Sainsbury's agrees Asda merger for 42% Walmart stake

Sainsbury's, the UK's second largest supermarket group, has agreed terms with Walmart over a merger with its third-placed UK supermarket chain Asda to create a £15bn market cap, £51bn-revenue business.

The agreed deal will see Sainsbury's, which also reported its final results on Monday, hold 58% of the combined business and retain its chairman, chief executive and chief financial officer, as well as its listing in London, in exchange for paying Walmart a £3bn cash payment and a huge chunk of its shares.

Walmart's 42% equity stake values Asda at £7.3bn on a debt-free, cash-free and pension-free basis, but a mix of non-voting shares will mean it only has 29.9% of the total voting rights, plus two non-executive seats in the Sainsbury's boardroom and Asda's chief executive joining the operating board.

A merger would see the 'big four' supermarkets become the 'big three', with Asda and Sainsbury each accounting for 15-16% of the market, or more correctly a 'big two and a half' as Morrisons 10% market share would be around a third the size of the big two. As well as shareholder approval, the deal is certain to face sizeable regulatory hurdles, with the Competition & Markets Authority confirming on Monday morning that an investigation is "likely".

To assuage concerns about a reduction in competition, the merged group planned to lower store prices by "circa 10%" on "many of the products customers buy regularly" and planned no store closures on either side.

Arguably competition will remain high, analysts said, as all UK incumbent supermarket groups have had to up their game and cut their prices after several years ceding market share and volume to discounters Aldi and Lidl. If the deal is approved by the CMA, a number of store disposals would be expected.

Sainsbury's expects at least £500m of synergies to group earnings before interests, tax, depreciation and amortisation, with double-digit earnings per share accretion and low-double-digit return on invested capital by the second full financial year post-completion.

Sainsbury's, which will fund the cash payment with new bank debt, highlighted other benefits from the merger as Asda's high freehold property ownership and pension-free balance sheet reducing its lease-adjusted leverage, while the highly cash generative business is expected to enable faster de-leveraging.

The Qatar Investment Authority, a 22% shareholder in the FTSE 100 group, was supportive of the discussions, Reuters reported.

Sainsbury's CEO Mike Coupe, who was previously a director at Asda, said: "This is a transformational opportunity to create a new force in UK retail, which will be more competitive and give customers more of what they want now and in the future. It will create a business that is more dynamic, more adaptable, more resilient and an even bigger contributor to the UK economy."

Asda CEO Roger Burnley, who was last year poached from Sainsbury's, said a merger "will be great news for Asda customers" as it would deliver lower prices in store and more choice. "Asda will continue to be Asda, but by coming together with Sainsbury's, supported by Walmart, we can further accelerate our existing strategy and make our offer even more compelling and competitive."

Walmart's international chief Judith McKenna highlighted the "unique and bold opportunity" after almost 20 years of Asda ownership, suggesting the combination will "unlock value for both customers and shareholders".

SAINSBURY'S RESULTS

In its 52-week fiscal year, Sainsbury's reported a return to profit growth, with underlying profit before tax up 1.4% to £589m, with profits up 11% in the second half after cutting £185m of costs. Looking to the current year, Coupe said he was "comfortable" with the current City forecast for underlying pre-tax profit of 7% to £629m.

Sales were up 9% to £31.7bn, with like-for-like sales up 1.3% over the year after slowing to 0.9% in the fourth quarter from 1.1% in the third quarter and 1.6% in the first half.

With free cash flow up 35% to £432m, net debt was reduced by £113m to £1.4bn and an 8% increase in the final dividend to 7.1p per share was declared, bringing the full year dividend to 10.2p, flat on the prior year.

Underlying earnings per share dropped 6% to 20.4p per share, primarily reflecting the impact of a full year's consolidation of the additional shares issued as part of the Argos acquisition.

Focusing on the current business, Coupe said his focus was on making Sainsbury's "a destination of choice", pointing to a further investment of £150m to lower prices.

With the Argos general merchandise performing ahead of the market, he said customer feedback and financial returns was leading to Argos stores being opened inside Sainsbury's supermarkets faster than originally planned, with £160m of EBITDA synergies expected to be generated by next March, six months ahead of plan.

REACTION & ANALYSIS

Sainsbury's shares were up 17% to 314.9p after around half an hour of trading on Monday.

Citi analysts said the merger "would have strategic and industrial logic" in the face of competition from the discounters and resurgent offers from other rivals. "As such we believe a merger to strengthen its market position in core grocery has clear strategic merit, over and above the diversification, space utilization and cost savings from the recent Argos acquisition.

"Moreover, in a low margin industry where overheads can be leveraged and scale begets buying power, we think a merger would drive significant synergies across a business for which we project a 2.3% FY17/18E EBIT margin."

But the first big question is "will a merger get regulatory clearance?"

HSBC expected the proposed merger to be given a full referral to the CMA and for that process to take a year to complete.

"This would be a horizontal merger, unlike Tesco-Booker, which was viewed by the CMA as a vertical one. We can see many issues such as store overlaps, local duopolies, etc. but ultimately the CMA will ask 'is this against the consumer interest?'. Prima facie, this merger would create a company (c29% market share) to rival Tesco (c27% market share) but we would expect a number of store disposals should it be cleared (which is not guaranteed)."

If a merger is approved and there are “remedy stores” to be sold, Morrisons was seen as the most likely buyer as Tesco would "presumably not be able to pick many up", the Co-Op out of large stores, Waitrose has limited resources, the discounters "could be interested in some stores".

Market analyst Japser Lawler at London Capital Group noted that short-sellers have been targeting retailers heavily over the past two years, meaning news of potential tie up between Sainsbury could see many caught on the wrong side of the bet in early trade.

"The timing of this deal is key. It comes potentially as a response to the Tesco and Bookers merger, which passed through the competitions agency without remedies and at a time when pressure from Amazon has stepped up following their purchase of high end supermarket Whole Foods. Given the more challenging outlook for the sector in the face of recent Tesco/Booker and Amazon/Whole foods tie up, Sainsbury and Asda were in danger of losing significant market share."

If agreed and approved by the Competition & Markets Authority, likely with some store disposals, the deal "could change the landscape of the sector dramatically creating a more powerful rival to market leader Tesco".

Michael Hewson at CMC Markets noted that while it seems likely that there might be some job losses given some store overlap between the two brands along with management duplication, many of these jobs could be soaked up as Aldi and Lidl are in the midst of a large store expansion program with plans to open up to 80 new stores by 2022 with the creation of thousands of new jobs.