1

Acquisition Proposal for J Sainsbury (Corporate Finance Project)

After viewing the initial proposal to look at J Sainsbury as a candidate for takeover, I can see

many potential reasons for such a move to be a success and that should create value for the

shareholders of Kwik-E-Mart (our company). Alongside all the reasons to move forward with the

takeover, there are several problems that need to be addressed that could increase the risk of

profitability in the acquisition. Not to liken this proposal to Walmart’s acquiring of Asda, which since

1999 has been somewhat a success, but previous to this Walmart acquired two German grocery

companies, which were subsequently sold at billion dollar losses in the mid-2000s, these were due

to several issues including cultural differences and not understanding the market before entering. A

quote from a report written about Walmart’s failed exploits in Germany; “Wal-Mart’s failure on the

German market has been the inevitable result of its inability – caused by an astounding degree of

ignorance of key principles of internationalization strategies and intercultural management – to

select and implement an adequate entry and business strategy.”1 We therefore would need to be

fully in tune with the UK business culture and consumer base and be clinical in our implementation

of our strategies.

Our key sales markets being Central America and Asia, are in itself very widespread due to

the large marketplace available, however it is understandable to see the European market and

especially the UK as a country to be good place to move into for diversification purposes, and some

much needed corporate governance and corporate social responsibility expertise. To begin

establishing a supermarket brand within the UK, would be very time consuming, and costly, as the

biggest four supermarkets in the UK, Tesco, Asda, J Sainsbury, Morrison, account for 76.2% of the UK

grocery market. These companies have been trading for many decades with 3 of them close to or

over 100 years old. With this in mind, it would be unfavourable to try and build our brand in the UK

(a highly contested market), and acquisition would be the most efficient way to enter. The UK

consumers seem to have a brand loyalty, which would make it hard to build a reputation, but would

make for a good reason to acquire a company with strong branding and loyalty such as J Sainsbury.

However to use this takeover as just an exercise for diversification would in my opinion, be a

mistake and not in the best interest for the shareholders. Even though it will hedge our risk when

certain regions aren’t performing well, our shareholders can diversify their risk and exposures

themselves by investing in companies such as J Sainsbury or other firms of their choice and rationale, 1 Why did Wal-Mart fail in Germany? By Andreas Knorr and Andreas Arndt

2

at a much cheaper price than the total costs involved in the acquisition. Unless we can exploit

synergies and economies of scale to cost-cut and improve growth, we will not find shareholder

approval in this deal, as creating a more diversified firm with less risk, may actually transfer wealth

from stockholders to bondholders, which will leave investors further disappointed if we fail to see

value creation by going through the acquisition. If this was to happen and even though it may be an

extreme case, it would lead the views of Kwik-E-Mart being under threat of takeover, being

strengthened, if the share price of our firm was to fall in such a case.

Diversification of product lines could be a great reason for the merger, to introduce

European lines, some of which are synonymous with prestige and great quality, and vice versa bring

American products across the Atlantic to the British market. However in recent times, we faced

criticisms of too many foreign products being sold in our stores, personally more choice the better,

but we need to stay in line with our customer’s views, as we do not want to alienate our domestic

market and be at the risk of harming our business. Although, what does come with a more global

product line, is a bigger global buying power, which should give us better margins on some our

products as well as J Sainsbury products. We have a conservative estimate of 0.7% reduction in J

Sainsbury cost of sales, which should not only reduce their costs, but ours also, for global brand

products we will be able to negotiate better contracts with suppliers, for example brand name global

appliances. Although this synergy has a short to medium term hurdle, due to current contracts in

place for both us and them, and so immediate synergy might not be realised.

My opinion would be to on acquiring, not to rebrand J Sainsbury, as it already has a loyal

customer base and is a recognised brand in the UK. Therefore we would not inquire any costs, as we

would run J Sainsbury as a subsidiary carrying on with its own name and branding. However, this

would make it harder to sell our own branded products, as a cost saving synergy, as it would then

rival J Sainsbury another of our brands if we were to buy them. We could however, merge

production facilities and have all our own brand food stuffs for example at the same processing,

packaging and manufacturing facilities.

Following on from facilities, the wider integration between ourselves and J Sainsbury would

have to be behind the scenes, as we do not want to have a major impact on the current brand that is

working well in the UK, which is 3rd in market share and not far behind 2nd placed Asda. In the

initial information provided, you have calculated additional growth in sales and reduction in cost of

sales, but I also believe we can save costs in IT; J Sainsbury will have a large IT team and on-going

costs to maintain their online grocery service. I believe we could integrate the teams and make

savings, in personnel and server costs. We could also save on wages paid by ourselves and J

3

Sainsbury to maintain a 24/7 team on hand to tend to the IT networks, as we could consolidate our

teams and theirs, due to our different time zones, so we can cater their night and vice versa. With

online sales growth in both the US and UK markets, growing strongly, over time this consolidation of

IT, could be a great cost saving synergy. J Sainsbury’s online sales growth is better than its rivals.2

Part of the J Sainsbury’s success has been their sustainability and responsibility campaigns,

for example J Sainsbury was the first to back and sell Fairtrade products in the UK, and is currently

the largest seller of Fairtrade produce in the world.3 We could bring these networks and marketing

teams that made Fairtrade in the UK a success and scale it up to the American market which is a

much larger consumer audience. Another initiative they have used is to promote domestic produce,

a region we have been lacking and have even seen criticism over, due to stocking too many foreign

goods, we could learn from J Sainsbury strategies that would help us regain faith as a supermarket

from the American consumers.

