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Morningstar | Sainsbury's Proposed Merger With Asda Mutually Beneficial but CMA's Investigation Raises Uncertainty

After taking a deeper look at Sainsbury’s proposed merger with Asda, and given that we think a favourable decision by the Competition and Markets Authority is more likely than not (though we do not have a strong opinion on the final outcome), we’re increasing our fair value estimate to GBX 360 from GBX 231 per share and our uncertainty rating to very high from high. We maintain our no-moat rating.

However, if a deal fails to materialise, owing to the CMA making an unfavourable decision or demanding a large number of store disposals (which could render the deal uneconomical), our fair value estimate would fall to GBX 256. This is 10% higher than our prior valuation based on the firm’s stand-alone operations, reflecting the rollover of our model to account for fiscal 2018 results and a hike of the grocer's retail sales growth coming from new Argos concessions in Sainsbury’s stores, on top of the 280 previously guided by management (management now thinks a range of 280-450 total Argos concessions would be feasible).

Our new GBX 360 fair value estimate implies a 75% probability of our base-case scenario taking place and a fiscal 2019 P/E multiple of close to 20 times, slightly lower than that of Morrisons and Tesco, reflecting uncertainty regarding the CMA's decision and execution risks that the merger of two culturally different organizations entails. We forecast GBP 930 million gross synergies at the EBITDA level in our base-case scenario (versus GBP 500 million net synergies guided) to fully materialize in fiscal 2022 and more than GBP 600 million of cumulative reinvestment in pricing/offering for the combined entity in fiscal 2021 and 2022, as the new entity expects to cut prices by 10% on items that customers buy regularly.

Finally, J Sainsbury issued a first-quarter sales update for the 16 weeks to June 30, with like-for-like sales, excluding fuel, at 0.2% growth and grocery sales at 0.5% growth versus a year ago, slightly lower than our expectations.

We have increased our uncertainty rating by one notch to very high from high to reflect higher variances introduced to our model resulting from the wide range of potential store disposal demands by CMA (from none in our bull-case scenario to 234 stores in our bear-case scenario) and its impact on the economics of the merger (synergies).

We maintain our negative trend rating on the basis of a challenging U.K. grocery market, owing to the disruptive growth of hard discounters and Sainsbury’s weak price positioning relative to peers in a market where value perception is of paramount importance. In case the deal comes through unconditionally or conditional on negligible store disposals, we intend to reevaluate our moat trend rating (proposing a stable moat rating) and anticipate raising our fair value estimate to GBX 390 from GBX 360, respectively reflecting improved scale-based buying power stemming from a market-leading position in the U.K. grocery market and the end of the uncertainty discount relating to CMA's decision. Our fair value estimate excluding CMA's decision uncertainty implies a fiscal 2022 P/E multiple of 13 times, a touch lower than Tesco's 14 times, on the back of merger execution risks.

Further, we highlight two key elements out of the latest first-quarter sales update. First, grocery sales underperformed relative to major peers (0.5% versus more than 2% for Tesco and 1.6% for Morrisons, which reported recently) largely owing to the company's price reductions in March (GBP 150 million). Management stated that these price reductions resulted in 150 basis points lower inflation and narrowed price gaps relative to competition by 1%. Second, general merchandise sales (1.7%) outperformed, supported by strong LFL sales from Argos (15% average sales growth for 74 Argos units open more than a year), though profitability of the segment is still uncertain.

On the grocery segment, healthy growth in online and convenience (7.3% and 3.6%, respectively) implies close to 1% negative volume growth for the segment. That said, we will closely monitor volume growth over the next two quarters (and expect noticeable improvement of grocery volumes), since according to management there is typically a three- to six-month lag to customer response.

Both developments are in line with our Sainsbury thesis, first on the need to invest more heavily back into the business to improve its pricing position relative to its Big Four peers, and second on the Argos deal, which we believe will not benefit the supermarket’s core grocery offering in terms of traffic and volumes. Rather, it will add to its top- and bottom-line cyclicality in a soon-to-be post-Brexit world. On the flip side, we expect Argos, which garners over half of its sales online, to continue to benefit from this acquisition, chiefly because of higher footfall in Argos concessions in Sainsbury’s supermarkets and better convenience through an expanded click-and-collect network. Argos synergies (GBP 160 million) and cost savings (GBP 200 million in fiscal 2019) were reaffirmed.

On the call, management didn't provide any update on the proposed Asda merger, other than that the firm has already secured a GBP 3.5 billion financing package on attractive terms. CMA's decision is expected in second-half calendar 2019. The merger, if approved, will create the largest U.K. grocer with a combined market share of 31.4% versus 27.6% for Tesco.