Sainsbury's released details of its proposed merger with Asda, valued at £7.3 billion on a cash-free, debt-free, pension-free basis or 5.8 times fiscal 2017 earnings before tax.
The merger, if approved, will create the largest U.K. grocer with a combined market share of 31.4% versus 27.6% for Tesco. Although we are still investigating the impact on our fair value estimate, we anticipate increasing our uncertainty rating to very high from high, as there is elevated uncertainty regarding the likelihood of the deal's final approval from the UK Competition and Markets Authority and the potential large-scale disposals that the CMA could impose.
Store disposals are central to the deal's viability, as announced synergies are mostly based on the expectation of an unconditional approval. Similarly, we opt to wait for more information from the CMA's investigation of the deal to warrant a reassessment of Sainsbury's economic moat and trend ratings. Sainsbury's stock jumped almost 20% at the April 30 open, partly reflecting optimism that the deal will go through, though some of the reaction could be the result of a short squeeze, as a relatively high percentage of shares are borrowed by short-sellers.
In our view, the deal makes sense from a store portfolio perspective – Sainsbury's has large exposure in the south, including London, while Asda holds a high market share in the north – and the scale argument is strong; the new group will have £51 billion in buying power versus £45 billion for Tesco-Booker.
However, the combined entity will have a high nonfood exposure, around 25% of total sales, almost double the usual proportion for its peers, in a post-Brexit world with tough competition from established players including Amazon. On top of that, the merged entity will have large-store exposure, average store size 35,000 square feet, with more than 85% of its sales coming from hypermarkets and supermarkets, formats in structural decline.
The deal's structure includes £3 billion cash and £4.3 billion worth of shares issued to Walmart, based on Sainsbury's share price of 269.8p at the April 27 close. This would render Walmart, of which Asda is a wholly owned subsidiary, the largest shareholder in the new merged entity with a 42% share.
When Will the Merger Go Ahead?
The merger is expected to close in the second half of calendar 2019. Management guided for double-digit earnings per share accretion as well as earnings before tax synergies of £500 million or 1% of combined sales £350 million buying, £75 million property, and £75 million operational cost.
This is in line with synergies derived from recent deals in the sector. The new entity expects to cut prices by 10% on items that customers buy regularly, an investment that is excluded from the aforementioned synergies and wasn't disclosed separately, the respective amount in the Ahold-Delhaize merger was €250 million out of the €750 million in total gross synergies. Current price differentials of Sainsbury's versus Tesco are close to 5%-7% across the range, so the deal could trigger a new round of price cuts in the short term.
Longer term, we view a consolidating U.K. grocery market as a net positive for almost all surviving players, especially those under our coverage, with Tesco and Morrisons benefiting as well, through higher buying power concentrated in the hands of retailers versus suppliers and opportunities for smaller grocers to increase their store network in below-market prices.
Walmart will be subject to a two-year lockup period following the merger's completion; it will be able to sell down to a minimum of 29.9% in years 2-4. In addition, Walmart will be unable to hike its stake in Sainsbury's for two years after completion, a condition that falls away in cases where there is a third-party offer.
Financing of the cash component will be sourced from Sainsbury's current financing agreements, which later will be replaced by long-term funding. Sainsbury's CEO and CFO as well as chairman of the board will lead the new entity, while Asda will continue to be run from Leeds with its own CEO, who will join the group operating board of the combined business.
Sainsbury's will present its preliminary fiscal 2018 result May 2.
