Abstract
The purpose of this report is to analyze the feasibility of a cross-border acquisition. US Store Inc offers a proposal to acquire a UK supermarket, Morrisons. The proposal explains the motivation of US Store Inc to acquire, which mainly focuses on entering UK market. The actual values calculated through standalone-basis and synergy-basis suggest that the current market value of Morrisons is undervalued. It is recommended that this acquisition should proceed in a friendly way because the synergy effect could create value for both bidder and target. The bid price in proposal is set at 30% premium over current Morrisons' market value because this high premium is expected to accelerate the process of acquisition. For bidder, it is suggested that bid should be financed by cash. Although there is certain asymmetric information on the target, cash payment could increase the possibility of acquisition success.
Executive Summary
For a company wants to explore a new market, acquire a local company is preferred. The acquisition case in this report is the one. US Store Inc intents to enter a new market (UK), thus targeting a local supermarket company Morrisons. Potential synergy effect would be the selling point in the proposal rendering to Morrisons' board and shareholders. The actual values calculated by standalone-basis and synergy-basis indicate that the current market value of Morrisons is undervalued, which is probably because of the impact of 2008 financial crisis.
It is recommended that the proposal with significant value-creation from synergy effect, is supposed to be attractive to the board. Therefore, a friendly acquisition strategy should be taken, which could be an economical way to acquire target under the 'win-win' atmosphere. It would be smart to make money with shaking hands rather than with bloody war. The analysis on the key personnel (CEO and chairman) and the biggest shareholder (Morrison Family) further implies that the feasibility of friendly acquisition. Nevertheless, the bid price is suggested to be 30% premium over current market value rather than (usual 15% - 20% premium when using friendly acquisition). The underlying reason is to make sure the deal would be done. The high bid price could beat other competitor bidders, and also could accelerate the decision of Morrisons board and shareholders.
The bid is suggested to be financed by cash. US Store Inc, which is half size of Wal-Mart, would have the capability to raise enough cash to finish this deal. Although the asymmetric information on target, such as the recent replacement of CEO, and low liquidity capacity (low quick ratio), would incur the acquirer's concern on actual operation and company value of the target, cash payment is still recommended because the fundamental analysis suggesting Morrisons is a good target.
Introduction
The US Store Inc is expanding its international market in order to re-pick up the market attention. Although US Store Inc has steady earnings, it loses the market belief on its future growth capability (reflected in its low P/E ratio in US stock market). It is necessary for the management to explore a new growth path (i.e. international expansion) to attract market's attention. Acquiring a UK major retailer (Wm Morrison Supermarkets PLC, in this report) is reasonable based on the consideration of language, and culture. UK market could be the first stage of expansion, Europe, Far East, and the Gulf States are expected following.
Section One: Motivation
Acquiring a UK retailer would make this case as a cross-border acquisition. Cross-border acquisition becomes a prevailing tendency in Merger and Acquisition activities recently (Mantecon, 2009). Theoretically, the benefits and costs over cross-border acquisition are still under debate. There are value-enhancing proponents [Bodnar et al (1999); Mantecon(2009)]. There are value-reduction claimers [Denis et al (2002); AkdoÄŸu (2009)]. Due to acquirer and target being in the same industry (supermarket sector), corporate synergies and economies of scale are expected [Trautwein (1990); Faccio and Masulis (2005)].The purpose of this cross-border case focuses on entering UK market as trial of company's international expansion. Tesco, Asda, Sainsbury, Morrisons and M&S are the candidates.
There are various criterions to choose Morrisons as the target. Comparing with other candidates, First of all, Morrisons has the lowest gearing ratio (Equity/Debt) among all candidates (companies' annual reports), which means Morrisons has the smallest business risk. Second, M&S should be deleted. M&S, a traditional famous UK 'upmarket' company, with international presence, would make acquisition difficult to implement for its global coverage and brand premium. Second, Tesco is also inappropriate because it is the giant in UK supermarket sector with global presence, which would increase the difficult in integration after acquisition (i.e. it would cost huge money to acquire but hard to digest). Third, although Sainsbury has similar business scale with Morrisons, Morrisons has higher Return On Equity (ROE) (Morrisons: 10.18; Sainsbury: 6.6; in 2009). Forth, Asda is unlikely to be a good target merely because it is whole-owned by Wal-Mart. According to current situation, Wal-Mart has no reason to sell its only subsidiary in UK to its US competitor. Therefore, Morrisons is chosen.
