More on Sainsbury (SBRY) and Home Retail Group (HOME)

Sainsbury published their Third Quarter Trading Statement this morning (13/1/2016) and they have also published a document arguing the merits of their possible bid for Home Retail Group under the title of “Accelerating our strategy for growth”. Home Retail Group previously rejected an approach from Sainsbury on the basis that it undervalued the company. This note discusses the latest news as a follow up to my previous comments on this matter.

Now I have previously declared an interest in this subject as I recently purchased a few Sainsbury shares on the basis it looked the best value in a depressed supermarket sector, which might recover sooner or later. My holding of Sainsbury is currently less than 0.2% of my whole portfolio by value in case anyone thinks I am getting too emotional on this topic. It’s a “value” purchase for me, with a good dividend yield which looks sustainable.

The relative market caps of these companies were £4.9 Billion for Sainsbury and £800 Million for Home Retail before the initial announcement of the possible offer, and with a rumoured bid of £1 Billion it might be digested without too much difficulty via a mix of cash and shares, which is what is on the table apparently. However Home Retail’s share price jumped by 40% on the day of the announcement, putting it on a prospective p/e of over 14 and a much higher valuation. But the key question is why would Sainsbury want to acquire these businesses (Argos, Homebase, et al) which have shown no growth in the last few years? Cash flow has been negative since 2011, with £55m more working capital to finance a loan book, £23m in restructuring costs (a persistent feature of recent accounts) and £49m in market share repurchases last year. Home Retail did look cheap (forecast adjusted p/e was 10.1) but whether it makes a good strategic fit looks more questionable.

As I said before, there was a lot of negative media comment about this proposal, and even assuming substantial “restructuring” by Sainsbury of Home Retail it is not clear where the benefits lie. As someone who has worked in the retailing sector in the past, I thought the best comment was this: “Its list of deal benefits appears to have flowed from the pen of an investment banker who has not been in Argos for a while or ever”….Tony Shiret of Haitong Research. Even a 25% shareholder in Sainsbury does not seem happy with it according to the Guardian, although Sainsbury denied they had come to any conclusion on it. The Financial Times reported retail analysts Richard Hyman as saying “I think this would be a strategic error for Sainsbury’s”, and Louise Cooper as saying “It’s a deal done from a position of weakness – it’s one ailing high street business trying to buy another ailing high street business. It doesn’t make sense”.

But it’s not a one-sided argument as if often the case with such bids as otherwise it would not have got this far. Paul Scott who writes for Stockopedia defended it on the basis that Argos stores could be used as local collection hubs and that Home Retail had “enormous balance sheet strength” with “net cash and an enormous storecard debtor book” but he did declare he had been a Home Retail shareholder.

Let’s look at the latest news. Firstly the Sainsbury third quarter trading. A mixed bag in essence with total sales up by 0.8% (excluding fuel), but like-for-like sales down – an important measure for retailers. Comments on Christmas trading were positive – over 550,000 Christmas puddings sold – but a closing remark was negative: “Food deflation and pressures on pricing will ensure that the market remains challenging for the foreseeable future”. There was minimal movement in the share price as a result on the day.

What does the “Accelerating our strategy….” document say? It mentions the need for customers to want a huge variety of products (correct), support of online and mobile (correct – Argos have a good system apparently), and both in-store, home delivered and click & collect (perhaps – I always perceived the latter mode as an intermediate channel of minority interest and there are other alternatives to using high street retail stores to support it). It has been suggested that Sainsbury could sell Homebase and use Argos stores for distribution of general merchandise, or dispose of them – many are on shortish leases apparently, but does using them for distribution make sense?

The Sainsbury document notes the ability and desire to grow general merchandise and financial services where Argos has some strengths, and the desire to expand their “convenience” store estate which Argos shops might be suitable for, except that the size, location, internal shop layouts, etc, might not be a good match. For example convenience stores typically need car parks or at least easy on-street parking which I don’t think many Argos stores have.

Sainsbury says “Home Retail Group’s strong multi-channel capabilities and infrastructure would step change our ability to meet our customer’s needs for further flexibility and choice” and “both businesses share a similar culture”. What it does not say is that the customer profile of the two companies is probably substantially different.

How should one look at this proposal? Financially on the basis that Sainsbury are buying assets on the cheap by acquiring a business that has been undervalued by the market based on the perception that it was a dog in decline? Or on strategic benefits? Sainsbury is arguing very much for support on the latter basis so they should surely be judged on that. Otherwise we can leave Home Retail to the circling private equity vultures.

The Sainsbury document about the possible merger goes on for some length explaining the detail possible synergies which this writer will not repeat, and concludes with the comment that it is a “strategically compelling strategy”.

Now some commentators have suggested this is a response to the threat from Amazon (who have opened a skeleton food store called Amazon Pantry in the UK recently, not that it looks very impressive at present). A move into general merchandise is a typical “got a problem in your current home market – diversify” type of reaction, which rarely works. There might be higher margins on general merchandise, and Tesco have been successful in extending their range into that sector, but it also means more floor space is required. But having it in Argos stores some distance away, even if rebranded as Sainsbury, hardly seems to make sense even if it is being used to service web sales. You don’t need high street stores to service web sales, on a direct delivery or click & collect service.

So this writer remains unconvinced unless the strategy is really to acquire Home Retail, sell off the saleable parts, dismantle most of the rest, and retain a few key assets including the cash and loan book of course. That way it might make sense. But that is not what Sainsbury are trying to sell us, perhaps because it would generate opposition anyway from the Home Retail board.

In general acquisitions of complementary businesses which can be integrated with little management effort make sense. Those that require large scale restructurings of businesses with probably different cultures and customers, and which consume a lot of management, time do not. This proposal looks more like the latter than the former. That in essence is probably why so many independent commentators have not so far been convinced of the merits of this proposition. And this writer remains to be convinced also.

There is a course a price for everything, but the price Sainsbury might be paying to meet the expectations of the Home Retail shareholders and their board looks way too much. When looking at these kinds of propositions, there is one simple question to ask: what else could Sainsbury do with the amount they might pay for Home Retail to grow their business, improve their competitiveness, improve their return on capital, expand their distribution or otherwise improve their business? Send your answers on a postcard to the Chairman of Sainsbury I suggest (and send ShareSoc a copy if you want them printed).

Or for those yet undecided, the beauty of investing in retailers is that you can visit the stores and see what you think about the business, talk to the staff and generally do your own research. So do some shopping in Sainsbury, Argos and Homebase and then make your mind up.
Roger Lawson