How the Tesco-Booker deal stacks up against the four key tests for any M&A deal

“It is hard to divine whether investors are more enthusiastic about Tesco’s promise to recommence dividend payments or its proposed merger with retailer and wholesaler Booker, but the 10% surge in Tesco and 16% gain in Booker suggests the deal is currently being viewed as a win-win for shareholders, despite the inevitable concerns about execution risk and a possible investigation by the Competition and Markets Authority, says AJ Bell Investment Director Russ Mould.

“Any merger and acquisition (M&A) deal must be subjected to four litmus tests and the Tesco-Booker deal maybe passes two, while the burden of proof rests with the newly-merged entity on the other two.

1. “The reasons for the deal: is to boost growth or create it? Both Tesco and Booker operate in mature markets, although Booker’s interims showed excellent like-for-like growth excluding tobacco. There is therefore a suspicion that the idea is to create growth where little exists, even if Tesco boss Dave Lewis and his equivalent at Booker Charles Wilson would doubtless argue the deal will augment gathering momentum in the two separate businesses. Case unproven.


2. “Most deals fail to deliver the targeted financial benefits. Research shows that more than 70% of all M&A transactions ultimately fail to deliver on their near-term financial goals. As such, Tesco’s claim the Booker merger will deliver £200 million of cost benefits, on an annual run-rate basis, within three years and a further £25 million of revenue synergies must be treated with some caution, especially in the latter case. Tesco’s poor prior track record with acquisitions, such as Giraffe and Dobbie’s Garden Centres, raises question marks, although the 2002 swoop for store group T&S brought a strategic boost in the key field of convenience stores, while Booker has done a brilliant job with its 2012 purchase of Makro, so Wilson’s expertise will be welcome in the Tesco board. Case unproven.


3. “The number of new variables introduced to the business: one is enough. Under Lewis Tesco had been focussing on its core domestic grocery and supermarkets offering, cutting back on overseas operations, withdrawing from areas like restaurants and ceasing to stock the Hudl tablet computer. As such, the Booker moves brings diversification via the move into wholesale but it does so in just one country, so the number of variables is just one. Most deals come to grief when M&A brings not just a new type of product or service but a new geography too. Passes the test.


4. “The price paid. As investors know, the valuation paid for a security is the ultimate arbiter of the return on investment. The 205p price implies a forward price/earnings multiple of 25x for Booker, which looks rich for a business that had a fairly skinny 3.2% interim operating margin and operates in a competitive, mature market.

“Tesco says the deal will be earnings accretive after two years, but this excludes implementation costs and assumes all synergies are met and again the multiple paid leaves little margin for error.

“However, the cash-and-stock nature of the £3.7 billion, 205p-a-share deal lessens the risk to Tesco, which will be handing over around £770 million cash and the rest in shares. Booker has a £59 million pension deficit but Tesco will also inherit a net cash pile of over £100 million straight away and Booker is highly cash generative – before today’s announcement it had been planning a fourth special dividend since its 2012 purchase of Makro. The cash-and-stock nature of the deal lessens the risk.

“Booker’s cashflow is a key attraction of the deal and its ability to keep forking out growing dividends is testimony to its strength. As such today’s leap in the Tesco share price may be more about dividends than the immediate strategic rationale for the Booker deal, as income-starved investors continue their search for yield, in the knowledge that earnings cover across the FTSE 100 is thin and the best long-term total shareholder returns (capital growth plus income) tend to come from firms which consistently grow their dividends over time – with Booker a classic case in point.”

Source: Company accounts, Digital Look, analysts’ consensus forecasts

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