US Stores Inc is a large US grocery retailer. It has steady turnover growth in its local market. In order to find opportunity for future growth, it decides to expand in UK market through acquiring a major UK retailer. After analyzing possible targets (the big 5 in UK market), Morrisons is chosen as the most appropriate target. This is because,
- Compared with other targets, Morrisons has suitable size (about 10% of US Stores Inc) for US stores Inc to takeover.
- Morrisons has more similar culture and strategy as US Stores Inc. By taking over this company, the bidder could maximize its synergy benefits.
- Morrisons has healthy gearing ratio, therefore, this takeover will not significantly change bidder's existing financial structure.
Then, the valuation of the company shows Morrisons's company value is similar to its market value (7.9 billion) and the maximum takeover price should be (11.8 billion). After considering the expense and integration cost of the bid, the first offer will be 20% premium of the Morrisions's stand-alone basis price (about 353p per share).
Moreover, cash is chosen as the payment method through analyzing the existing corporate governance structure and debt ability of the bidder and the preference of the target company' shareholders. In order to get first mover advantage, the hostile takeover will be chosen.
US Stores Inc, as the one of the USA's largest retailer (Wal-Mart is the largest), encounters slow growth problem in its local market. The main strategy of the company is 'offer a low price that no competitor can afford'. In order to sustain steady growth, it prepares to enter in a non-US market. Europe is a reasonable target market for US Stores Inc, because it has relatively familiar religious, government and economic institutions as USA. Especially, Ring and Tigert (2001) suggest UK grocery market which has large population and specific acquisition opportunity is an attractive target in total EU market. Through acquiring companies in UK grocery market, bidders can generate higher margin and market share. Especially, the case of 'Wal-Mart takeover ASDA' (Arnold and Fernie, 2000) shed the light of acquiring a major UK retailer for US Stores Inc.
The report will be divided into 5 sections. In section 1, the way to enter UK market will be discussed. In section 2, the target company will be chosen based on its ability to maximize the possible synergies benefits to the bidder. The valuation of Morrison and the maximum price that bidder will pay will be discussed in section 3. In section 4, the payment method will be decided according to bidder's debt capacity, existing leverage, and existing corporate governance structure and the target company's shareholders' preference. Finally, in section 5, the format of the takeover will be analyzed according to target company's characteristics.
Section 1: the way to enter
Mergers and acquisition may be more appropriate way to enter into the UK grocery market than organic store development. There are 4 main grocery retailers in the market: Tesco, ASDA, Sainsbury's, and Morrisons. Tesco is market leader which capture more than 30% of the market share. Asda/Wal-Mart and Sainsbury's capture relatively similar market share (about 17%) (IGD, 2010). Morrisons is the smallest one in the big 4. These 4 retailers dominate in this market (75% market share) and left few expanding opportunities through large scale organic store development. This causes 'merger and acquisition' particularly important for other companies who want enter the market/increase market share in the market (Poole et al., 2004).
Section 2: target company
Compared with other similar companies in UK grocery market, Morrisons does not have comparative advantage in its market share, stores coverage, brand loyalty and growth potential. However, there are mainly 3 most attractive places of Morrisons to be chosen as the target company
- Culture and Strategy
- Morrisons might be more appropriate target than the other 2 after taking the benefit of 'operating synergies' into account. Based on the case study of Wal-Mart takeover Asda, Arnold and Fernie (1999) argue that Asda has similar price proposition, target customers, and management style as Wal-Mart's. Acquiring the company with similar culture basis, Wal-Mart could maximize the benefit of operating synergies through reducing the cost of enculturation of Wal-Mart way. This might be one of the possible reasons for Wal-Mart acquires Asda rather than other companies with similar size. According to this, Morrisons might be a more appropriate target for US Stores Inc who also focuses on providing good quality products at low price and providing convenient locations. Trautwein, (1990) suggest by taking over companies with similar culture/strategy, the synergies benefits are more likely to be realized. On the other hand, US Stores Inc may incur higher training and enculturation cost for acquiring Sainsbury and M&S (providing high margin products).
- Financial performance
According to the market value of these retailers, the most appropriate merge targets might be Sainsbury's Morrisons and M&S. Because all of their size is about 10% of US Store Inc and all of them has modest market share in UK market. On the other hand, it might more risky to takeover Tesco which is about half the size of US Store Inc. By acquiring such a large company, the bidder may encounter some problems, such as cash shortage, and shocks to the bidder's financial and culture structure. In addition, Asda has already been acquired by Wal-Mart in 1999. Therefore, it seems difficult to acquire this retailer.
