Crown Investment Group (CIG) will be used as the acquiring company. CIG is a fictional non-existing business entity. The following assumptions are made regarding CIG group. The first assumption is that CIG group is a US based retail giant listed on the New York Stock Exchange with a current market capitalization of $240.14 billion. The second assumption is that CIG group is the largest supermarket chain in the US both by market capitalization and client base. CIG's interest in acquiring Sainsbury has been predominantly driven by the company's expansion strategy. It recorded over 19 million customer transactions during the just concluded fiscal year. Moreover, despite the tough competition within the UK retail segment, the firm recorded a remarkable 16.1 % increase in market share though with a nominal increase of 0.2 % over the previous year's performance. Sainsbury's sustained growth coupled by its long term growth strategy has made it an attractive acquisition target. This paper will serve as an evaluation report to the Board of Directors on the suitability of Sainsbury plc as an acquisition target. The paper will explore various acquisition motives, financing alternatives, stock valuation techniques and make recommendations to the board of directors.
J Sainsbury plc is the third largest retail chain in the United Kingdom. The firm's operations are segmented into retailing through a chain of supermarkets and convenience store holdings; banking and financial services through its joint venture subsidiary- Sainsbury's Bank joint venture. The firm also operates in the property investment segment through the British Land joint venture and Land securities joint venture. Currently, the Sainsbury operates 890 retail stores that consist of 547 supermarkets and 343 convenience stores across the UK. The retail giant co-owns Sainsbury's Bank with Lloyds Banking Group. Besides, the firm co-owns two property ventures with Land Securities Group plc and the British Land Company plc. The firm is headquartered in London, UK and unlike its arch rival Tesco plc; its scope of operations is limited within the UK with no global operations. The firm has investment in three major segments of the UK economy: retail stores, financial services and property. The firm has extensively invested in human resources with total personnel of 146,900 employees on its payroll. This number is inclusive of 99,600 casual employees.
The company's financial statements reveal an impressive performance in the previous financial year. It posted revenues totaling £19,964 million during FY2010, with an impressive 5.6 % increase over FY2009. Despite dismal performance in the core retailing segment, the firm posted an increase of 5.5% in operating profits with £710 million ($1,133.4 million) in FY2010 (Annual Report, 2010). There was a significant increase in net profits recorded in the FY2010 as compared to FY2009. The firm realized £585 million ($933.9 million) and £289 million ($461.3 million) in net profits in FY2010 and FY2009 respectively (Annual Report, 2010). Sainsbury's financial services segment recorded £19 million in operating profits in the FY2010. The firm opened 51 more convenience stores around the UK in the FY2009/2010. The firm currently operates a total of 343 convenience stores and plans are underway to open 75 to 100 stores in the FY2010/11 (Sainsbury, 2011)
Motive of the Acquisition
The available literature on acquisition is voluminous as the subject of Mergers and Acquisition has been extensively researched. The available literature has significantly contributed to the exploration of the primary motives that predetermine acquisition transactions. According to Honore and Maheia (2003), there exist myriad reasons that motivate firms to seek for mergers and acquisitions. However, for the purpose of this paper the focus shall be on corporate motives of acquisitions. Cox (2006) stipulates numerous fundamental motives which drive firms into pursuing acquisitions. Accordingly, Russo and Perrini (2006) assert that most acquisitions are motivated by synergy and valuation. Based on the Valuation of the target firm, he argues that the acquiring firm may be lured by a positive Net Present Value (NPV). Firstbrook (2007) posits that there lacks universal consensus on whether the real motive behind acquisition is to achieve monopolistic power or other management driven reasons. Furthermore, Nakamura (2005) argues that there is exists limited evidence to justify acquisition motives as alluded to by the process and raider theories. On the contrary, Gughan (2002) pragmatically reviews the motives that drive firms into acquisition. He, unlike Folta (2004) affirms that acquisition provides firms with an opportunity for accelerated growth. He states that acquisition serves as a means by which quoted companies increase their market capitalization while tapping into more lucrative business segments.
