Sainsbury and Home Retail Group (HR) confirmed yesterday that HR
received an approach from Sainsbury in the form of cash and shares back
in November, which HR rejected. In accordance with the City Code on
Takeovers and Mergers, the deadline to announce a firm offer is less than
a month from now, on 2 Feb at 5pm to be precise, and, therefore,
Sainsbury’s could decide to formally bid at a higher price in the coming
weeks (HR +41% yesterday to 139p). In general, we are of the view that
merging two businesses that are structurally challenged (Sainsbury by the
discounters and the excess capacity in the food retail industry and HR by
Amazon and by perhaps even more exacerbated industry capacity issues)
would not necessarily make the resulting entity more competitive. At a
time when, in our view, the worst is still to come in food retail (gross
margin investment at Tesco and Asda triggering further price competition
across the board, ongoing net space closure at the Big 4, online becoming
more competitive), we believe that, should the deal materialize, there
could be some distraction at Sainsbury’s, the one among the Big 4 that has
executed best up until now, in the short term.
Terms of the deal and potential financial impact. The price and split
between shares and cash of Sainsbury's approach to HR are unknown.
HR has stated that the board rejected the approach because it
‘undervalued HR and its long-term prospects’. We would be inclined to
think that any potential firm offer from Sainsbury’s would consist mainly
of shares given its B/S constraints (4x LA ND/EBITDAR on margins
that face downside risk, in our view) and muted cash generation. For
illustrative purposes only, in the event that Sainsbury's decided to offer a
20% premium to yesterday's HR share price close (c£1.3bn), structured
30/70 split between cash and shares, it would cost the company c£400mn
(c9% of its current market cap) plus the equity. For sensitivity purposes
only, assuming £100mn synergies, 5% cost of debt and £100mn PBT for
Home Retail we get to a c10% EPS accretive deal for Sainsbury’s. LA
Net Debt/ EBITDAR would go up from c4x to 4.5x (adding £115mn of
pension liabilities and c£2.5bn of capitalized leases).
HR brief description: HR operates c840 Argos outlets and c270
Homebase stores. Of HR’s retail sales 41% is made up of electricals
(consumer electronics and domestic appliances), 45% home
enhancement (ie housewares, DIY and other home/garden furniture) and
14% other general merchandise products such as jewellery, toys and
leisure equipment. At Argos, internet orders represent c46% of all sales,
versus online sales participation of c8% at Homebase.