In addition, compared with other retailers with similar size, Morrison has very small gearing ratio (37.23) and relative high profitability (4.51%). Through taking over a financial healthy company with good performance, the US Store Inc's company image (complacent) will be improved. Furthermore, the bidder company's finance structure may be improved (reduce gearing ratio) by acquiring Morrison which has relative low gear ratio (the effects of debt financing is not taken in account here). In addition, Morrison has 7.7 billion freehold-property portfolio which is more attractive for takeover.
Section 3: valuation of Morrison
- Calculation of WACC
- the fair value for Morrisons on stand-alone basis
- The fair value of synergies
- The maximum price
Because Morrisons is in the FTSE100 index, the FTSE100 6 months' rate of return could be used as the approximation of the market rate of return (rm=9.36%). 3 months' treasure bill rate will be used as risk free rate. And, Beta of Morrisons is 0.4602 (Financial Times).
Thus, the cost of equity could be calculated by using this formula: ri=rf+(rm-rf)=0.0461.
There are two bonds with 8.5 years in the market. one of them is quoted as (?200m Sterling bonds 6.125% December 2018 at market value of ?110.55m) and the other one is quoted as (?200m Sterling bonds 6.125% December 2018 at market value ?109.3m) (Investors Chronicle, 2010). Then, the Yield to maturity of both bonds can be calculated through the IRR method (see details in appendix 1). The cost of debt equal the yield to maturity of the 8.5 years bonds (the one close to 10 years) minus the tax benefits of debt. rd=0.0472
The market value of Morrisons is 7.9billion which equals market value of shares multiply the number of shares (Financial Times) and market value of its debt is 784million excluding deferred tax. Then the WACC= ED+Eri+DD+Erd=0.0649.
Morrisons sales growth will be approximately in line with 10 years treasury bond interest rate (4%). It is reasonable to assume the cost of sales and operating expense will grow at the same rate (as constant proportion of the turnover). After calculating the profit after tax and interest, the depreciation which assumed to be keeping a constant figure in next 10 years will be added back to calculate the free cash flow. On the other hand, capital expenditure which is the cash paid to acquire more asset (not shown in the income statement) will also be deducted at a constant rate after 2009. In addition, because the working capital is negative, it will be ignored in the calculation (appendix 2).
The company value has slightly difference from the company's market value. This might be caused by the unrealistic assumption of constant depreciation and capital expenditure, and ignorance of negative working capital. With respect to the estimation of cost of capital of the company, the market return (FTSE100) used in calculating the cost of equity might not be an efficient approximation of the actual market grocery market return. This is because grocery market always has smaller correlation with the FTSE 100 index than other normal shares in the period of financial crisis. Moreover, one bond with the close maturity to 10 years is used to estimate yield to maturity. Therefore, by using thus estimated YTM in estimating the cost of debt cannot take account the entire debt information.
Then the fair value of synergies will be calculated according to the mergers' impacts on the target company. In detail, Morrisons' turnover will increase 2% faster than pre-merger period for the next 5 years, and the cost of sales will decrease by 1% forever (economies of scale). The new company value can be calculated by inputting the new information. As stated above, there are no significant cultural differences and strategy differences between US Stores Inc and Morrison that could impede the integration process. However, there may still have risk in integrating the two companies' organizational culture. Therefore, an extra safe risk factor (0.5%) should be added into the WACC (6.4%) to take account the integrating risk.
The company value increase 4861 millions (synergies' fair value) after the merger. However, it is impossible that all of the synergies can be realized because the existence of integrating cost and culture shocks (Gaughan, 2007). Normally, half of the synergies will be realized. Thus, the maximum price might be 10385 million.
Section 4: Payment method/the way to finance
In making a merger and acquisition bid, the bidder will decide to pay by cash or share. There are conflict interests between the two payment methods. Given that most bidders (include US Stores Inc) has limited cash, cash offers always need extra financing. Thus, bidder will face the tradeoff between debt financing which may increase company's gearing ratio and financial distress, and equity financing which may have significant impact on company's corporate governance (Faccio and Masulis, 2005). Thus, bidder's payment method (also the way to finance) can be significantly influenced by (1) bidder' debt capacity and existing leverage, and (2) existing corporate governance structure. Moreover, the (3) signaling effects will also be considered.
