Why the Sainsbury / Asda merger is necessary but not sufficient

Sainsbury, Asda and other large UK supermarkets are currently engaged in an all-out price war with Aldi and Lidl.

While price wars may be good for customers, they are rarely good for companies, their profit margins or their shareholders.

Sainsbury and Asda are hoping to protect their profit margins and shareholders by combining their businesses.

As a single business, they should be able to:

  1. make their combined distribution network more cost-effective (by sharing warehouses, for example) and
  2. negotiate harder with suppliers as their combined purchase orders will be that much larger.

Both of these will lower Sainsbury’s and Asda’s expenses, which should make the company more competitive, more profitable and more appealing to investors.

In my opinion, this merger (or something very similar to it) is a necessary step for Sainsbury as it appears to be in a lot of difficulty at the moment.

Sainsbury: Negative growth, low profitability and high debts

Sainsbury financial results 2018
Sainsbury has struggled to cope with the post-financial crisis world

When I’m looking at a company there are three absolutely essential features I look for:

  1. Reasonable profitability: Profits re-invested into fixed and working capital assets such as stores, warehouses and stock should generate a return of at least 7% per year (and preferably much more).
  2. Inflation-beating growth: Relatively consistent growth which is, at the very least, beating inflation.
  3. Balance sheet strength: Prudent debt and pension obligations which the company can easily manage during tough times.

Somewhat surprisingly, Sainsbury does not meet any of these criteria. Instead, it has:

Negative growth: Sainsbury’s ten-year growth rate, averaged across revenues, earnings and dividends, is minus 2.8%.  Add in inflation at about 2% and the company has been shrinking by almost 5% per year (in real terms) for the last decade.

That breaks one of my most basic investment rules:

Investment rule
Only invest in a company if its ten-year growth rate is above 2%.

Paltry profits: For a company of its size, Sainsbury makes very little profit.

Looking at profit margins after tax, over the last ten years, the company generated average revenues of £23.6 billion and average profits of £0.5 billion. That gives Sainsbury an average profit margin of just 2%, which is terrible.

Alternatively, Sainsbury produced average post-tax returns on capital employed (ROCE) of just 5.4% per year. In other words (and somewhat simplistically), each pound of earnings reinvested in stock, warehouses and stores returned just 5.4% per year.

If management had instead paid out those earnings as a dividend, investors could have achieved far better returns by reinvesting them into more profitable businesses, or even just a simple index tracker.

As you might have guessed, this also breaks one of my investment rules:

Investment rule
Only invest in a company if its ten-year return on capital employed is above 7%.

Towering debts: According to its 2018 annual results, Sainsbury has borrowings of almost £2.3 billion, which is more than five times its recent average profits (giving it a “debt ratio” of more than 5).

That breaks yet another investment rule:

Investment rule
Only invest in a defensive sector company if its debt to five-year average profit ratio is less than five.

The situation gets even worse when you factor in the £10 billion Sainsbury pension scheme. That’s more than 20-times the company’s recent average profits, and so that also breaks one of my rules:

Investment rule
Only invest in a company if its pension fund to five-year average profit ratio is less than ten.

This combination of negative growth, weak profitability and large financial obligations is a potentially explosive cocktail.

That’s why I’m not surprised to see Sainsbury desperately seeking a deal with Asda.

Asda, as far as I can tell, is in a much better position than Sainsbury.

Asda: Positive growth, higher profitability and lower debts

Asda financial results 2016
Asda appears to have done better than Sainsbury

First off, there are a couple of things I should point out here:

  1. Asda’s results only go up to 2016 because it’s a wholly owned subsidiary of US supermarket giant Walmart and more recent results are not yet available. However, Companies House does have Asda’s annual results up to 2016, so that will have to do.
  2. The dividends in the chart above are an approximation of what might have been paid out if the company had been listed on the UK stock exchange. In reality, Asda’s dividends were all over the place because, as a wholly owned subsidiary, it has great flexibility in any dividends paid to its parent company.

Those limitations aside, Asda’s results do appear to be better than Sainsbury’s (although they’re not exactly awe-inspiring). Asda has:

Reasonable growth: Asda’s ten-year growth rate, averaged across revenues, profits and dividends, is 3.4% per year. That’s better than inflation so it doesn’t fall foul of my growth rule.

Acceptable profitability: The company also has relatively impressive levels of profitability for a supermarket.

Its ten-year average profit margins are still wafer thin at 3.1%, but that’s 50% better than Sainsbury’s 2% profit margin.

The same goes for returns on capital employed. Asda has a ten-year average ROCE of 9.7%, which is almost double Sainsbury’s 5.4%. As with Asda’s growth rate, this is good enough to avoid breaking my rule on profitability.

Manageable debt and pension liabilities: Asda has less than £0.2 billion in borrowings, which is peanuts for a company making almost £1 billion in profits each year.

On the pension side of things, the picture is not quite so good as there is a pension obligation of about £3.4 billion. However, that’s less than five times Asda’s recent average profits, so it’s comfortably within my rule on pension fund size.

