Weighing up M&A

“In the short term the market is a voting machine, in the long term it is a weighing machine” is one of the most famous stock market quotes, by Benjamin Graham. It denotes how the consensual views about a company or industry can get carried away and move to extreme levels in the short term, but ultimately share prices will reflect the true worth (or “weight”) of businesses.  Nowhere is this more visible than in the world of mergers and acquisitions.  How often have we seen the stock market get really enthusiastic about a takeover deal or, more broadly, an acquisitive company, only to have a rude awakening later on, when the dust settles?

I think it is interesting, though, to look for the opposite type of situation. Companies that have done brave deals, but have been widely chastised at the time.  These are particularly notable because the management and board had to fight many critics to pursue their strategies. The stock market initially voted that these were poor deals, but in the fullness of time, their weight may be reassessed.  I will focus on three large deals in the UK that may fit the bill1.

The first deal I have referred to before. In Three Lions and a Dog… I described the way that GlaxoSmithKline has been transformed by an asset swap with Novartis into a much more diversified business.  GSK only had 8 positive recommendations from the 34 broking analysts that covered it.  Partly, this was due to deep scepticism over the deal, that involved GSK selling their fast growing oncology drugs – a very popular subsector – and becoming a less focused business.  Since the deal was consummated, however, GSK has made good progress in delivering growth and improved profitability in their vaccines and consumer health businesses.  Also, we have seen increasing pressure on drug pricing in the key US market.  Whilst it is too soon to say that GSK’s strategy of reducing exposure to highly priced drugs in the USA has been vindicated, they are certainly starting to demonstrate that a more diversified strategy has its own merits.

The second deal to look at is the purchase of BG by Royal Dutch Shell. Against a background of a tumbling oil price in 2015, the stock market was extremely nervous about Shell gearing up to buy a company with some strong assets but a history of disappointments on production growth and poor cash flow. Stock market commentary has focused on whether the company paid too much for BG, and whether Shell can make necessary asset sales to help it sustain its dividend payments, against a background of lower oil prices and higher debt.  The stock market may not have voted “no” but Shell certainly did not get a rounding vote of applause on the deal.

But will history judge the BG purchase deal differently? The acquisition completed in February 2016, about a month after the trough of the oil price.  It would have been hard to time the purchase better.  When the oil price was higher, BG would probably not have been up for sale, and once the oil price started to recover, BG shareholders may have wanted to hold on for the recovery in profitability.  Although the oil price fell during the offer period, meaning that the initial offer price looked high compared to recent profitability, a large proportion of the purchase was paid in Shell shares, which also came down in value.  Therefore the actual price paid for BG also adjusted downwards with the oil price.

Perhaps most importantly, Shell has bought some excellent assets within BG. In Brazil, they have a large stake in one of the world’s most promising oil regions, with rapidly rising production at low costs per barrel.  Although Brazil had seen several delays to production growth, the big oil fields are now ramping up well and recent adjustments to the oil and gas regime look favourable for foreign investors.  BG also brings a strong position in the liquid natural gas (LNG) market, making Shell the clear global market leader in this important energy market.   From a timing point of view, BG was also nearing the point of cash flow inflection, where it was moving from consuming cash to generating surplus cash, which was a good time to buy the business.  It is just possible, that history will judge this deal as one of the defining deals within the oil & gas industry, given the excellent timing and the quality of the assets that Shell has bought which allow it to refocus the portfolio and increase capital efficiency.

Finally, perhaps the most contentious deal, is Sainsbury’s purchase of Home Retail Group, the owner of Argos. This is a catalogue based retailer of general (non-food) merchandise, which is increasingly becoming an online retailer.  Sainsbury has its own challenges in a fiercely competitive food retail industry, which has suffered from overcapacity and increasing penetration of the German discounters Aldi and Lidl.  Argos has £4bn of sales, but has struggled to grow in recent years, with operating profits of £83m in 2016, lower than the £94m earned in 20122. Its main competitor is Amazon, a formidable online operator. The City remains sceptical of Sainsbury in general, and of this deal in particular, as can be seen from Sainsbury’s modest valuation and the fact that only 1/3rd of analysts covering the stock have buy recommendations3.

However the short term voting of the stock market could prove premature. The deal actually looks very interesting from two distinct perspectives; financial and strategic. Financially, Sainsbury paid £1.1bn for Home Retail. However, the business came with £300m of cash and a customer loan book of £600m, which has been absorbed into Sainsbury Bank.  The net cost of buying the Argos business was therefore around £300m for the Sainsbury retail business (allowing for c.£100m extra capital within the bank).  Sainsbury expect to generate synergies from buying Argos of £160m, from areas such as property – relocating Argos branches into Sainsbury supermarkets, central costs, purchasing and so on. Even allowing for the costs of integrating Argos, the £200m+ potential extra profit should make this a very financially appealing deal.

The strategic logic for buying Argos is more important than the short term financial implications. Argos brings huge scale to Sainsbury’s purchasing of non-food items, it will allow Sainsbury to sell their non-food products, such as the Tu clothing line via the Argos network and allow the optimisation of the best products in the supermarkets. Bringing Argos counters and collection points into Sainsbury will bring extra customers into stores, and make use of some surplus space that Sainsbury has identified.  Most importantly, Argos brings leading logistical networks capable of same day delivery to home or stores, and large item delivery.  These networks are extremely difficult and expensive to create and need significant scale to operate effectively.  Combined with Sainsbury’s growing online food delivery network, the business now has key strategic capabilities to deal with changing shopping habits in the future.

These three examples are all situations where the stock market has initially been sceptical of bold strategic moves. Whilst it is too early to judge any of them definitively, and the Sainsbury deal has only just been completed, there are good reasons why history could look back at each of them as important, positive developments for the businesses concerned.  The stock market weighing machine may ultimately have a different opinion than the voting machine.

Simon Gergel

 

1. 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.
2. Source; home Retail Group Report & Accounts 2016.
3. Source: Bloomberg 4.Dec.2016

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Author - Simon Gergel

Simon Gergel

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