J Sainsbury plc was founded in 1869 and today operates a total of 890 stores comprising 547 supermarkets and 343 convenience stores. It jointly owns Sainsbury's Bank with Lloyds Banking Group and has two property joint ventures with Land Securities Group PLC and The British Land Company PLC. Sainsbury, with its 150000 employers, now serves over 19 million customers a week and its large stores offer around 30,000 products and complementary non-food products and services too. An internet-based home delivery shopping service is also available to nearly 90 per cent of UK households. The Sainsbury's brand is built upon a heritage of providing customers with healthy, safe, fresh and tasty food. Quality and fair prices go hand-in-hand with a responsible approach to business. Sainsbury's stores have a particular emphasis on fresh food and they strive to innovate continuously and improve products in line with their customer needs.
Despite these clear and good objectives on the development, the corporation suffered losses and has been on decline. In the last decade it turned from being the first most successful supermarket chain into the third. In terms of market shares it currently has the 16.3% against the 17% of Asda and 30% of Tesco.
According to the corporate governance prospectus of the firm, objectives of Sainsbury's are:
Great food at fair prices
Accelerating the growth of complementary non-food ranges and services
Reaching more customers through additional channels
Growing supermarket space
Active property management
Analyzing these objectives makes us think that Sainsbury's is following the wrong way to improve and achieve a higher standard of quality both of its brand's name and value. The corporation is trying to grow in its structure instead of paying attention to its own value development. Sainsbury's is trying to do more than its capabilities allow on the improvement of the general performance instead of upgrading its status. The corporation is putting too much effort on the development of the quantity of its brand instead of the quality, thus resulting in a loss of the value. From these problems come our motivations to support the proposed acquisition: the acquisition we want to offer is meant to turn the value of the combined companies greater than the sum of the two single parts, as we propose a synergy whose aim is to add capital in the development of the value of the firm and its quality. We think that the key to success for the development of J Sainsbury plc is improving the management and services it offers, as it is already a well-widespread recognized brand that needs to improve the quality of services rather than enlarge its market.
These are the ways how Tesco and Asda, strong competitors which overtook Sainsbury's it in the last decade, make their business and their corporate strategies.
TESCO: Importantly, the strategy has given the business momentum to grow well through the economic downturn. By continuing to invest through the recession - in the customer offer, in infrastructure and in our people - we are now well placed to grow faster and improve shareholder returns as the global economic environment improves.
ASDA: At Asda we're dedicated to keeping prices low and delivering great value to you, our customer. Saving you money every day isn't just a slogan you know - we make it our daily mission. We think you'll agree that value for money is simply good business. But we know we can always be better, and we're continually working to make Asda a better business, for our customers, colleagues and the planet.
Definitely it is important to scrutinize that both corporations pay attention on keeping low prices to diversify and amplify the range of customers. In addition, Tesco and Asda missions are to focus on the satisfaction of both the shareholders and the customers. The way they develop their interaction with customers is mainly through an improvement of the place they act as a service for the society.
Sainsbury's corporate decisions and strategies went wrong because the firm paid too much attention on the spread of the brand without eradicating it in the society and in the place they want to serve with their products. A synergy permits to improve the financial capitalization of the firm by reducing the capital expenses and reducing the agency costs.
"No. 3 position in the U.K. food retail market, with a particularly strong position in southeast England. Good brand recognition and an umbrella of own-label sub-brands. A lack of discretionary cash flow due to high capex. Weakened credit measures, as increased leverage has not been fully mitigated by improvements in earnings. The ratings on J Sainsbury PLC reflect Standard&Poor's Ratings Services' view of the company's satisfactory business risk profile. This is supported by Sainsbury's position as the U.K.'s third-largest grocery retailer, with widely recognized brands and a supporting umbrella of own-label sub-brands, and by the nondiscretionary nature of food spending. The ratings also reflect our view of Sainsbury's significant financial risk profile, specifically its weak free cash flow because of high capital investments" - S&P Credit Research
In our point of view Sainsbury's is a well-built brand that needs only to develop its potentials by improving its services. The synergy with an improvement and a diversification of the economies of scale will increase the profitability.
