The Motives Of Acquisition For Different Companies

Published Date: 02 Nov 2017

Introduction

This objective of this report is to evaluate whether company should bidding for J Sainsbury Plc. This report is combined by four parts (Motives, Valuation, Financing and recommendations).As the competition in our main market is increasing and our company’s profit margins is running down thus company should find an acquiring opportunity to improve its value. After research, company set the target as J Sainsbury Plc. J Sainsbury was founded in 1869 and today operates over 1,000 supermarkets and convenience stores and an online grocery and general merchandise operation. 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. (J Sainsbury website 2013)

Motives

The motives of acquisition for different companies and industries can be varying. However, three main groups involved in M&A which are strategic, financial and managerial (Johnson, Whittington & Scholes, 2011 Exploring Strategy) will be discussing below.

Strategic motive is about improving and developing the business. It is including gain economies of scale, increase financial growth, stimulate innovation, eliminate competition, expand into new markets and acquire new customers (method frameworks, 2011). Therefore, according to the situation of our company (declining profit margins, want to further diversify geographically and increasing competition), they are all the strategic motives to acquire J Sainsbury. Sainsbury has the UK’s largest loyalty scheme about 18.5 million members and almost ￡200 million of points redeemed in 2012. Sainsbury’s grew its share of the market from 16.5 per cent to16.6 per cent and the size of the UK grocery market was ￡138.2 billion.(Sainsbury annual report 2012)

Since Sainsbury occupied a portion of market share and have stable consumers thus it can let our company to expand market to England, increase the economies of scale, reduce the competition in retail market thereby increase the profit margins. Moreover, J Sainsbury’s business structure is diversifying. It involved in different area such as Banking, energy, property and entertainment. Thus, it will strongly simulate innovation and improve the technology if our company acquiring J Sainsbury.

Financial motive also will be considered for acquisition. Evidence showed that some repeat acquirers or combined companies get very good at the process and generate significant value from mergers and acquisitions (Barkema & Vermeulen, 1998).As the CEO informed the board that there is now considerable pressure from the main shareholders to take measures to improve the value of our company. Thus, financial motive can certainly push company to acquire J Sainsbury. Synergistic benefits can be the financial motive and it is divided to two basic categories which are operating Synergies (revenue enhancement, cost reduction) and Financial Synergies (cost of capital and tax advantage) (Martynova and Renneboog, 2006). Within the context of mergers, synergy means the performance of firms after a merger (in certain areas and overall) will be better than the sum of their performances before the merger (Blog B school, 2010).J Sainsbury was found in 1869 year and has 144 years of history (Sainsbury-story, 2013).Additionally, Sainsbury has 22 million customer visits every week, employing around 150,000 colleagues and 2,000 direct suppliers over 70 countries (Sainsbury annual report, 2012).Therefore, our company can sharing central facilities with Sainsbury and have a greater power to negotiate prices with suppliers thereby cutting costs if our company acquiring Sainsbury. As J Sainsbury is listed in FTSE 100 thus it is easier to raise capital. Our company can increase debt capacity thereby gain tax advantage. Moreover, the cost of issue will be lower when our company need to issuing debt and equity after acquiring so it can decrease cost of capital.

Managerial motive is also take part in the acquiring consideration. UK is a country with a relatively good record of corporate governance and corporate social responsibility. According to the Sainsbury’s 2012 annual report, Sainsbury has its excellent Remuneration Policy and effective governance. Sainsbury’s corporate responsibility awarded lots of achievement in last few years such as Highest performer relative to our sector, 2011/12, Gold class and sector leader, 2011/12, Most Sustainable Companies in the World, 2012(Sainsbury annual report, 2012).Thus if our company acquire J Sainsbury, we not only can acquire its exist excellent corporate governance but also can imitate or refer it governance system.

Valuation

As the company pondering to acquire J Sainsbury thus corporate valuation is needed. Discounted Cash Flow model combined with ratio-based valuations was chosen in this case. In order to make fundamental discussion of the two companies, their operations and their future earnings potential. In addition, financial and operative ratios are used to allow for effective comparisons in the discussions and negotiations (Corporate valuation).The main reason why the DCF valuation model has become so popular are because It is theoretically correct, corresponds well to market values, works well for all types of companies, unaffected by window dressing, gives the analyst a good understanding of the underlying business. The assumption of Discounted Cash Flow model is that the company has uninterrupted activities with no bankruptcy (going concern). The DCF valuation is followed by these steps. Calculating the weighted Average cost of capital (WACC) and free cash flow in the explicit period, figuring terminal value, discounting and finally add up all the values to get the Enterprise value.

The weighted Average Cost of capital of company is use as the discounted rate to get the present value of the company’s free cash flows and terminal value from the forecasted period 2013 to 2017. The Cost of Debt (kd) is use the Yield to maturity of Sainsbury’s bond which about 4.25%.As the latest statistics from yahoo finance and FT reveal that the Beta, Debt as % of Capital (wd), and Market Risk Premium of the company are 0.6241,33.5% and 5% respectively. Therefore, found out that the WACC of J Sainsbury is 4.232%.When compute the terminal value of J Sainsbury, it is assumed that the company does not earn abnormal profit after the forecasted period.