Acquisitions are motivated by the need for anticipated benefits that come as a result of applying and implementing superior management practices to the targeted firm. Thus Gurghan (2002) contends that acquisitions are motivated by diverse complex factors that considerably differ from deal to deal. Hence he concurs with Cox's (2006) assertion that acquisition motives cannot be predetermined by any particular hypothetical approach. Firstbrook (2007) posits that technological knowledge continues to be a primary motive that drives corporate acquisitions. He argues that acquisition facilitates means by which companies externally acquire new technological synergies which fundamentally drives product development and innovation (Picot, 2002). Due to intense pressure for firms to innovate, corporate acquisition provides access to the required technological resources that compel firms to pursue resource based strategies (Gaughan, 2002). Motivated by this strategy, firms primarily aim at acquiring valuable technological assets including intellectual property policy of the target firm. This is because a company's patent portfolio has a direct impact on the firm's innovative potential (Nakamura, 2005). Gurghan (2005) and Cox (2006) both concur that a firm's patent portfolio predetermines its innovative potential especially where complimentary technological synergies exist between the target and acquiring firm. A review of Sainsbury has revealed that the firm wields considerable technological synergies. The group operates internet based 30, 0000 food and non-food products and services to over 19 million customers. It provides internet home delivery shopping to over 90% of UK customers.
Corporate acquisitions are largely influenced by resource based motivations (Papadakis, 2005). Accordingly, Gaughan (2002) contends that the firm's technological endowment considerably impact on the bid value of the firm. The value of quoted firms is determined by the financial markets efficiency thereby reflecting on the amount of publicly available literature on the target firm that reveals future revenue projections. Sainsbury plc is listed on the UK mains financial markets through the London Stock Exchange. The UK financial markets are internationally acclaimed for their operational efficiency and transparency which makes the acquisition deal even more attractive. Daniel and Phillips (2007) posit that acquisitions encompass the acquiring firm gaining considerable influence over the target firm's market value.
Through acquisition, firms seek to amass economic growth necessitated by economies of scale that emerge. Acquisition increases the firm's market capitalization and financial capacity which positions the merged to take advantage of economies of scale (Chunlai & Findley, 2003). Acquisition creates larger firms compared to pre-acquisition firms; hence the larger firms can easily access capital markets that were previously inaccessible prior to the acquisition. Access to more capital markets leads to lower costs of capital besides other financial benefits that accrue from economies of scale (Cox, 2006). CIG should consider the acquisition of Sainsbury plc to benefit from economies of scale and numerous complimentary synergies between the two firms.
According to Hussinger (2006), firms engage in acquisitions to realize economies of scale. Through this acquisition, CIG's fixed costs associated with R&D will be spread over the expansive post acquisition R&D output of the merged entity. Moreover, R&D costs can be further cutback since the acquisition will eliminate duplicated inputs of the same output. Another motive to pursue the acquisition is the economies of scope, which according to Russo and Perrini (2006) is an important factor that drives acquisitions. He argues that post acquisition investment costs can be spread across multiple R&D teams. Therefore overall cost reductions will be achieved due to optimum resource utilization in the merged firm (Frey & Hussinger, 2006).
Another motivation to pursue the acquisition of Sainsbury plc is the expected synergy that will result from the merging of the two technology portfolios (Cox, 2006). This view is supported by Ahuja and Katila (2001) who posit that the target firm's technology portfolio would usually compliment the technology stock of the acquiring firm. Furthermore, it leads to enhanced competencies of the merged entity (Cassiman et al., 2005; Hussinger, 2005). A review of Sainsbury's technological portfolio suggests a strong R&D investment. It is further apparent that Sainsbury's continued investment in R&D has continued to drive innovation which gives the firm a competitive edge over its competitors. According to Honore and Maheia (2003), acquisition is motivated by the need by the acquiring firm to acquire the intellectual property rights of the target firm. This is because the acquisition of intellectual property rights boosts the R&D capacity of the acquiring firm. Besides technology acquisition, another fundamental motive that drives companies into acquisition is a gain in the market share, gaining access to specific markets, increased efficiency and elimination of competition (Firstbrook, 2007). Premised on this hypothesis, the proposed acquisition of Sainsbury plc will accrue the above benefits to the merged firm.
