The stock market’s initial reaction to takeover deals can often be a poor indicator of how those deals work out.
Just look at the market’s sceptical response to Sainsbury’s purchase of Argos owner Home Retail Group as a recent example. Now we have another unexpected deal in the supermarket sector with Tesco bidding to take over Booker, the UK’s largest food wholesaler (they politely call it a merger).
The initial market reaction was far more enthusiastic, with Tesco shares rising 9 per cent and Booker by 16 per cent, compared to a 5 per cent fall in the Sainsbury share price when it announced its interest in Home Retail Group. But will this really turn out to be a great deal, or will Booker turn out to be an unwanted item in Tesco’s bagging area?
First, a quick trip down Memory Lane. In some ways, the fact that this deal is even being proposed is quite extraordinary.
In the early 2000s, I remember Booker being seen as a challenged business. The powerful supermarkets were growing fast and rapidly expanding into the convenience food market. Tesco was 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.
On the other hand, Tesco was seen as one of the strongest growth businesses in the UK, with an extremely well-regarded management team. The company’s results for the year ending 25 February 2006 demonstrated its formidable success: “For the full year on a 52-week basis, Group sales have increased by 13.2 per cent to £41.8bn and Group profit before tax has grown by 16.7 per cent to £2.2bn… The full year dividend is up 14.2 per cent 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 hot water.
Booker, in contrast, was revitalised as a business under its chief executive Charles Wilson, and has thrived over the last decade. Since Booker re-listed on the stock market in June 2007, Tesco’s market value has more than halved to around £16bn, while Booker’s value has increased from below £500m to £3.7bn, including the benefits of acquisitions. Proportionately, Booker has grown from under 1.5 per cent of Tesco’s value to almost a quarter of the size.
So how should we assess this deal? I like to think in terms of financial and strategic merits.
Tesco is paying £3.7bn for Booker. It is expected to make around £175m operating profit this year and earnings per share of 8p. At the offer price of about 205p, that gives a price to earnings ratio of 25x, which is quite high by most standards. However Tesco believes it can find synergies of around £200m. If management can do that, they can double the profitability and bring the purchase price down to a more reasonable level. They also claim the deal can earn a return above Tesco’s cost of capital by year two (excluding exceptional costs) and significantly in excess by year three, with earnings accretion in the second full financial year. If this is achieved, then financially the deal will be acceptable.
However, the key rationale for any deal should be strategic. Financial discipline is important, but strategy is critical.
Tesco points 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 Wilson, the well-respected Booker chief executive, join its 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 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.
It is too early to say whether this deal will be a success. There is a financial and strategic rationale, but also some clear risks. While the share price’s initial reaction seems to be taking the optimistic viewpoint, I am yet to be convinced that this is a deal worth walking down the supermarket aisle for.