Valuation
This report intends to analyze the valuation of Sainsbury's with three different models:
Dividend Discount Model (DDM)
Free Cash Flow Valuation - Discounted Free Cash Flows (DCF)
Multiples' Valuation - Comparable Valuation Ratios
Dividend Discount Model:
Having calculated Sainsbury's expected return and the beta (correlation) between the corporate and the market by using a 10 year risk free rate from FTSE All Share, the cost of equity was solved by using the CAPM. The Dividend Growth Rate was then calculated by multiplying the historical return on equity by the historical retention ration of the last twenty years.
Value of stock = Dividend per share / (Discount rate - Dividend growth rate)
The discount rate is the cost of equity:
Historical Retention Ratio
15.82%
Historical Average ROE
7.95%
Dividend Growth Rate
1.26%
The outcome of this model is £6,622,836,655.
Free Cash Flow Valuation:
The DFC model analyzes the worth of a company by valuating its assets and in particular by discounting to the present the expected future cash flows of the firm. The size of the discount depends on opportunity costs of capital, defined as WACC (weighted average cost of capital), in which each source of capital is proportionately weighted.
This worksheet model is from Dr. Alexandridis, ICMA Centre, University of Reading, adapted to our valuation. This valuation takes the average required yield on debt for their credit rating of Baa3 (moody's) or BBB- (S&P). The hypothetical post acquisition value of the company has the same capital structure of the acquiring firm, as we took as assumption that the firms have a similar capital structure.
FCF = NOPAT + Depreciation - CAPEX - ΔNWC; it is the EBIT (1-Tc) + Non-cash charges - CAPEX - Increase in NWC, in which EBIT(1-Tc) = Net Income + (interest x (1 - Tc) )
DCF Valuations
Current value
£9,655.96
Value w/ Synergies
£16,730.77
Value w/ S & New Cap. Structure
£19,128.03
So the result of this model is £9,655,955,025
Multiples' Valuation - Price to Earnings Ratio
The P/E Ratio reflects the capital structure of the company and as it is calculated as "price per share / annual earnings per share" it alternatively shows the number of years that the corporation needs to get a return equal to the investment in that share. Sainsbury's is currently trading at a P/E ratio of 10- 10.50 (10.37) so it means that it needs about 10 years to recapitalize the investment, that means an high-priced acquisition.
P/E ratio also expresses the market view on expected future earnings of a company, but it is important not to misunderstand this ratio. J Sainsbury plc has a high stock price relative to its earnings because it makes the most use of the payout policy through dividends- policy that is barely sustainable without a real and intrinsic improvement of the value and do not contribute to the expansion of the company.
The result of this model is £6,140,114,417
Analysis
What this evaluation does not take into account is that a huge improvement on profit and so a higher final value on the firms can come from the synergy we are proposing. Both cost and profits should be assumed in order to get a better valuation, even though the acquisition we are pushing on improves the brand and its opportunity by spreading our brand into the EU market.
The geographical diversification along with Sainsbury's awareness about how the UK market moves is just one of the multiple advantages arising from the acquisition. Main advantages are larger volumes with lower costs of products through efficient shipping between the countries. Sharing managerial ideas and IT technologies will also improve the corporate governance of Sainsbury's and will improve its value.
As we can notice in the previous analysis, the DFC value indicates that Sainsbury's is undervalued, as there is between £2m-£2,5m (£2,364m) of long term debt that needs to be used. This can be an interesting starting point to push for an acquisition as we can make a better use of the debt, and so improve the value of the company if its price is lower than the cost of investment.
The main expectation of this acquisition is:
Increase in sales by 3% in 2012
Increase in sales of 1% for the next years
Reduction of sales/cost of sales ratio by 1%
Reduction of administration costs/sales by 20%
Thus resulting in a new DCF valuation of about £16m - £17m, that is really excessive in comparison to the existing market capitalization. As J Sainsbury plc D/C ratio is 56% and the E/C ratio is 44%, after an acquisition the valuation of the corporation could improve. Therefore this acquisition intends to be the way to improve the capital structure of Sainsbury's by increasing the E/D ratio through our source of free cash flows.