Overall, Asda appears to have done a better job of coping with the price war of the last five years. And that’s good because the last thing Sainsbury needs is to merge with a company that’s even less competitive than itself.

So that’s the back story on each individual company, but what will happen if they’re merged into one?

Sainsbury + Asda = Greater economies of scale

Sainsbury - Asda financial results 2018
Sainsbury’s and Asda’s combined results are slow but steady

The chart above shows the combined histories of Sainsbury and Asda as if they had been one company all along.

These financial results are perhaps what you might expect from a very large, mature, geographically restricted company operating in a highly competitive market.

In other words, they’re just not that impressive.

For example, the combined growth rate of the two companies is just 1.2% and the combined profitability (ten-year ROCE) is just 7%.

Both of those numbers are below average for a FTSE 100 company.

Of course, Sainsbury and Asda think the merger will improve their competitive positions, their profit margins and their growth rates, thanks to greater economies of scale and greater bargaining power. And I think they’re right.

I think the merger is necessary for the survival of both businesses, especially now that Tesco has massively increased its own scale by taking over Bookers, the UK’s largest food wholesaler.

However, while the merger may be necessary, it isn’t sufficient to make me want to invest.

Sainsbury + Asda = Greater uncertainty

One big problem with investing in Sainsbury today is the amount of uncertainty.

Investing is hard enough without deliberately getting into situations where change, disruption and uncertainty are off the charts.

And that’s what mergers often bring.

There are countless issues that need to be addressed when two companies are brought together and the results are often not pretty.

Just look at Morrison’s acquisition of Safeway for an example of how it can all go horribly wrong.

There are many important lessons to learn from the mistakes of others, and one lesson I’ve learned is this:

Investment lesson
Avoid companies that have spent more on acquisitions in the last decade than they made in profits.

And that’s exactly what Sainsbury will have done if this merger goes ahead.

And if the merger doesn’t go ahead?

If the merger doesn’t go ahead I still wouldn’t invest in Sainsbury because its growth rate is negative, its profitability is shockingly low and its debt and pension obligations are worryingly high.

Author: John Kingham

I cover both the theory and practice of investing in high-quality UK dividend stocks for long-term income and growth.

14 thoughts on “Why the Sainsbury / Asda merger is necessary but not sufficient”

  1. I think this is a huge mistake as Sainsbury is turning a one-and-a-half front war into a four-front war. Sainsbury is quite safely embedded at the premium end of the big four. Waitrose has been taking some market share from a higher-end position but Sainsburys major challenge is to to remain reasonably price competitive when the rest of the big four cuts their prices. Asda on the other hand is stuck at the bottom of the premium-scale of the the big-four and are sandwiched between Lidl and Aldi below them and Morrisons and Tesco above them which is reflected in their performance during the previous five years (https://ichef.bbci.co.uk/news/624/cpsprodpb/13FA6/production/_101103818_2-topgrocerintheuk-nc.png).

    As I see it the acquisition is a typical example of management feeling compelled to act even when there are no attractive courses of action to take. By acquiring Asda management takes action but it also means that they commit further resources to fighting a battle where Sainsbury is strongly committed to the overcrowded segment of large retail outside the city centres and will own two losing actors with conflicting business strategies just as Morrisons did but in an even more exposed situation.

    Supplier relationships are a perfect example of an area I think where this conflict will become evident. Sainsbury can justify their mild-premium position by having better than average supplier relationships with a high proportion of UK produce, on the other hand Asda is maintaining a low price position which requires a more aggressive course of action versus supplies which is also reflected in public rankings (http://www.fwi.co.uk/business/supermarket-treatment-suppliers-good-bad-ugly.htm). By harmonizing supplier relationships Sainsbury, Asda or both will inevitably lose some of their differentiation to peers while stuck in the highly competitive physical retail space.

    Appearing weak or inactive while waiting for a more viable time to act would in my opinion have been more prudent by the management and a good example of why I prefer founder-led companies or owning families over hired career executives who need to maintain their own reputation while running the company.

    1. Excellent points and I agree with everything you said, except I don’t think the merger is a huge mistake.

      “Sainsbury is strongly committed to the overcrowded segment of large retail outside the city centres”

      That’s the key point; Sainsbury is in an oversupplied sector and there’s nothing it can do about it. Supermarkets are a commodity and now that there’s almost one supermarket per person in the UK (or so it seems) Sainsbury has little choice but to try to be the lowest cost operator in its mid-quality segment.

      The other obvious option is to have a premium brand, which I don’t think Sainsbury does.

      Either way I’ll be watching from the sidelines rather than as a shareholder.

  2. The review by John and comments by Aktieingenjören are excellent. My experience as shareholder in Sainsbury until recently and as a customer for many years, suggests me that there will be severe difficulties in integrating Asda with Sainsbury. I have noticed that Sainsbury has poor customer service and high prices. The quality of food at Sainsbury is just above average and not premium, but with premium prices. I have noticed locally that Aldi and Lidl have opened up new large format stores. These stores are always packed with customers. Aldi do have quality food items at very reasonable prices. Having observed these, I believe, it will be a difficult road for Sainsbury to come out of declining sales and profits, unless they have a very different strategy. Cutting costs may not be easy and may not yield long term growth and profit.