Morrisons is a purely UK-local supermarket without international presence. It occupies the fourth largest market share in UK supermarket sector, and is still in highly growth period. Morrisons identifies its clear and distinguish competing strategy to Tesco and Sainsbury, i.e. Morrisons mainly focuses on convenience store. Moreover, the products line of Morrisons is concentrated: most stores focus on groceries and homewares, with fewer electronics, clothing and furnishings than its main supermarket rivals (Tesco and Sainsbury all have their financial divisions). Concentrated products line is important because the failure, Asda bought Gateway Superstores for 705 million pounds in 1989, was caused by Gateway's highly diversified products (hard to integrate after acquisition). Last but not least, acquiring Morrisons is like Wal-Mart bought Asda in 1999, which is proved that cross-border acquisition between UK and US supermarket companies is feasible.
Section Two: Valuation
Free-Cash-Flow (FCF) method is employed in this section for calculating the value of Morrisons. FCF method provides a sensible measurement comparing to other valuation methods (such as P/E method, dividends growth model) since it emphasis the importance of 'cash' in valuing a target company. The accounting express of FCF is:
In valuing the target (Morrisons), first, its standalone FCF-based value would be calculated. Second, the expected synergy value after acquisition would be given. There are three components contained in calculating FCF value. The first one is to get the cost of capital rate as being the discount rate on future cash flows (convert them into present value). The second one is to estimate the annually sales growth (usually compare with the benchmark: Treasury bill rate). The last one is to calculate the net present value of the company value by discounting the estimated future cash flow.
2.1 Standalone Valuation
Step One: First of all, the discount rate on future cash flow (Weighted Average Cost of Capital, WACC) has its formula:
Cost of Capital
WACC*
8.50%
Cost of equity
7.92%
Cost of debt
4.31%
Tax rate
30%
Equity/firm value-ratio
81.30%
Debt/firm value-ratio
18.70%
The cost of equity (Er) is derived from CAPM model. Er = r + ß (Em-r). r is the risk free rate (4%) (UK 3-month Treasury bill rate is employed in this report). ß is the risk measure (0.581, from Morrisons 2009 annual report). Em is the weighted market return (10% assumed, usually it could be derived from FTSE index average return). Therefore, the cost of equity (Er) is 7.92% from CAPM model.
The cost of debt is 4.31% which is the yield rate of Safeway bond (Maturity: 17 Dec 2018). The tax rate is 30% deriving from Morrisons 2009 annual report. The proportion of Debt and Equity is derived from Morrisons 2009 annual report respectively (Debt/Equity ratio = 0.23).
According to figures from CAPM (Er) and cost of debt (Safeway bond yield), initial WACC is calculated as 7%. However, being a cross-border acquisition in this case, a risk-premium (1.5%) is added. Therefore, the adjusted WACC equals to 8.5%.
Step Two: the standardalone value illustrates the intrinsic value of Mosrrisons. This intrinsic value is based on the sale growth in line with UK Treasury Bill rate for future 5-year cash flow. For the future cash flow, several assumptions are made:
Figure
Assumptions Based on Standardalone FCF Method
4.00%
Morrisons's growth rate is in line with UK treasury-bill rate
30.00%
Tax rate remain constant from 2009
280 million
Average depreciation amount from previous five years
0 pound
Net working capital (adjust negative figure to 0)
1049 million
Long-term debt from 2009 annual report
23.00%
Debt/Equity ratio from 2009 annual report
4.31%
Safeway bond yield (maturity: 17 Dec 2018)
91.00%
COGS ratio is calculated as 91% with previous five years average data
Step Three: discounting the future cash flows with WACC. The standalone equity value being estimated is 8.328 billion, which is far more than current equity value (7.7 billion, in 2010, data from London Stock Exchange). The equity value of Morrisons is undervalued, which is a clear signal for acquiring opportunity.
2.2 Synergy Valuation
The calculation for synergy value for Morrisons is aiming at demonstrating that how much Morrisons could benefit from this merger or acquisition (i.e. value creating). The major benefit lied in the expected growth on sales. It would increase by 2% over Treasury-bill rate (4%) to 6%. Moreover, the synergy effect is expected on reduction on cost of sale or administration expenses (cost of sale would reduce by 1% to 90% in this case).
Figure
Additional assumptions Based on Synergy FCF Method
6.00%
6% for the years from 2010 to 2014, back to 4% from 2015
90.00%
COGS ratio is reduced to as 90% because of the synergy effect
The synergy value is 12.75 billion which reflects all the ideal synergy effects (on sales growth and cost reduction). It is 1.65 times over current market equity value. Therefore, in this case, the maximum price could be offered is the synergy value, 12.75 billion pounds.
Section Three: Strategy
Generally speaking, there are two strategies on how to acquire the target company: friendly and hostile. The major difference between these two is lying in the attitude of target company management (or board) on this acquisition. If they are happy and welcome this deal, the detail, term, price of the bid could be negotiated with the board. On the contrary, if the board is unhappy with this proposal and turns it down, to acquire continuously, the US Store Inc has to convince the shareholders of Morrisons directly instead of negotiating with company board.
