After struggling for more than two years with falling sales, Tesco’s (LSE: TSCO) recovery finally seems to be gaining traction.
Indeed, Tesco’s first-half report was full of positive figures. The volume of goods sold at Tesco’s stores rose 1.4% during the period, and the number of transactions rose 1.5% as Tesco started to win back customers. Further, in the six months to August 29, Tesco generated free cash flow of £281m, compared with a £134m outflow in the year-earlier period. Many City analysts weren’t expecting Tesco to generate any cash at all.
Asset sales have also helped to get Tesco’s debt under control.
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Still, it’s clear that Tesco’s sales will continue to contract for the foreseeable future as, while the company is reporting an increasing volume of goods sold, food deflation is pushing prices down across the grocery sector. To offset this decline, Tesco could decide to go all-out and make a bid for one of its smaller peers, Sainsbury’s (LSE: SBRY) or Morrisons (LSE: MRW).
This proposal isn’t as ludicrous as it first appears. Using some financial alchemy, Tesco could actually improve the state of its balance sheet by buying one of its smaller peers and boost sales at the same time.
For example, both Morrisons and Sainsbury’s are both valued at less than the value of the property on their balance sheets, indicating that it is cheaper for Tesco to buy one of the companies than build the extra capacity itself. Sainsbury’s property is worth £9.6bn, and Morrisons’ real estate is worth £7.3bn, compared to market caps of £4.9bn and £3.6bn respectively.
To make the most of any deal Tesco would need to make its offer for Sainsbury’s or Morrisons an all-stock transaction, or 75% stock with a 25% cash kicker. An all-stock deal would give Tesco more financial flexibility as, when the deal completes, the supermarket giant would be able to sell a portion of the acquired real estate to pay down debt. In many towns and cities there’s an overlap between Morrisons and Tesco stores’ catchment areas, so selling stores with an overlap wouldn’t cost Tesco too much regarding sales. Selling half of Morrisons’ real estate (£3.7bn) would allow the enlarged Tesco to pay off debt acquired from Morrisons (£2.5bn) and pay down an additional £1.7bn of Tesco’s legacy debt. Moreover, the deal would boost Tesco’s sales by over £8bn (after factoring in 50% store sales) and could increase group free cash flow by 40%.
Acquiring Sainsbury’s could be even more beneficial for Tesco. As Sainsbury’s balance sheet is much stronger than that Morrisons’ with only £2.8bn of debt and £9.6bn of real estate, Tesco, the acquirer, could raise £4.8bn from property sales, using £2.8bn to pay off Sainsbury’s acquired debt and £2bn to pay off legacy debt.
