Four issues explain why two big shareholders oppose the Tesco-Booker deal

It is two months since Tesco and Booker announced their merger and the combination of a subsequent 9% slide in Tesco shares (taking them back to where they started before the deal became public) and opposition from two key shareholders is raising the question of whether the transaction is a good one for shareholders or not.
28 March 2017

Russ Mould, investment director at AJ Bell, comments:

“Any merger and acquisition (M&A) deal must be subjected to four litmus tests and the Tesco-Booker deal maybe passes one and looks to fail two, while the burden of proof rests with the newly-merged entity on the other.

“This helps to explain why both Schroders and Artisan are both proclaiming their opposition to the planned transaction especially as the ultimate arbiter of any return on investment is the price paid and it is here that the greatest doubts are emerging.

1.    “The reasons for the deal: is to boost growth or create it? Both Tesco and Booker operate in mature markets, although Booker’s interims showed excellent like-for-like growth excluding tobacco. There is therefore a suspicion that the idea is to create growth where little exists, even if Tesco boss Dave Lewis and his equivalent at Booker Charles Wilson would doubtless argue the deal will augment gathering momentum in the two separate businesses. Test failed.

2.    “Will the deal deliver the targeted financial benefits? Research shows that more than 70% of all M&A transactions ultimately fail to deliver on their near-term financial goals. As such, Tesco’s claim the Booker merger will deliver £200 million of cost benefits, on an annual run-rate basis, within three years and a further £25 million of revenue synergies must be treated with some caution, especially in the latter case.

Tesco’s poor prior track record with acquisitions, such as Giraffe and Dobbie’s Garden Centres, raises question marks, although the 2002 swoop for store group T&S brought a strategic boost in the key field of convenience stores, while Booker has done a brilliant job with its 2012 purchase of Makro, so Wilson’s expertise will be welcome in the Tesco board. Test failed.

3.    “The number of new variables introduced to the business: one is enough. Under Lewis Tesco had been focussing on its core domestic grocery and supermarkets offering, cutting back on overseas operations, withdrawing from areas like restaurants and ceasing to stock the Hudl tablet computer. As such, the Booker deal brings diversification via the move into wholesale but it does so in just one country, so the number of variables is just one. Most deals come to grief when M&A brings not just a new type of product or service but a new geography too. Test passed.

4.    “The price paid. As investors know, the valuation paid for a security is the ultimate arbiter of the return on investment. The 205.3p price implied when the deal was first announced works out at forward price/earnings multiple 23.8 times for Booker for the year to March 2018. That looks rich for a business that had a fairly skinny 3.2% interim operating margin and operates in a competitive, mature market.

“Tesco says the deal will be earnings accretive after two years, but this excludes implementation costs and assumes all synergies are met and again the multiple paid leaves little margin for error, especially as the FTSE 100 firm has its hands full dealing with its own competitors.

“However, the cash-and-stock nature of the £3.7 billion, 205.3p-a-share deal lessens the risk to Tesco, which will be handing over around £770 million cash and the rest in shares. Booker has a £59 million pension deficit but Tesco will also inherit a net cash pile of over £100 million straight away and Booker is highly cash generative – before today’s announcement it had been planning a fourth special dividend since its 2012 purchase of Makro. The cash-and-stock nature of the deal lessens the risk but the offer price is lofty – case unproven.

“Tesco’s shares have lost all of the gains they made upon announcement of the deal and at 197p Booker is trading below the offer price implied by the structure of 0.861 Tesco shares and 42.6p per each Booker share.

“Some shareholders clearly have their doubts and that is before any investigation by the Competition and Markets Authority, whose involvement will give both shareholders and the two management teams plenty of time to state their case.

“All eyes in the short-term will now turn to Booker’s fourth-quarter trading statement which is due on Thursday.”

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