Another primary motive behind acquisition is to assert the position of the merged entity to gain a competitive edge in technological competition (Russo & Perrini., 2006). Thus through convergence of technological resources, the merged firm will be better positioned to establish barriers for new entry into specific technological segments. Thus according to Chunlai & Findley (2003) the acquired patents can be utilized to block competitors from launching patent applications of similar technological alternatives thus giving them an edge over their industry rivals. Hussinger (2006) suggests that defensive blocking through patents can give the firm considerable leverage in the market. He argues that the merged firm will be better positioned to block patent applications by competitors by threatening their novelty requirements thus giving them a monopolistic edge in that specific technological niche.
Valuation of Sainsbury Plc: Valuation Report
Price/Book Value Ratio
P/B ratio is commonly used in computing the current market value of a public firm. Interested investors use the P/B ratio to compare a stock's per share price to its book value (Russo and Perrini, 2006). The P/B ratio usually suggests how much the shareholders are paying for net assets of the firm. The ratio represents an estimation of the value of the company and thus it helps the investors to compare the firm's market value with the book value (Hussinger, 2006). Hence P/B ratio indicates the current stock price of a firm divided by its book value per share. On the other hand, Equity per share is derived by dividing the firm's equity by the total number of outstanding shares.
CALCULATIONS: P/B Ratio
Price/Book Value Ratio is computed as follows:
Price/Book=Stock Price per share / Equity per share
Stock price per share = 22.0; Equity per share = 5.45.
P/B = 22.00/5.45; P/B = 4.0;
The P/B ratio was very significant in calculating the value of firms during the time when most listed companies were capital intensive. Consequently, P/B ratio was effective in computing the value of these firms based on their book value. However, the recent upsurge in service oriented firms means that such firms create value using intangible assets which do not appear in the book value of the company. Investors must also be cautious about the book value as it is usually misleading. Moreover, P/B ratio is usually linked to the firm's Return On Equity. Thus considering two similar companies, a higher ROE usually corresponds to a higher P/B ratio whereas a lower ROE value indicates a decline in the P/B value (Russo and Perrini, 2006). This is because firms with high ROE have the potential to compound their equity at a higher rate. Consequently, this leads to a faster growth in equity. The value of such a firm would be higher and as a result it would attract a higher stock price thereby causing a corresponding increase in its P/B.
Price/Sales Ratio:
Price-to-sales ratio is computed by taking the current stock price of a firm and dividing it by the accrued sales (Revenue) per share.
P/S ratio is computed as follows:
Price-to-sales = Stock price per share/sales per share
Stock price per share = 22.0; sales per share = 4.45.
P/S = 22.00/4.45; P/S Ratio = 4.94.
(Source: Bloomberg)
The benefits of using P/S ratio is that sales are usually perceived to be more stable and cleaner compared to earnings that are highly volatile (Cox, 2006). It's perceived to be cleaner and more dependable than the P/B ratio, as it's free from accounting wiles that could be employed to boost earnings (Russo and Perrini, 2006). However, the greatest disadvantage of using P/S ratio is that sales do not usually reflect a firm's profitability hence the need to use it together with other valuation ratios.
Price/Earnings (P/E Ratio):
Price-to-Earnings Ratio (P/E) is the most common valuation ratio that compares the firm's current share price to the firm's current Earnings.
