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Tesco's proposed Booker merger unlikely to transform the supermarket, analysts say

Last updated: 10:20 30 Mar 2017 BST, First published: 09:27 30 Mar 2017 BST

Tesco
Tesco has received backlash from shareholders over its proposed Booker takeover

Tesco plc’s (LON:TSCO) plan to buy wholesaler Booker Group plc (LON:BOK) is unlikely to transform the supermarket as it grapples with tough competition and rising inflation, analysts at Shore Capital think.

The supermarket in late January announced it would buy Booker, the owner of Budgens, Premier and Londis convenience-store brands, for £3.7bn.

But earlier this week the proposed merger reached a stumbling block after two of Tesco’s largest shareholders, Schroders and Artisan Partners, expressed their opposition to the deal.

The shareholders argued the bid for Booker was too high and the merger would detract Tesco’s focus away from its restructuring.

Booker worth the price?...

Tesco has offered a 12% premium to Booker's share price, which doubled from 2012 to before the deal was announced. The takeover values Booker at 26 times forward earnings.

Booker has an impressive record of profit growth and a strong balance sheet but some investors questioned whether the company would continue to improve enough to make the expensive price-tag worth it for Tesco.

Schroders fund manager Nick Kirrage told the Financial Times: “They’re paying 23 times the peak profit of the business. We’re not opposed to a deal at any price. But if you start from there, it’s hard to get to a multiple of profits that we would think objectively is a sensible place for them to start to create value.”

Daniel O'Keefe, fund manager at Artisan Partners, told the newspaper he thought the merger plan was too ambitious.

“Let’s say that things go really, really well, which they almost never do in acquisitions but just suppose,” he said.

“Getting Tesco back to normal operating margins is worth maybe £11bn to shareholders. They’re putting that at risk to do a £3.7bn deal.”

Tesco’s boss Dave Lewis has defended the proposal and insisted the supermarket was “completely committed to the deal”.

The supermarket has said despite the high multiple, the acqusition covers its cost of capital within two years. 

Tesco expects the deal will unlock synergies of £200mln a year, with at least £25mln from revenues. The company has also argued the merger would improve efficiency, reduce procurement costs and cut food waste.

Booker’s chief executive Charles Wilson is equallly supportive of the deal. In today’s fourth quarter trading update, he said: "We are excited about the benefits the enlarged group will bring to consumers, our customers, suppliers, colleagues and shareholders."

Tesco needs to be more convincing...

While the deal has the backing of board members at Tesco and Booker, it will also need approval from shareholders and the UK Competition & Markets Authority.

Shore Capital believes the potential for the deal to fall through presents a major risk for Booker and shareholders should walk away before they lose too much money. The broker rates Booker at ‘sell’.

“Indeed, we struggle to see how Booker could regain its long-standing premium ratings (price-earnings ratio, enterprise value [EV] divided by underlying earnings [EBITDA] or EV/sales) here on and there is, therefore, very considerable downside risk from a failure to complete,” ShoreCap said.

“Added to which, if Booker shareholders really want Tesco paper then they can buy it at any time they want. Accordingly, with the link to the Tesco share price, we continue to suggest that Booker shareholders remove the merger risk, reflect on the time value of money - because they can easily invest at short notice in Tesco - and move on.”

For Tesco, the market’s reaction has been underwhelming with investors opposing the merger and the company’s shares failing to hold onto gains since the deal was announced.

The group will need to do a lot more convincing to receive acceptance of the deal,  ShoreCap said, reiterating a 'hold' rating on the stock.

“Tesco will have to present a more compelling case for this merger, we sense, than the very amateurish presentation pack for this still fine establishment that was produced at the time of the merger announcement, one which sadly was subject to much ridicule and comic appraisal in many of our exchanges with the market in subsequent weeks,” the broker said.

Tesco reports its preliminary results on 12 April, which may be an opportunity to promote the deal, ShoreCap believes.  

Tesco's investment case...

ShoreCap thinks the merger transforms the Booker investment case but will not structurally change the Tesco investment story.

Tesco has been overhauling its business to contend with firece competition between the UK's major supermarkets, which have been losing market share to smaller discounters, including Aldi and Lidl.

Supermarkets had been cutting prices to claw back market share until recently since having to contend with higher import costs due to a weaker pound post Brexit.

Realising these challenges, Tesco's wants to buy Booker to expand beyond its traditional retail business.

Meanwhile, Booker today reported a 0.5% increase in total sales for the 12 weeks to 24 March, as a 7.9% decline in tobacco sales was mitigated by a 4.5% rise in non-tobacco sales.

On a like-for-like basis sales increased 0.7%, including a 7.5% drop in tobacco sales and a 4.7% gain in non-tobacco sales.

Booker said it would not be making forward looking statements while it is under offer in its planned merger with Tesco but the chief executive said sales “were the best we have ever achieved” in fiscal year 2016/17. 

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