We are pushing for this acquisition because Sainsbury's in the last years had more troubles in turning its net profit to gross profit than its competitors. The synergies we are offering decrease the cost of turning expenses into profit.
Financing
There are mainly three ways to contract and finance a merger and acquisition:
Payment of cash
Issuing stocks - Stock swap
Hybrid, so a combination of the two above
The transaction occurring with the acquisition provides a specified amount of money to the shareholders for each share that they hold if it is through the payment of cash, while they replace their shares with the shares of the acquiring company in the equity financed transaction (Stock-Swap).
"In cash transactions, acquiring shareholders take on the entire risk that the expected synergy value embedded in the acquisition premium will not materialize. In stock transactions, that risk is shared with selling shareholders. More precisely, in stock transactions, the synergy risk is shared in proportion to the percentage of the combined company the acquiring and selling shareholders each will own." (Harvard Business Review)
"The expected net gain to the acquirer from an acquisition-we call it the shareholder value added (SVA)-is the difference between the estimated value of the synergies obtained through the acquisition and the acquisition premium. By financing the acquisition by issuing new shares, the SVA for its existing stockholders will drop. The equity transaction places the same value as did the cash offer. But upon the deal's completion, the acquiring shareholders will find that their ownership has been reduced." (Harvard Business Review)
In financing the acquisition we have to pay attention both to the shareholders' satisfaction and to the disadvantages that the firms may suffer. As analyzed above shareholders may suffer from equity financed transaction as they lose part of their ownership even though it means no transaction costs of reinvesting for the firm and no tax on capital gains, important advantages for the corporations. Probably both shareholders and public investors prefer cash purchase as they do not have to pay capital gains tax and they know precisely what they are getting.
Financing costs for the acquisition are:
Cash financed transaction: the amount of debt to cover the amount of cash, so the amount of money to be borrowed, is the market capitalization of Sainsbury's by assuming that the value of the shares is the premium we would have to pay on them. As we assume that the transaction is financed with debt, the outcome of this acquisition is in the increase of the gearing ratio so an increase of the price that we have to pay for the corporation, as by improving the level of debt it improves the level of funds.
Stock financed transaction: the exchange ratio of the target's share price plus the premium to the price of a share of the acquirer, assuming that the share price of both firms remains the same. Having found out this ratio we have to multiply the reverse of it by the market value of the targets ordinary shares plus the market value of the ordinary shares of the acquirer. It is the number of the new shares of the acquirer valued at the current market price of the acquirer, noticing that Sainsbury's shares will have disappeared.
Before pushing for an acquisition it is important to analyze the interest cover ratio that is: "A ratio used to determine how easily a company can pay interest on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) of one period by the company's interest expenses of the same period. The lower the ratio, the more the company is burdened by debt expense. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 indicates the company is not generating sufficient revenues to satisfy interest expenses". (Investopedia).
It is really significant because this ratio can be used with acquisition by putting in the equation values of different firms. Therefore it is important to pay attention if the value is under 1.5. If so, there would be no reason to continue the acquisition.
Recommendations
As a result of the previous analysis of the advantages of an acquisition, we recommend to present to the board of directors at the J Sainsbury plc the offer of the acquisition whose aim is to develop both corporations through an intense synergy.
Synergies are meant to develop both corporations by sharing winning managerial strategies and overcome possible weaknesses. As we can notice the growing price suggests an improvement of the value of the firm but it definitely means that waiting can improve the opportunity costs by eliminating the benefits of the acquisition.
Sainsbury's can achieve a higher standard of quality by following our managerial ideas especially in the way of serving customers. J Sainsbury plc already has a good relationship with customers and it is already a recognisable household brand, that is why we want to make shopping a more pleasant experience in order to welcome more customers and so get more profit.
The outcome of my report is to press for the acquisition of Sainsbury's in order to achieve the main outcome of a synergy. The revenue enhancement is greater thanks to the share of strategic benefits and complementary services. The development of the economies of scale is possible thanks to the common use of facilities and strategies, so that it is also possible to achieve a greater power to negotiate prices with suppliers. Financial synergies can lead to tax advantages and a lower cost of capital, as it is easier for bigger firms to raise their capital and be subjected to debt.