My valuation of J Sainsbury will be a valuation on the multiples and comparables with other

UK supermarket firms. Another option would be to use the discounted cashflow method however, J

Sainsbury has had several years of negative free cashflows and therefore, I do not wish to use this

method of discounted cashflows, as basing it on the historical figures, the valuation of J Sainsbury

would be too far from the reality. DCF tries to find the intrinsic value of the firm, and in this

circumstance a company with possible anomalies in its FCFs and therefore the calculations will be

off. It is also very sensitive to inputs such as terminal growth, current profitability and J Sainsbury’s

weighted average cost of capital. Valuation by comparables attempts to price the company relative

to similar peer firms such as Tesco, Morrison and Marks & Spencer. This gives us an idea on how it is

currently priced against its peers. Comparables also therefore takes into account for market

consensus, rather than DCFs based purely on fundamentals. I will not be comparing J Sainsbury with

any other firms from outside the UK, due to having different financial cultures in terms of capital

structure and debt to equity norms.

The multiples I will be using to compare firms will be several different financials but will all

be using Enterprise Value of the company rather than the stock price. This is because as an acquirer

we are looking at the entire business, debt included, as we would be taking on this obligation for any

outstanding liabilities. Another benefit of this is we will avoid any distortion of valuations due to

varying cash reserves between firms. (Enterprise Value is calculated as “EV = market capitalisation +

(long-term debt – cash & cash equivalents”).

2 J Sainsbury’s Annual Report and Financial Statements3 J Sainsbury’s Sustainability Report

4

The table above4 compares some selected financials between 4 UK listed supermarkets.

Firstly the Market Capitalisation is the stock price multiplied by the total amount of outstanding

shares. This is the total value of all the equity in the firm, when you add debt and subtract cash

reserves you get the EV value. Debt/EV is a figure which shows you the portion of the total value of

the company that is arrived from debt. With all the firms having very similar Debt/EV it shows that J

Sainsbury does not have an irregular capital structure for the sector. EV/Sales shows us the EV as a

function of Sales, however this does rely on the firms all having similar profitability margins.

However, even so in this case if we were to simplify the figure as cost per unit sales, J Sainsbury is

the cheapest out of the 4 firms shown. The next two columns are the most interesting; these show

us the EV as a multiple of Earnings Before Interest & Tax (EBIT) and Earnings Before Interest, Tax,

Depreciation & Amortisation (EBITDA). Again for these a lower figure the better, however here we

can see that J Sainsbury is slightly higher than both Morrison and Marks & Spencer. J Sainsbury is

significantly lower in this respect compared to Tesco, and these could be explained by the fact, J

Sainsbury carry out a large amount of sustainability agendas, which can have an adverse effect on

profitability margins, for example on Fairtrade goods where the idea is to not to aim for the best

margin but rather help the farmers and producers of the goods. This could be improved by our

conservative estimates of an additional 2% sales growth, 0.7% fall in cost of sales to sales ratio and

12% in administrative costs to sales ratio. All of these benefits would be shown by an increase in

EBIT and EBITDA, and therefore the EV/EBIT and EV/EBITDA would fall. I have also included EV/CF to

show you that although the EV/EBIT may not be as desirable, the EV/CF is still very healthy and the

best out of the 4 firms. Pay only a small attention to the EV/FCF as this shows how much of an

anomaly the FCF data has been for the past few years, and I expect within the next few years to

4 Bloomberg Terminal

5

come back into normal figures, as marked by Tesco who also have a high EV/FCF and are still a

monopoly in the UK supermarket sector, therefore we shouldn’t be put off by J Sainsbury FCF figures

for the past couple of years.

Using some assumptions I will attempt to recalculate some of the comparables using our

projected additional growth and savings we can offer J Sainsbury. Firstly, an additional 2% in sales

growth, using J Sainsbury’s expected sales figures for 2013 from Bloomberg and adding an additional

2%, I can get a better EV/Sales figure. This may seem an odd thing to do due to not account for

projected growth in the EV of J Sainsbury without our input, however I am assuming this

informational being publically available is already price incorporated and discounted in the stock

price and therefore the EV shall remain ceteris paribus. EV/Sales, without 2% additional growth in

sales, becomes 0.40 which is even better of an already leading figure in the industry. The projected

EV/Sales falls to 0.39 without our intervention and therefore I see with our predicted 1% for the

following 4 years that EV/Sales will fall further potentially around 0.35 or 0.36 in total.5

For EV/EBIT, I will account for the savings in cost of sales to sales ratio and administrative

costs from Bloomberg’s 2012 filed accounts, and this should give a higher EBIT and therefore lower

EV/EBIT. I have calculated that the EV/EBIT will drop to 9.31 whilst EV/EBITDA falls to 6.20. These

figures are produced using 2012 posted figures on J Sainsbury’s admin costs, sales and sale’s costs.