In order to ask for target shareholders' support, the bidder needs to make the proposition attractive to them. Thus, the payment method is also significantly influenced by the (4) target shareholders' preference. The shareholders face the tradeoff between the possible tax benefits (deferring tax liability) of stock and the liquidity and risk minimizing (avoid the risk to become a minority shareholder in bidder's company) of cash (Faccio and Masulis, 2005).
- Bidder's debt capacity and existing leverage
- The bidder's existing corporate structure
- The signaling effects
- The target shareholders' preference
- The type of shareholders in Morrisons
- The potential growth rate of US stores
According to Hovakimian, Opler, and Titman (2001), the bidder's debt capacity is positive correlated with earning growth, tangible assets and assts diversification, and negative correlated with volatility of asset. Thus, the market value, tangible assets, earnings growth and leverage level will be used to determine bidder's willingness to pay by cash and the ability to issue extra debt.
According to the table, The US Store Inc is a big company with large amount of tangible assets. Its assets are well diversified and not violated. Moreover, as a major grocery retailer (defensive industry), it is less affected by the financial crisis in recent years. In addition, compared with other grocery retailers in USA, it has very healthy gearing ratio (industry average is about 36%) (Wal-Mart' annual report, 2009). Through taking over the Morrison who has even lower gearing ratio than US Store Inc, bidder's gearing ratio will not significantly increase (excluding the effect of debt financing). Based on bidder's debt capacity and existing leverage, it seems the company might more willing to pay by cash and has sufficient ability to raise enough funds to acquire the Morrisons.
In addition, if the funds are raised by debt, the US Stores Inc's existing gearing ratio will increase from 0.324 to 0.406. This will increase some financial risk of the bidder. Compared with the industry average (about 36%), the bidder's financial structure still acceptable.
The US Stores corporate governance structure is similar as Wal-Mart's (Walton Enterprises holds block shareholding). There is a US Stores enterprises which is held by family has block shareholding in the company. In order to sustain voting rights in the bidder company, this block shareholder may more likely to accept the cash deal consideration. Moreover, for the same reason, the debt financing might be accepted by the bidder.
There are different signaling effects for the two payment methods respectively. For example, given that directors have better information about the company than the investors, share for share offers signaling the investors that the bidder's price market may be full value or overvalue the bidder's actual share price. Rational investors in the market may not want to hold the shares through receiving this signal. This will cause the significantly negative average announcement returns of share for share offer (Brown and Rynagaert, 1991, and Fishman, 1989). In contrast, debt deal consideration could have a significantly positive announcement average return to the bidder (Myers and Majluf, 1984).
In this part, 2 factors will be discussed to determine target shareholders preference to payment method.
According to the profile of Morrisons' shareholders, there are one block shareholder (Wilson) who has 9.36% of Morrisons and several other individual shareholders who have more than 3%. All of these individual shareholders take account about 25% of the total shares. On the other hand, Institutions and banks has about 25% share holding. The rest of shares are held by the individual investors in the market.
The individual shareholders with more than 3% shares may prefer cash to stock, because they do not want to become minority share holders in the US Store Inc. in addition, in cross-border deals, holding stocks in foreign company might be considered as greater trading cost, lower liquidity and higher exposure to exchange risk (Grinblatt and Keloharju, 2001). However, Wilson who has more than 9% share holding in the company may prefer shares. This is because the tax benefits of share. On the other hand, the institutions and banks might not care the payment method, because they are less exposure to exchange risk and tax loss.
High growth bidder' shares which offer the opportunities to growth are more attractive to target shareholders. High book to market ratio always positively correlated with potential growth rate. Compare US Store Inc's book to market ratio with the industry average, the company seems to have relative low and steady growth in the future. Thus, target shareholders may prefer the cash to shares deal.
In conclusion, cash payment/or higher proportion of cash in total payment is more appropriate for both bidders and target shareholders. In addition, according to financial structure and corporate governance structure, the debt financing is more appropriate to the bidder.
Section 5: the format of the bidder
- friendly or hostile
- Stages of the hostile takeover
- Possible competition
The more appropriate way to takeover Morrisons might be hostile takeover according to Morrisons's existing corporate governance structure. As stated above, unlike US companies, several individual shareholders (25%) and institutions and banks (25%) own significant proportion of the total shares in Morrisons. If US Stores Inc first meets the director of the Morrison to propose a friendly takeover (always offer 15% to 20% premium on prebid price), rational block shareholders/institutions and banks may refuse the takeover through using the 50% of total voting rights. This is because such low premium will mainly benefit the bidder and the directors of the Morrisons rather than the shareholders. Then, US Stores Inc will have to start a hostile takeover without first mover advantage. Thus, rather than propose a friendly takeover to the director, the bidder directly attacks the target when it is not expected to take the first mover advantage.