3.1 CEO of Morrisons
First of all, the first key person (the CEO) in Morrisons has just changed. Dalton Philips replaced Marc Bolland in March 2010. This is the first time Philips takes the job as CEO of one listed company. He previously worked as chief operating officer of Loblaw (Canada's largest food distributor), and was recommended by Allan Leighton (president of Loblaw, friend of Morrison family). Since Philips has just arrived in Morrisons, he would probably be supported by the biggest shareholder (Morrison family) in order to maintain the stability of business operation and market confidence. If taking hostile acquisition at this moment, which means Philips is unhappy with this deal, Morrison family would probably reject this deal to support Philips as well, if so, the acquisition would face huge risk because it would not get cooperation or support from both board and shareholders. More importantly, Morrisons has low gearing ratio, which means they would have the money or ability to borrow money from banks to buy back shares from the public market. Moreover, Morrison family has significant influence in UK supermarket sector, which means they have the ability to form alliance against the hostile acquisition from a US company. Therefore, it would be smart to be friend of them rather than enemy.
3.2 Chairman of Morrisons
The second key person is the chairman of board. Sir Ian Gibson (Morrisons current board chairman) was appointed in 2007. Sir Ian Gibson is also the deputy chairman of Asda, which means he will not feel uncomfortable and strange to the situation of a UK-based company acquired by a US company. Asda is acquired by Wal-Mart as the whole-owned subsidiary. Post-acquisition, the development of Asda seems to be quite well, it has already been the second largest player in UK supermarket sector (Market share from high to low: Tesco, Asda, Sainsbury, Morrisons in 2010). It is believed that Sir Ian Gibson understands the efficiency (synergy effect) that could bring by a US supermarket company, and he is believed to have the ability on dealing with coordination post-acquisition (i.e. having the capacity and experience to explore synergy effect). In conclusion, Sir Ian Gibson shoulder the expectation on Morrisons' recovery from 2008 financial crisis, this deal (acquisition proposal from US Store Inc on Morrisons) could be the new growth engine for Morrisons. Gibson has the capability to convince the board, and the shareholders, that it will be a good deal for everyone's interest.
3.3 Morrison Family
Finally, the attitude of the biggest shareholder, the Morrison family (taking 15.5% share of company) is crucial as well. On one side, Morrsison Family would agree that acquisition in supermarket sector is the way to get bigger, and only getting bigger (location and cost are key elements in supermarket competition), the company could survive in the competition. Acquiring Safeway in 2004 expanded the business of Morrisons from northern to southern in UK. Sir Ken Morrison (son of the founder William Morrison, former chairman) has witnessed the development of Morrisons (from small to becoming one of the 'Big-4' in UK supermarket, also being a contained in FTSE 100 index). Nevertheless, Morrisons is the smallest one in 'Big-4', which increases its exposure of being acquired or merged. Therefore, Morrisons being targeted by oversea supermarket giants (US Store Inc, and other potential bidder) could be understood by Morrison Family. On the other side, the retirement of Sir Ken Morrison, and recruitment of chairman (Sir Ian Gibson, in 2007) and CEO (Dalton Philips, in 2010) from outside the family, shows Morrison family would take any step to push the development of the company rather than struggling for the control power on the company. It is believed Morrison family would support this acquisition if the deal does bring the synergy effect. Moreover, the oversea background of bidder (US Store Inc) would convince shareholders that acquisition would not only bring synergy effect for Morrisons, but also increase the possibility of Morrisons' international expansion in the future. To sum up, acquisition this time, Morrisons would bridge US Store Inc from US to UK, and post-acquisition, US Store Inc could bridge Morrsions from UK to international.
3.4 Bid price
With benchmark (Morrisons' current market value 7.7 billion), friendly acquisition on Morrisons would cost between 8.855 (7.7 Ã- 1.15) and 9.24 (7.7 Ã- 1.2) billion pounds (i.e. 15% - 20% premium on its market value). However, the hostile acquisition would cost based on Morrisons' standalone value (8.328 billion) plus 25%-40% premium, because the management would claim that current market value is undervalued (it does). Thus, hostile strategy would be 10.41 (8.328 Ã- 1.25) to 11.7 (8.328 Ã- 1.4) billion pounds (i.e. 25% - 40% premium on standalone value). The maximum price (i.e. walk away price) is 12.75 billion pounds (synergy value).
In this case, using friendly acquisition strategy is reasonable, not only because it is cheaper than hostile strategy, but also the board of Mossisons would has welcome attitude on this deal (besides the better terms they can get from friendly acquisition, theoretically). Therefore, US Stores Inc is suggested to offer 10 billion pounds (with 30% premiums over Morrisons' current market value), the reason for this premium (over the up bound of friendly acquisition premium 20%) is US Stores Inc would face potential competitor bidders, especially, those with hostile strategy. The high premium is expected to accelerate the process of acquisition.