These figures now show J Sainsbury as very cheap relative to the likes of Tesco, it becomes best in

terms of EV/EBITDA and close to best for EV/EBIT. This is all whilst J Sainsbury undertakes great

levels of social responsibility and sustainability projects, which would reduce profitability, small

sacrifice if its image is what makes it so successful, and something we need to be taking note of.

As for valuing the firm’s equity, using my new calculated amount of EBITDA which is 1526

million, times this value by the old EV/EBITDA of 7.47, I get a new EV of 11,403 million, subtracting

for debt from the EV, I value the equity in the firm to be 8627 million. With 1890 million shares

outstanding, I value each share at 456.5p. At a current share price of 380.4p, this represents possible

76.1p premium or exactly 20% at current market rate. Therefore it is my suggestion to move forward

with this acquisition as long as we pay below this premium. The lower the better, as it will give us a

better return, but we will be gaining many things aside from wealth gain, such as the expertise and

knowledge, which can be used in our own business, in areas already outlined as concerns in current

operating markets. I wouldn’t advise paying any higher as a premium, as even though this is using

conservative figures for synergy levels, we need to be able to create value for our shareholders for

this to go ahead, as we are not doing this to just diversify or empire build, because this would mean

5 Data is calculated using Bloomberg for J Sainsbury’s financial reports

6

we would be paying over the odds and would fall victim to what is known as the winners curse. This

trap is easy to fall into if we don’t “Separate price from value. The intrinsic value of a target company

is a function of its future free cash flows, predicated on how it transforms market position,

organisation, capital and other assets into performance.”6 We need to be paying less than the

intrinsic value + synergies, for this to be profitable and reduce the risk of long term failure. The

graph7 shown nicely visualises on our stand point dependant on the value, and price point paid,

although we would need a better

intrinsic value method such as DCF

model, which can be done as further

diligence after this report.

For financing this acquisition,

there are several possibilities, as to how

we could do this. We could buy the firm

in cash, pay with shares or leverage and

borrow to buy J Sainsbury. Our firm is cash rich, and therefore it may be best and simplest to go with

this route, but ill explore the alternatives that are options. To pay with our own shares, may not be

the best option, with our depreciated value in stock, as usually when there are acquisitions with

payment in shares, it signals the acquirer’s share price is overvalued, and with our current

undervalue in stock, we wouldn’t want our stock price to fall further. On the other side our stock is

an undervalued currency at the moment, so it would be not a good idea to use as payment anyway.

We could go down the leveraged buyout route, by borrowing ourselves, if we do not have enough

cash reserves to buy the company entirely. This would however change our debt to equity ratios in

the firm and may alter our investor’s views on the health of the firm, although we would have the

advantage of being able to borrow either using ours or J Sainsbury’s cost of capital and use J

Sainsbury’s assets as the collateral on the loans. For this we could talk to the J Sainsbury’s

management and have them take out loans to cover our shortfall, and they would go through a

share buyback scheme, and we would take over the firm using our cash reserves for the remaining

cost, however we would receive a much more debt loaded company. The other downside to this

would our interest costs go up, even if is a tax shield.

For these reasons, if the acquisition does go ahead, I would go with using as much as

possible of our cash reserves, which we have built up and would be distributing to our shareholders

eventually anyway, and instead we can retain these funds and hopefully create more value for them

66 and 7 Making M&A Pay: Avoiding the “Winner's Curse” by Milyae Park7

7

in the long term by this deal. The key for the acquisition to go ahead is to be not bullied by the J

Sainsbury’s shareholders into paying over the odds for their shares, as my calculated maximum

premium to be offer is 20%, but it below 2012s average premium paid, which at the time was at an

11 year high.8

ReferencesAndreas Knorr and Andreas Arndt “Why did Wal-Mart fail in Germany?” http://www.iwim.uni-bremen.de/publikationen/pdf/w024.pdf8 CNN “Companies are paying up for deals”

8

BBC “Wal-Mart abandons German venture”http://news.bbc.co.uk/1/hi/business/5223432.stm

Bradley, Don B., III. Urban, Bettina “Wal-Mart's learning curve in the German market.” Journal of International Business Researchhttp://www.freepatentsonline.com/article/Journal-International-Business-Research/166850563.html

J Sainsbury’s Annual Report and Financial Statements http://www.j-sainsbury.co.uk/media/649393/j_sainsbury_ara_2012.pdf

J Sainsbury’s Sustainability Report http://www.j-sainsbury.co.uk/media/1377005/jsainsbury_20x20_sustainability_brochure.pdf

Milyae Park “Making M&A Pay: Avoiding the “Winner's Curse””http://law.wustl.edu/courses/lehrer/spring2006/CourseMat/2006/winners%20curse%20making_pay.pdf

CNN “Companies are paying up for deals”http://finance.fortune.cnn.com/2012/07/31/companies-are-paying-up-for-deals/

Google Finance (Stock price) (Accessed: 24 April 2013)https://www.google.com/finance?q=SBRY