US Stores Inc could start from building up a large shareholding (up limit is 30%). The bidder can employ some 'agents' each building up a small proportion of shares in the Morrisons. Then, it will control a lot of shares without be realized by the Morrisons's director. Moreover, a premium price could be paid to add bidder's shareholding in a short period of time. However, after holding sufficient shareholding in the Morrisons, the bidder could choose a time when the target company's director is least able to response. The next stage is to send a proposal document which states the detail of the bid to the target company. The target company has 60 days to response the takeover. If the offer is accepted or the bidder build up more than 50% of the total shareholding, the bidder become owner of the company and has the obligation to buy the shares left on the same terms.
The other grocery retailers in the market will defense themselves through joining the bid. Because of the anti-trust law, Tesco cannot own extra 12% market shares. However, it can also buy the companies and sell them to other little competitors to stop a big competitors enter into the market. Sainsbury's, and Asda/Wal-Mart may join this party to bid up the price to make the takeover more expensive to US Stores Inc.
This report helps US Store Inc to find a possible takeover target in UK grocery market. After analyzing the size, synergies benefits, financial structure of possible target companies, Morrisons is chosen as the most appropriate target. The other companies, including ASDA, Sainsbury's, M&S, and Tesco cannot provide same potential benefits. Discount free cash flow valuation shows Morrisons's company value is similar with its market value and the fair value of synergies. After taking half of the synergies and other integrating cost into account, the first bid price is set at 353p which 20% premium of the current market price. Combining with the bidder's debt capacity, existing leverage, and existing corporate governance structure and the target company's shareholders' preference, cash payment and debt finance is more appropriate for the takeover. When structuring the bid, hostile takeover will be chose to get the first mover advantage and the defense of possible completion should be prepared.
- Arnold, S. J. and Fernie, J. (2000) Wal-mart in Europe: prospects for the UK. International Marketing Review. 17 (4/5), pp. 416-432.
- Brown, D.T. and Ryngaert, M.D. (1991) The model of acquisition in takeovers: Taxes and asymmetric information, Journal of Finance 46, pp.653-669.
- Faccio, M. and Masulis, R.W. (2005) The choice of payment method in European mergers and acquisitions. The Journal of Finance. 60 (3), pp. 1345-1388.
- Fishman, M.J. (1989) Preemptive bidding and the role of the medium of exchange in acquisitions. The Journal of Finance. 44 (1), pp. 41-57.
- Gaughan, P.A. (2007) Merger Strategy. Mergers, acquisition, and corporate restructurings. New Jersey: John Wiley & Sons, Inc.
- Grinblatt, M. and Keloharju, M. (2001) How distance, language and culture influence stockholdings and trades, Journal of Finance 56, pp 1053-1073.
- Hovakimian, Opler, A.T. and Titman, S. (2001) The debt to equity choice, Journal of Finannal of Financial and Quantitative Analysis 36, pp. 1-25.
- Investors Chronicle (2010) Popular sterling-denominated corporate bonds-Safeway. [online] Available from: http://www.fixedincomeinvestor.co.uk/x/ic-bondtable.html?groupid=GBPBonds [accessed 20 April 2010]
- Myers, S.C. and Nicholas S.M. (1984) Corporate financing and investment decisions when firms have information that investors do not have, Journal of Financial Economics 13, pp. 324-351.
- Ring, L.J. and Tigert, D.J. (2001) Viewpoint: the decline and fall of internet grocery retailers. International Journal of Retail & Distribution Management. 29 (6), pp. 264-71.
- IGD retail analysis (2010) Tesco's growth strength. [online] Available from: http://www.igd.com/analysis/news/index.asp?nid=6634 [accessed 21 April 2010]
- Poole, R., Clarke, G. P. and Clarke, D. (2003) The battle for Safeway. International Journal of Retailing & Distribution Management. 31, (5), pp. 280-289.
- Trautwein, F. (1990) Merger motives and merger prescriptions. Strategic Management Journal. 11 (4), pp. 283-295
- Wal-Mart Supermarkets PLC (2010) Annual Report 2009. United States
- WM Morrison Supermarkets PLC (2010) Annual Report 2009. United Kingdom/London.