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Sainsbury/Asda and Tesco – a duopoly in the making?

The proposed tie-up would create the UK's biggest grocery chain with sales of £51bn
April 30, 2018

They’ve agreed the numbers; now comes the charm offensive. J Sainsbury (SBRY) and Asda have confirmed plans to merge in a deal that would hand Asda’s current owner, Walmart, around £2.98bn in cash and a 42 per cent stake in the combined business (although with maximum voting rights of 29.9 per cent). Walmart's holding will also be subject to a lock-up for the first two years following completion. The deal values Asda at around £7.3bn on a cash-free, debt-free and pension-free basis, with a resultant implied enterprise/cash profit multiple (EV/Ebitda) of 5.8.

IC TIP: Hold at 315p

A tie-up would leave a combined entity with sales of around £51bn, a network of more than 2,800 Sainsbury's, Asda and Argos stores, and potential cost synergies of £500m through enhanced economies of scale. Leasehold arrangements have become something of a bugbear for the high-street grocers, so shareholders would certainly welcome a fall in Sainsbury’s lease-adjusted leverage, on the back of Asda's high rate of freehold property ownership. The merger also makes some geographical sense, given Sainsbury's relative strength in southern England and Northern Ireland and Asda's greater promise in northern England, Scotland and Wales. You could argue that the deal offers diversification benefits, as the combined group will be targeting the premium and value ends of the market, and the likes of Marks and Spencer (MKS), Waitrose and Germany's Lidl.

The deal was well received by investors, sending shares in Sainsbury's up by almost a fifth in early trading, but the merger's proponents will have to convince more than just shareholders. That's a task made even more problematic because the Competition and Markets Authority (CMA) itself will come under scrutiny in this matter, after it recently gave the green light to Tesco’s (TSCO) £3.7bn acquisition of wholesaler Booker.

To ward off criticism from unions and consumer groups alike, both companies say they plan to keep all stores open, and will reduce prices on a range of popular, high-volume items. The last point – presumably to head off fears of price hikes – is essentially moot, as you would imagine that the combined group, with around 30 per cent of the UK grocery market, would have increased buying power – surely part of the rationale for the deal. (Although as Lidl and Aldi have shown, scale isn’t everything).

Not so long ago, you would have bet against a merger of this nature gaining regulatory assent, but the CMA will be making its deliberations partly with reference to “new or rapidly changing markets where business models are evolving”. That evolution could encompass the potential danger posed by Amazon’s (US:AMZN) entry into the UK grocery market – a point not lost on UK regulators.