The ratio is computed as follows:
Price-to-Earnings = Stock Price per share / Earnings per share (EPS)
P/E= (stock price per share)/EPS
Market value per share = 22.00 ($22.00)*
Earnings per share (EPS) =1.53
Therefore, P/E = 22/1.53 = P/E Ratio = 14.37
Assumptions: -EPS is an annual estimate for FY 2011; Market value per share is based on JSAIY: US. (Source: Bloomberg)
P/E is popular among investors who use it to compare a firm's current P/E ratio with its previous P/E ratios. The P/E ratio is used to compare a company's performance with others in the same industry. However, P/E ratio alone is insufficient in computing the value of a listed firm as it is susceptible to certain computational shortfalls. For instance, EPS used in calculating P/E ratio is depended on accounting practices that utilize assumptions when calculating earnings (Daytrading, 2011). Another flaw is that the value of earnings is predisposed to manipulation hence P/E cannot be accurately relied upon. A lower P/E cannot be construed to reflect an impressive acquisition deal. This because a highly profitable firm with a low debt/equity ratio could reflect a high P/E and still present an attractive acquisition deal due to its high potential for future cash flow (Daytrading, 2011). Despite the above mentioned shortfalls, P/E is significant in comparing market values of companies that operate within the same industry using a specific industry benchmark. Therefore when P/E is used as a valuation tool, investors must monitor factors that could lead to vague earnings (E).
Price /Earnings to Growth-PEG Ratio
PEG is a valuation ratio used by investors to compute a target firm's stock value while incorporating the firm's growth in earnings.
PEG is computed as follows:
PEG = (Price/Earnings Ratio)/Annual EPS Growth; PEG = P/E Ratio/Annual EPS Growth
P/E =14.37; Annual EPS Growth = 5.6%;
PEG = 14.37/5.6; PEG Ratio = 2.57;
PEG Interpretation:
PEG <0.5 = Strong Buy; 0.5-1.0 = Buy; 1.0-1.25 = Hold; 1.25-2.0 = Avoid; >2.0 = Sell.
The PEG ratio for Sainsbury plc is 2.57. The PEG> 2.0 thus suggesting a strong sell. It implies therefore that the shareholders are advised to divest their stocks hence the price per share is likely to decline due to demand and supply forces. This makes the firm a better target for acquisition based on the PEG ratio. However, there exists disparity in the value of Sainsbury's stocks in the UK and US financial markets. This could be attributed to variations in the market fundamentals of the two countries.
PEG is often used by investors to determine the value of a company's stock. It differs from the P/E ratio in that it incorporates growth which is a key indicator of the value of a stock. Due to this, it's preferred by investors as it provides a more accurate reflection of the value of a firm. Thus a lower PEG indicates that the stock is significantly undervalued whereas a higher PEG would indicate significant overvaluation (Cox, 2006). The downside of PEG ratio is that it's less accurate as figures used in computation are usually projections. Moreover, significant variations accrue due to varying earnings derived from different fiscal years. Therefore the lower the PEG ratio, the better the value of the company as this would imply that the investor would invest less per unit of earnings growth (Day Trading, 2011).
Financing Alternatives
Equity Financing through Retained Earnings
Crown Investment Group (CIG), listed on the New York Stock Exchange has various alternative means of raising capital to finance the proposed acquisition of Sainsbury plc. One of the most common methods of raising capital by listed firms is by increasing retained earnings. According to Firstbrook (2004), the value of retained earnings has a corresponding impact on the value of dividends. Instead of declaring dividend payment, CIG would opt to withhold dividends as retained earnings and re-invest them in the acquisition of Sainsbury plc. Cox (2006) suggests several reasons that drive companies to opt for internal equity financing through retained earnings as opposed to high dividend payout. Financing the acquisition through retained earnings will incur no extra costs given that retained earnings do not result to a cash outflow (Daniel & Phillips, 2007). Secondly, the CIG's dividend policy regards retained earnings as the most financing alternative as the acquisition of Sainsbury would be completed albeit the need for shareholder involvement. Thirdly, retained earnings financing eliminates issue costs that are usually associated with the issuance of new shares. Lastly, the use of retained earnings eliminates any likelihood of change in management control that could arise through issuance of new shares. However downside of self-financing through retained earnings is that shareholders may turn down the directors' proposition to retain dividends payable (Hussinger, 2006).