Section Four: Financing
Usually, bid could be financed by cash, or equity of acquirer, or mixed.
4.1 Cash, not equity
Although equity payment is popular recently [DePamphilis (2007); Alexandridis et al (2008)], and there is strong creditor protection regulation policy in UK [Enrique (2005); Gaughan (2007)], equity payment is still not option for this case. First, equity payment happens when acquirer finds its market value is overvalued (signal effect) [Sundarsanam (2004); Weston et al (2007)]. If US Store Inc is listed on US stock market, its stock price might go up recently but is still wander at relative low level. The aftermath of 2008 global financial crisis made the company equity value undervalued in many cases. Equity payment would be a good choice in 2007 (booming market) but not in 2010. Second, US Store Inc has its approximate market value 103 billion US dollar (half of Wal-Mart 206 billion dollar). Consequently, there is no need to share risk with Morrisons through paying with equity because the acquisition price on Morrisons is relatively small (9.24 billion pounds) (Petzemas, 2009). Third, equity payment would probably fail in the context of cross-border acquisition because there might be regulation on oversea equity investments (Faccio and Masulis, 2005). Finally, Share-for-share offers are associated with negative price moves (of the bidder) after the announcement, which makes it unattractive for US Store Inc's shareholders (Faccio and Masulis, 2005).
In this case, cash payment is preferred. First, cash is always welcomed by target because of its simplicity and value certainty [Fishman, (1989); Trautwein, (1990)]. Second, large company would choose cash payment when acquiring small company (Faccio and Masulis, 2005). As a company with half of Wal-Mart market value, US Store Inc has the cash or has the capability to raise enough cash in short time. It is believed that this deal of acquiring Morrisons would probably bring profit for US Store Inc, therefore, if US Store Inc wants to borrow cash from banks by debt, it will and it can (although Banks may feel reluctant to release loan after 2008 financial crisis). Moreover, US Stores Inc could also raise money through issuing corporate bond. Third, if acquirer wants to gain certain voting power on the target, cash payment is mostly used (Faccio and Masulis, 2005). US Store Inc certainly wants to have significant influence on the board, which could accelerate the process of integration to explore synergy effect. Thus cash is the choice for US Store Inc. Moreover, theoretically, the raising cash through debt would release certain tax burden for the acquirer. Nevertheless, since the gearing ratio and cash reserves of US Store Inc are unknown, it is assumed that the US acquirer has the capability to raise enough cash to finish the deal.
4.2 Asymmetric information on Morrisons
Nevertheless, there is certain asymmetric information on the target. First, it really draws concern that the former CEO Marc Bolland announced for M&S CEO in December 2009 and left Morrisons in March 2010. It is questioned that whether Marc Bolland did not do a good job on the Morrisons recovery process, then kicked out by the board, or whether Marc Bolland did a fantastic job but M&S offers a better salary. The replacement of CEO has direct relationship with company's actual value. Second, there are liquidity problem for Morrisons. Morrisons' quick ratio is the smallest among its competitors, which is a warning signal on company's operation efficiency because liquidity is the key in supermarket sector. Third, it is strange that Morrisons has good performance on EBIT growth compare to other competitors, however, Morrisons is the meanest on dividend paying. The successive low dividend paying from 2006 to 2009 did help the company to recover from 2008 financial crisis, but on the other side, it would incur hostile acquisition by declaring that low dividend payment harms shareholders' interest.
Although there is certain asymmetric information on the target, in this case, showing sincerity on this acquisition to the Morrisons board and shareholders, and building mutual trust (friendly acquisition) is more important, therefore, cash payment is recommended. Additionally, the high bid price (10 billion pounds) is expected to attract Morrisons' shareholders, thus beat other hostile bidders.
Conclusion
This case analyses the feasibility of a cross-border acquisition on Morrisons (a UK supermarket). The acquirer (US Store Inc) mainly intents to enter UK markets through buying a product-concentrated, high competitive advantage, no global presence, medium-scale local retailer, and Morrisons is appropriate target. The valuation (8.328 billion for standalone-basis, 12.75 billion for synergy-basis) on Morrisons discovers that current Morrisons' market value (7.7 billion) is undervalued. After analyzing the personal of board (CEO and chairman) and the biggest shareholder (Morrison Family), friendly acquisition strategy is recommended. Bid price is set at 10 billion pounds with 30% premium over market value. The bid is suggested to be financed by cash mainly because US Store Inc has the ability to pay in cash and cash payment would accelerate the process of acquisition.