J Sainsbury’s standalone valuation

As the table shows above, the revenue growth rate is taken as about 6%, which is found out from the J Sainsbury’s 2012 annual report. As the requirement to forecast the revenues for next five years so assumed that the growth rate of Sainsbury would remain stable from 2013 onwards on the basis of the consideration that J Sainsbury’s is in the maturity stage of its life cycle. This assumption would ensure that Sainsbury is not over-valued.

The Cost of Goods Sold (COGS)/Sales ratio is 94.57%, which is computed as the Cost of Goods sold divided by the revenues sales in 2012. Those figures are found out from J Sainsbury’s financial statement. Then, the forecast of gross profits for next five years can be compute easily. Also, the SG&A/Sales is 1.88% which computed in a similar method.

The difference between the total current assets and the total current liability is called Net Working Capital (NWC). The NWC divided by the Sales to get the ratio of -4.95%. This implies that J Sainsbury is in trouble to repay its short term obligations.

Steady State growth for the valuation was assumed to be 1.66%, which is the 10 years UK government bond yield. When J Sainsbury runs into the steady state, its growth rate is relatively similar to future cash flow growth of the whole UK economy so assume that steady state growth equal to the 10 years UK government bond yield. According to the Sainsbury’s 2012 annual report, the Income tax at UK corporation tax rate is 26.07%.

Valuation after acquisition

The method of calculation is with the same pattern as standalone valuation. However, after acquisition, J Sainsbury’s value will be enhancing. Therefore, it has the further growth rate by 2% in 2013 and 1% from 2014 to 2017. Meanwhile, cost of sales/sales ratio and administrative costs/sales ratio will reduced each year by 0.7% and 12% respectively. After acquisition, synergy is generating directly. Because of the revenue enhancement and cost reduction. The enterprise value is then has considerable boost which is￡42879.16 million, about￡ 30531 million increase compare with the J Sainsbury’s standalone value(￡12347.29 million).

After computing the Enterprise value as a stand-alone firm and merger, multiple-based valuations is coming as follow. J Sainsbury’s multiples will compare with its competitors and industry level. It can be make the DCF valuation more accurate.

Equity price based multiples

P/E tells us how much investors are willing to pay per dollar of earnings and is influenced by forecast trends, rumors or myths of the moment (Guide to analysing companies ,third edition, Bob Vause). By compared the P/E ratio, J Sainsbury is about 6.4% lower than the industry level but has not a big difference compared with Tesco and Morrison. It may have considered fair value and possibly a higher earnings growth. However, it just a part of story.

P/B is the ratio share price over its book value of equity. It can use to find the undervalued companies. Sainsbury’s P/B ratio is roughly 0.8% lower than industry level. It could mean that the stock is possible to undervalue or some fundamental problem with company.

The P/S ratio for Sainsbury is 0.32 which mean if the stock is trading at a price/sales multiple over 0.32 it implies that the stock might be overvalued, vice versa. Additionally, the Equity value can be computed by formula Equity value=P/S ratio * forecasted sales for next year which is 0.32*ï¿¡23542million. The equity value is about (ï¿¡7533.44) million. J Sainsbury may undervalue in case.

Enterprise value based multiples

EV/EBITDA is a valuation multiple used to measure the value of company and it is unaffected by the company’s capital structure.Apply the EV/EBITDA ratio to the formula (enterprise multiple*EBITDA) can compute the enterprise value of J Sainsbury which is 7.12*￡1287million equal to about￡9163.44million.It implied that an undervaluation of a company may happened.

J Sainsbury

Tesco

Morrison

Industry

Beta

0.62

0.61

0.35

0.6

Beta indicates the sensitivity of the company’s share price to general movements of the stock market. The beta of Sainsbury is about 0.62 which reached the industry level thus has not significant high risk resist in Sainsbury compare with competitors.

Although the multiples valuation is simple and the multiples are based on key statistics that investor can be search easily compare to the discount cash flow valuation, it is just involved in a single point in time and difficult to compare. Moreover, it does not fully capture the dynamic nature of business and competition (Peter Suozzo, 2001). And the main point is multiple valuations are only useful when performed accurately. By contrast, poor performed multiple valuations can lead to misleading conclusion. Therefore, the discount cash flow model is exercise in this report.

Financing:

Acquisition financing is a necessary process for company to acquire J Sainsbury Plc. Therefore, this paragraph will introduce diverse acquisition financing methods with comparison in order to find the most appropriate financing approach for acquisition and clearly explain the ideas to the board of Directors.