Private Investments in Public Equity (PIPE)
Private Investments in Public Equity (PIPE) are a prevalent financing alternative available to publicly listed firms in the United States. A PIPE transaction involves a listed company issuing common stock or securities convertible to common stock to a limited number of investors in exchange for cash (DiGeorgio, 2003). The company is then required to register the issued common stocks during a private placement with the US securities and Exchanges Commission (Schraeder, 2003). PIPE could be used as a financing alternative by CIG to raise funds required for the acquisition of Sainsbury plc. The downside of this method of capital financing is that investors are required to hold securities issued in a private placement for a limited period of six months (Firstbrook, 2006). Nonetheless, given that CIG will require registering the resale with the SEC, investors are permitted to divest them on the capital markets immediately on the closure of private placement and on the effective declaration of the registration statement. PIPE transactions are an essential financing alternative for public firms seeking new investments through acquisitions. The limitation for this alternative is that it has a limited market capitalization ceiling of $250 billion which limits companies with a market capitalization that exceed this statutory threshold (Nakamura, 2005).
Rights Issue:
CIG group can use rights issue as a financing alternative to raise capital for the acquisition. Through rights issue, the firm would raise new share capital by offering existing investors new shares in exchange for cash (Hussinger, 2006). In a rights issue, the new shares are issued in proportion to the already existing share capital. However, CIG will have to set a competitive share price to attract existing shareholders though not too low as to cause excessive dilution of the firm's earnings per share portfolio. The downside of the Rights issue is that it may not raise sufficient capital needed for the acquisition. In a bid to attract investors, the new share prices may be too low thereby causing dilution of earnings per share (Cox, 2006).
Preference Shares Issue
CIG group can raise capital for the acquisition through preference share issues. Preference shares are preferred due to their fixed percentage of dividend that is payable to ordinary shareholders. The advantage of this financing alternative is that preference dividend is only payable when the firm records impressive profits with the exception of cumulative preference shares in which the right to unpaid dividend is carried forward (Schraeder, 2003). However, the arrears on the cumulative preference dividends are accorded payment priority compared to dividend payment on ordinary shares. This alternative would be preferred given that dividend payment would not be expedited when the firm records dismal profits (Russo, 2006). On the contrary, Nakamura (2005) posits that interest payable on long term debt would have to be paid regardless of the firm's performance. Schraeder (2003) concurs that preference shares have no voting rights, and consequently does not impact on the shareholder control structure whereas equity financing dilutes control by the existing shareholders. Moreover, he asserts that financing by means of issuing preference shares does not impede on the firm's borrowing capacity since preference share capital does not require asset security.
Recommendations
Based on the valuation statistics, it is established that the acquisition of Sainsbury Plc is an attractive investment opportunity for CIG group. Despite a failed acquisition of 25% stake by a Qatar based Delta Investment Group; the firm continues to be an attractive acquisition target due to its technological synergies and its command of 16.1% of the UK retail market, financial services and property investment segments. The firm's current PEG ratio is >2 suggesting a strong sell for the equity holders, hence a strong buy for the investor. Considering the value of the acquisition, a mix of the following financing alternatives is recommended.
Equity Financing through Retained Earnings
Equity financing through retained earnings is strongly recommended. Instead of declaring dividend payment, CIG should instead withhold dividends as retained earnings and re-invest them in the acquisition of Sainsbury plc.
PIPE Financing
PIPE presents an attractive financing alternative for the Sainsbury acquisition bid. Unlike the UK, there are no legislations in the US that limit the criteria for raising capital through the sale of PIPE shares. The limitation for this alternative is that it has a limited market capitalization ceiling of $250 billion. However, considering Sainsbury market capitalization of $240 Billion, PIPE financing can still be used.
Rights Issue
We recommend that the company makes use of the rights issue to raise capital together with the other financing alternatives. Using rights issue, the CIG should raise new share capital and offer it to the existing shareholders in exchange for cash. Nonetheless, it is important to note the demerits of using rights issue as discussed in the paper.