  3. I have no interest in investing in any supermarkets at this moment, but this merger is interesting.

    Personally I do not expect something good out of it, but you will never know!

    I believe they will continue to run two brands, otherwise there will be huge trouble because their customer base is very different. Sainsbury is still losing clients in the premiuim sector, mainly because it does not work harder to understand their clients and invests in their businesses. The Sainsbury shoping experience has become poorer in the last 5 years – I am someone who used to shop at Sainsbury and I am disappointed. I cannot see how this merger will help, apart from getting a bit more discount based on volume – my personal view is that the sinergies are overstated.

    1. Hi Eugen, I don’t know about the shopping experience at Sainsbury’s, but I tend to agree with you; I think a dramatic turnaround seems unlikely, but the merger could help to reduce any further decline (in Sainsbury especially).

  4. I recommend anyone interested to find out why supermarkets are struggling to read the book “Niche: The missing middle and why business needs to specialise to survive”. In the past supermarket built a business by destroying independent grocers, fruit and veg shops, butchers, bakers, tobacconists and etc.

    Unfortunately for the supermarket peoples shopping behaviour is reverting back to a pre-supermarket shopping mentality with a preference to independent shopping and buying goods when they need them rather than bulk purchasing which supermarkets depend on like the 2 for 1 deals.

    If this continues I expect further pain for the supermarket sector.

    1. Hi Reg, the changing habits of shoppers is an interesting angle. Personally I haven’t changed my habits at all, but then again I almost never do any shopping either! So I’m not very representative, but Aldi and Lidl have certainly taken advantage of a general move towards more local stores, i.e. the high street rather than out of town superstores (I love out of town superstores for convenience, but again, I’m probably not representative).

      As for niches, I agree that being niche is one way to succeed, but I can’t see how that applies to general stores such as supermarkets. Their aim is to provide food shoppers with the best combination of convenience, range, quality and price. Because of the current weak economic environment, price is king and so we’re in the middle of a price war which is fuelling a desperate lunge for greater economies of scale by everybody.

      Having said that, perhaps supermarkets need to pull back towards the food niche, which people are more reluctant to buy online (i.e. without touching and poking).

      1. Hi John,

        I would recommend you to read the book I mentioned its a bit of an eye-opener and quite entertaining. The fundamental argument of the book is the Pareto law, how 80% of the profit of any company is most likely due to 20% of the product line. Therefore most companies should focus on their key products/service.

        Between 1980-2008 Supermarkets engaged in empire building mentality gobbling up various specialities found on the high street. Unfortunately, most of these departments were not in the circle of competence of supermarkets. The best example I can think of is pharmacies. These activities consumed significant capital at the expense of the investor. On paper, it led to a huge growth in revenue but operating margin slumped. As most of the profit was still generated by the original segments of the company which now constituted a small segment but unfortunately all the new divisions which helped to enlarge the supermarket was eating up cash.

        Supermarkets were able to get away with this until a shift in shopping habits partly facilitated by the internet which helped to educate the consumer. This has led to a fall in the number of shoppers per store as people are foregoing the supermarket habit and instead buy goods when they need them and from specialists.

        I genuinely believe supermarket is still a workable format but they need to shrink in size. If I use Walmart as an example its initial growth was based on opening budget general stores in small towns which did not have one but it could support only one if someone did decide to open one. I would wager that if Walmart went expansion-crazy and started to opening multiple stores in the same town the company would go bankrupt as there simply was not enough business to support more than one store.

        Unfortunately, this is the reason why supermarkets are in a slump. If management reduced the number of supermarket stores in the UK and focused on the product line which earned them the most profit they could probably dig themselves out of this ditch.

      2. I totally agree and I’m a big fan of companies focusing on their core. There are so many examples of companies diversifying away from their core when core growth becomes difficult, and the result is often a failed and costly adventure into areas where the company has no competitive advantage.

        As for supermarkets shrinking to improve their results, it might work, but it will be a cold day in hell before most CEO’s intentionally shrink their business!

      3. Agreed most CEO’s would not engage in such bold tactics. Although it is necessary for the supermarket chains future survival.

  5. Two drunks propping each other at the bar. They will effectively exacerbate their own overcapacity and running two brands means little will change apart from said cost reductions — I see less than they are stating, as their sourcing will still be largely separate and the logistics channels will still be somewhat separate.
    The scope to mess this up seems far greater than any benefit.

    And still Aldi and Lidl expand and improve quality and chip away at the specialty aspects, like adding bakeries, supplying excellent own brand baby products, gluten dairy free ranges — they are faster at making these changes than any of the big 4 and shoppers, once switched tend to stay switched.

    A previous poster hit the nail on the head, it’s a classic career management (with no skin in the game) seen to be acting with a strategy and tactics, irrespective of whether they make logical sense or offer real economic benefits.

    If I owned SBRY I’d sell it and move on before it gets very messy.


    1. A firm but fair assessment I think. Unfortunately for the drunks in question, if they don’t prop each other up they could fall flat on their faces…

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