Generally, There are three financing mechanism which is cash offer, stock for stock offer and hybrid (combination of stock and cash).The results reveal significant differences in the abnormal returns between common stock exchanges and cash offers. (NICKOLAOS G. TRAVLOS 1987)

Cash offer is a method of financing which acquiring company pay cash to purchase the stock of acquired company. Typically, the acquiring firm will first purchase any shares held by the target company, then seek to purchase any shares currently in the possession of investors. (Wise seek).There are some advantages of cash offer, cash offer has certain purchase price which mean that it will not be affected by fluctuate value like stocks thus it is less risky than stock for stock offer and cash offer can also prevent the acquired company to occupy acquiring company’s ownership (Amihud, Lev, and Travlos, 1990), acquired company are not eligible to gain our company’s coming profit. On the other hand, Cash offer will loss plenty of acquiring company’s cash reserves (liquid assets) thereby has a higher risk to face with serious debt problems if the cash is come from bank loans (ehow.com). Additionally, cash offer will create tax obligations to the acquired company’s shareholders because the acquiring company need to pay a higher acquisition price to cover the tax burden of the acquired company’s shareholders. Cash for financing can come from free cash flow, debt or right issue. Under the FCF hypothesis, takeovers financed from internal fund should show the worse performance, whilst those funded from debt should show the best performance (Martynova and Renneboog , 2009).Therefore, evaluation of debt financing will reveal below. In particular, debt financing can decrease the agency problems; incite organizational efficiency and improving management (Jensen, M.C, 1986).Additionally, debt financing can maintain ownership, has tax deduction and possible to has lower interest rate. However, debt financing can impact company’s credit rating (Daniel Richards, ND)

Another method of financing is stock for stock offer also known as stock swap. It occurs when shareholders' ownership of the target company's shares are exchanged for shares of the acquiring company as part of a merger or acquisition. During a stock swap, each company's shares must be accurately valued in order to determine a fair swap ratio (investopedia,nd).The cons of stock for stock offer is no repayment, immunity(investors share company’s profits and loss) and good credit rating, However, stock for stock offer will weaken acquiring company’s ownership(loss of control),has Lifelong obligation and Higher outgo (N Nayab,2010).Moreover, increase in number of shares will fall in share price thereby possible signalling of overvaluation.

So what kind of financing Method Company should choose? The evidence indicates that bidding firms suffer significant losses in pure stock exchange acquisitions, but they experience "normal" returns in cash offers (NICKOLAOS G. TRAVLOS 1987). US and UK target shareholders realize that significantly greater gains from cash offers relative to stock offers (Franks, Harris and Mayer ,1988). If other conditions being equal, the returns to bidding firms in cash offers will be higher than in common stock exchange offers (Paul Asquith and David W. Mullins, 1986). A cash acquisition might offset the negative changes in the bidding firms' common stock prices, caused by the co-insurance effect, leaving the bidding firms' stock prices unchanged (Carol Ellen Eger, 1983). However, due to the differential tax treatment, the bidding firm must pay a higher acquisition price in the case of a cash offer to offset the tax burden of the selling stockholders (Wansley, Lane, and Yang, 1983). By contrast, a common stock exchange offer leads to a wealth transfer from stockholders to bondholders, implying a fall in stock prices (E. Han Kim and John J. McConnell, 1977). For acquisitions of publicly traded targets, document significant negative average announcement returns to acquirers when the method of payment is stock rather than cash. One dominant explanation for this pattern is that stock financing creates an adverse selection effect similar to a seasoned stock offering (Servaes, Henri, 1991).On the other hand,stock for stock offer is not taxable if the acquiring company to offer shareholders an exchange of all the shares they hold in the target company for shares in the acquiring company(investopedia, nd).

However, there is not a totally right of financing method. An acquiring firm’s financing decision can be strongly influenced by its debt capacity, existing leverage and target leverage ratio. Bidders have greater incentives to finance with stock when the asymmetric information about target assets is high (Hansen, 1987). Bidders will prefer to finance with stock when they consider their stock overvalued by the market and prefer to finance with cash when they consider their stock undervalued ( Myers and Majluf ,1983). Cash offers signal a high valuation and therefore designed to be pre-emptive (Fishman 1998)

As our company financially sound with plenty of cash reserves and a good mix of debt/equity in capital structure and certainly within target ratio thus I suggest that company to use the combination financing method though.Use higher portion of cash and issue lower portion of stock for financing. If company financing by this way, hybird financing can offset the disadvantages from each method of financing. Although lots of evidences supported by the references which had been reveal above are prefer to choose cash offer financing and our company have plenty of cash reserves, company will lose its liquidity if just financing with cash.

Recommendation:

It is not doubt that J sainsbury should be set as our acquiring target.The reasons can be reconize in serval area. J sainsbury has its excellent corporate management policy and the Brand rating .Additionally, UK it a country with a relatively good record of corporate governance and corporate social responsibility. Therefore, J Sainsbury is a good choice if company wants to make a position in UK. The second reason is J Sainsbury has diversity business such as energy thus it can offer company technological innovation. According to the valuation above, J Sainsbury is possibly undervalue therefore it can be the reason to acquire. The key reason can be reflected by the J Sainsbury’s enterprise value(￡12347million) and the enterprise value after acquisition(￡42879 million) which calculated by DCF valuation. The synergic effect is huge. If company want to bid for J Sainsbury ,the recommend bid range should between ￡10000 million to ￡30000million.Since the forecasted growth is always uncertain, company cannot set the bid too high. Therefore, a bid which is less than this range might lead to rejection, while a bid higher than that could result in loss of premium. Gather the reasons, it can be believe that J Sainsbury can help company to rebuild it image and geographically extended.