5 minute read
James Balfour considers the implications of a tie-up between Sainsbury’s and Asda on the grocery retailing sector.
At the end of April, details emerged of a possible merger between Sainsbury’s and Asda that could – should it go ahead - result in the creation of the UK’s largest grocery retailer1. While the overall impact is unlikely to become clear for another 18 months or so, it will nonetheless have considerable ramifications for other players and suppliers in the grocery retailing sector.
The merger, worth around £10 billion and scheduled for completion in mid-2019, would produce a combined group with 2,800 stores across the UK and a market share of around 31 per cent, slightly more than that of the current market leader, Tesco. Walmart, which has owned Asda since 1999, would receive shares in Sainsbury’s in exchange for Asda’s 600 supermarkets, and in the process become the new group’s biggest shareholder.
If the deal leads to consolidation within the market through store closures or their transfer to other sectors, it could be positive for investors. However, it could prove far less welcome if it also results in a vicious price war similar to that seen three years ago, which left many suppliers and retailers reeling. Sainsbury’s, when it announced the deal, said some of the resulting cost savings would be redirected into its pricing strategies.
Asda, which focuses on the economy-end of the market, has struggled against the advance of discounters such as Aldi and the growth of e-commerce. It is also weak in own-label brands. By contrast, Sainsbury’s is strong in premium foodstuffs, online grocery shopping and own-label brands but weak in the no frills area of the market. Moreover, while Asda is a major player in the north of the country, Sainsbury’s is focused on the south-east.
In this Q&A, UK equities fund manager James Balfour, considers the pros and cons of the deal for the two parties and implications for investors.
What is driving the proposed merger?
The continuing evolution of the retailing sector in general in the UK. The rise of the discounters, convenience stores and online grocery shopping are impacting the major grocers. Sainsbury’s has admitted there is still too much capacity in the market and new store space is still being added. So consolidation is needed to maintain the profit pool, or margins are likely to be eroded across the value chain. A merger in the food retail sector has been long touted, although this pairing was rarely considered. Amazon’s entry into the market via its takeover of Whole Foods and Tesco’s acquisition of Booker has given added impetus to industry consolidation.
The deal is likely to come under scrutiny from the Competition and Markets Authority (CMA)– what factors in particular will it be looking at?
The amount of data now available to the regulators means they will be able to analyse the impact of the merger on a store-by-store basis. Those catchment areas where customers only have a choice between an Asda and a Sainsbury’s outlet will come under the greatest scrutiny. The CMA will look at the pricing power that could be accumulated by the consolidation of two stores into one. If, however, there is significant competition in an area, the CMA is likely to determine that shoppers will not be disadvantaged by the merger. Sainsbury’s management has clearly stated there will be no store closures. But it will dispose of some stores. It will then be up to whoever acquires them to decide whether to keep them open or not.
Why would Walmart consider such a deal?
Asda has been a poor performer over the past few years, losing market share. Consequently, questions were being asked about whether Walmart would increase investment in the UK retailer to boost Asda’s competitiveness. Asda’s US owner has clearly decided to take a more capital-light approach to the market. Given the competition Walmart faces in the US, it appears to be reducing its direct global footprint, apart from its operations in Mexico, China and India. It has recently agreed to buy Flipkart in India for US$16bn as it looks to invest in technology to reduce costs across its portfolio.
What does Sainsbury's stand to gain?
The main advantage for Sainsbury's is the extra scale it will gain as a result of merging with Asda. Combined, Sainsbury’s and Asda would hold almost a third of the UK grocery market (pre disposals), with the deal catapulting the merged entity ahead of long-time market leader Tesco. The deal would strengthen Sainsbury’s buying power and cut costs, particularly in back office logistics. It would provide a greater store footprint for Sainsbury’s Argos outlets, significantly increase its customer base and provide access to the data of a fresh swathe of shoppers. The deal makes financial sense if Sainsbury’s does not have to dispose of a significant number of stores. However, the deal would increase Sainsbury’s focus on a fiercely competitive market that is subject to massive disruptive forces, rather than diversifying the business into other adjacent markets.
If it goes ahead, what are the implications for the competitive landscape and investors in the sector?
The overall impact is unlikely to become clear for around 18 months. Following the completion of the deal, management could announce major price cuts on some lines, particularly at Asda. Investors should be alert to the effect of these price cuts on earnings. A price war is most likely to hurt the discounters. However, all food retailers were adversely affected three years ago by a widespread price war. If Tesco also announces price cuts, concerns will grow that margins will flatten rather than increase. Tesco’s acquisition of the UK’s largest wholesaler Booker, completed in March 2018, provided the UK’s current biggest supermarket chain with exposure to the wholesale channel and the penetration of Just Eat/Deliveroo as people diversify the way they consume food. Booker supplies many of the UK’s restaurants and takeaways.
