those deals may work out. I referenced the market’s sceptical response to Sainsbury’s purchase of Argos owner, Home Retail group. We now have another unexpected deal in the supermarket sector with Tesco bidding to take over Booker, the UK’s largest food wholesaler (they call it a merger).
The initial reaction of the stock market was far more enthusiastic with Tesco shares rising 9% and Booker by 16%, compared to a 5% fall in the Sainsbury share price when they announced their interest in Home Retail Group. But will this turn out to be a great deal, or will the market’s enthusiasm prove premature?
Before I give my thoughts on this, I will reflect a bit on the past. In some ways, the fact that this deal is being proposed is quite extraordinary. In my blog – the Elephant and the Goldfish – I talk about how the “elephant” investor needs to have a good memory to “be able to learn from experience, to draw parallels with history and to avoid getting sucked into the numerous investment fads that often end in tears”.
In the early 2000’s, I remember Booker being seen as a challenged business. The powerful supermarkets were growing fast and rapidly expanding into the convenience food market. Ironically, Tesco were leading the charge, adding over 100 Tesco Express stores in the year ending February 2006, taking the total to over 650. The small independent convenience shops were finding life difficult, and Booker, as a leading supplier was also suffering.
Booker’s (stock market) Admission document of May 2007, states1; ‘The results for Booker Holdings in the six months to 16 September 2005 showed a fall in sales of approximately 5.9 per cent., a fall in EBITDA of approximately 41.0 per cent. and a fall in operating profit before goodwill amortisation, goodwill impairment and exceptional items of 54.0 per cent.”
In contrast, I recall Tesco being seen as one of the strongest growth businesses in the UK with an extremely well regarded management team. Tesco’s results for the year ending 25th Feb 2006 demonstrated its formidable success2; “For the full year on a 52-week basis, Group sales have increased by 13.2% to £41.8 billion and Group profit before tax has grown by 16.7% to £2.2 billion….The full year dividend is up 14.2% broadly in line with earnings per share”
How times have changed. Tesco’s subsequent history and fall from grace is well known. The food retail industry over-expanded, and then suffered from rising discounter competition, falling prices and, eventually, collapsing profit margins. Tesco’s aggressive buying and accounting practices also got the business into trouble.
Booker, in contrast, was revitalised as a business under its chief executive, Charles Wilson and has thrived over the last decade. The chart below shows the market values of both businesses since Booker re-listed on the stock market in June 2007. Tesco’s market value has more than halved to around £16bn, whilst Booker’s value has increased from below £500m to £3.7bn, including the benefits of acquisitions. Proportionately, Booker has grown from under 1.5% of Tesco’s value, to almost a quarter of the size.
How can this deal be assessed?3 I like to think in terms of financial and strategic merits. Tesco are paying £3.7bn for Booker. It is expected to make around £175m4 operating profit this year and earnings per share of 8p4. At the offer price of c.205p, that gives a price to earnings ratio of 25x, which is quite high by most standards. However Tesco believe they can find synergies of c.£200m. If they can do that, they can double the profitability and bring the purchase price down to a more reasonable level. They claim the deal can earn a return above Tesco’s cost of capital by year 2 (excluding exceptional costs) and significantly in excess by year 3, with earnings accretion in the second full financial year. If this is achieved, then financially the deal will be acceptable. By contrast, in Weighing up M&A, I showed that the financial rationale for Sainsbury buying Argos is far more compelling.
The key rationale for any deal should however be strategic. Financial discipline is important, but strategy is critical. Tesco point to strategic benefits for all their stakeholders. For shareholders, they point to higher growth from accessing faster growing markets, like catering and independent food suppliers, and also improved innovation and asset utilisation. An improved growth rate is desirable, but the impact on Tesco’s overall growth rate will be limited. Elsewhere, there seem to be only modest strategic improvements promised for Tesco’s core retail proposition, although the company will benefit from having Charles Wilson, the well respected Booker chief executive, join their board.
An assessment of M&A cannot be complete without consideration of the risks. There is a risk that this deal does not complete. The combined group will have significant scale both in the retail market and as buyers of consumer goods. This will raise competition issues that need to be investigated. Another risk is that the deal and the subsequent merger will take up a considerable amount of management time, and could lead to distraction, just as Tesco is at an important point in its turnaround strategy. Furthermore, extracting the targeted synergy benefits will involve integrating complex systems and numerous facilities as well as different cultures which all carry associated risks.
In a highly unusual move, one of Tesco’s non-executive directors, Richard Cousins, chief executive of catering group Compass, has resigned over the deal. He is quoted in the Financial Times5 as saying he was “very much against the deal and felt I should resign” adding, “Tesco is in the middle of a price war…. They need to make the business simpler not more complex.” Whether that is right or not, it is worth considering why Tesco are willing to take on this task right now.
It is too early to say whether this deal will be a success. There is a financial and strategic rationale for the deal, but also some clear risks. The initial reaction of the share price seems to be taking the optimistic viewpoint.
1. Source Booker PLC website
2. Tesco Annual Review – year ending 25th Feb 2006
3. This is no recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.
4. source Bloomberg: 28.1.17
5. FT 28.1.17