Investors should also watch for signs that capacity is being taken out of the market, either as a result of store closures or the sale of stores to non-grocery retailers. Such a move would benefit the whole industry. Potentially, the major players could invest in price cuts and still see margins rise. It will be unclear who will buy surplus stores as they will need to be identified and a bidding process will have to take place. Tesco is unlikely to try and acquire any given the scale of its existing market share. Morrison’s could benefit if it is able to acquire profitable stores at attractive prices but it could also come under further pressure if its fails to do so. However, it is unlikely to disappear given it owns the freehold of a very large proportion of its property empire and is able to control its own rent levels more efficiently than other retailers.
With its George and Tu brands, the combined entity will be the second largest player in the clothes market and pressurise the likes of direct competitors such as Primark. Management has yet to give clear direction on their ambitions for their clothing interests and whether the brands will be distributed through each other’s stores. Such a move would further pressure smaller high street clothing retailers.
Could it prove a trigger for further consolidation in the sector, not just at the retail level but among suppliers?
If this deal proceeds, two players, (Sainsbury’s/Asda and Tesco) each with over 27 per cent of the market, will emerge. Morrison’s and other retailers would lag by a considerable distance and so further deals could be initiated. However, the rationale for further mergers becomes less clear cut when prospects for individual retailers are considered. Waitrose is unlikely to seek to acquire either Morrison’s or the Co-op due to the different markets they serve. Meanwhile, it is difficult to envisage Aldi and Lidl combining to form a large discounter. It’s more likely M&A will be led by players from outside the market, with a big online portal, for example, seeking to acquire store space.
Consolidation could be possible within the supply chain as scale is required to square up to two large retailers rather than just one. Some of the suppliers are already having problems and therefore Greencore/Bakkavor/2 Sisters could consider merging to gain leverage and bargaining power. On the farming side, further consolidation is unlikely. However, it cannot be ruled out since some contracts will be changed, gross margins might be reset lower for promises of increased volumes.
Could the merger prove a harbinger of a general increase in M&A activity in the UK?
We have seen a record level of deals announced globally so far this year, with a number occurring in the UK. We believe this reflects the state of the economic cycle and the global growth outlook. Most markets are growing, albeit not significantly and therefore players continue to seek to increase the scale of their operations. The pick up in M&A activity may also reflect the prospect that the days of ultra-low interest rates are ending and financing will not be so cheap in future.
Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (Aviva Investors) as at 14 May 2018. Unless stated otherwise any view sand opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this document, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This document is not a recommendation to sell or purchase any investment.
In the UK & Europe this document has been prepared and issued by Aviva Investors Global Services Limited, registered in England No.1151805. Registered Office: St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Authorised and regulated in the UK by the Financial Conduct Authority. Contact us at Aviva Investors Global Services Limited, St. Helen’s, 1 Undershaft, London, EC3P 3DQ. Telephone calls to Aviva Investors may be recorded for training or monitoring purposes. In Singapore, this document is being circulated by way of an arrangement with Aviva Investors Asia Pte. Limited for distribution to institutional investors only. Please note that Aviva Investors Asia Pte. Limited does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Asia Pte. Limited in respect of any matters arising from, or in connection with, this document. Aviva Investors Asia Pte. Limited, a company incorporated under the laws of Singapore with registration number200813519W, holds a valid Capital Markets Services Licence to carry out fund management activities issued under the Securities and Futures Act (Singapore Statute Cap. 289) and Asian Exempt Financial Adviser for the purposes of the Financial Advisers Act (Singapore Statute Cap.110). Registered Office: 1Raffles Quay, #27-13 South Tower, Singapore 048583.In Australia, this document is being circulated by way of an arrangement with Aviva Investors Pacific Pty Ltd for distribution to wholesale investors only. Please note that Aviva Investors Pacific Pty Ltd does not provide any independent research or analysis in the substance or preparation of this document. Recipients of this document are to contact Aviva Investors Pacific Pty Ltd in respect of any matters arising from, or in connection with, this document. Aviva Investors Pacific Pty Ltd, a company incorporated under the laws of Australia with Australian Business No. 87 153 200 278 and Australian Company No. 153 200 278, holds an Australian Financial Services License (AFSL 411458) issued by the Australian Securities and Investments Commission. Business Address: Level 30, Collins Place, 35 Collins Street, Melbourne, Vic 3000
The name “Aviva Investors” as used in this presentation refers to the global organization of affiliated asset management businesses operating under the Aviva Investors name. Each Aviva investors’ affiliate is a subsidiary of Aviva plc, a publicly- traded multi-national financial services company headquartered in the United Kingdom. Aviva Investors Canada, Inc. (“AIC”) is located in Toronto and is registered with the Ontario Securities Commission (“OSC”) as a Portfolio Manager, an Exempt Market Dealer, and a Commodity Trading Manager. Aviva Investors Americas LLC is a federally registered investment advisor with the U.S. Securities and Exchange Commission. Aviva Investors Americas is also a commodity trading advisor (“CTA”) and commodity pool operator (“CPO”) registered with the Commodity Futures Trading Commission (“CFTC”), and is a member of the National Futures Association (“NFA”). AIA’s Form ADV Part 2A, which provides background information about the firm and its business practices, is available upon written request to: Compliance Department, 225 West Wacker Drive, Suite 2250, Chicago, IL 60606