Sainsbury's & Asda proposed merger: can it be happily ever after?

Q How did the proposed deal come about?

A Unlikely sources – Walmart and the CMA. Two separate factors paved the way for the proposed merger (or ‘combination’ as it is being termed):

1. Walmart’s desire to exit the UK market

2. The Competition and Markets Authority’s (CMA’s) treatment of the merger of Tesco with Booker.

Asda is Walmart’s largest international business. However, it has underperformed for a number of years and attempts to continually shore up the bottom line have affected wider investment in the business. Despite arguably being Walmart’s best international business, Asda has become something of a ‘problem child’ and the US business has been quietly looking to offload its UK division for a number of years.

The fact that it is writing off ca. $2 billion on the back of the merger underlines its deep-seated desire to end a 20 year association with the UK foodstore market. Sainsbury’s interest in Asda is therefore both opportunistic and defensive – they would not want Asda falling into the arms of a competitor.

Ordinarily, competition concerns would have deterred any potential consolidation within the Big Four and the prospect of ‘Four becoming Three’ seemed inconceivable – until recently. Although a different deal altogether, the merger between Tesco and Booker was surprisingly given unconditional approval by the CMA.

If Tesco/Booker received the green light, why not Sainsbury’s/Asda too? That is effectively the gauntlet that is being laid down to the CMA.

As the biggest deal to ever materialise in the UK grocery market, the knock-on effects would be huge

Q What are the terms of the deal?

A Fairly straightforward, on paper. The terms of the merger are ‘friendly’ – this is not a hostile takeover. The plan is to retain the two brands and run them as complementary businesses with little front-end crossover (Argos implants in Asda stores notwithstanding).

Both head offices will be retained, with Sainsbury’s CEO Mike Coupe being CEO of the Combined Group and Asda’s CEO Roger Burnley (formerly of Sainsbury’s) continuing to run the Asda brand from Leeds.

Walmart will hold 42% of the Combined Group’s issued share capital, although it will hold no more than 29.9% of total voting rights. Reading between the lines, the US giant will have very limited involvement in the day-to-day running and strategic direction of the Combined Group. Its ongoing involvement is largely notional and it will probably sell its stake at an appropriate juncture in the future.

A merger on this scale has predictably given rise to alarmist media headlines of widespread store closures, rationalisation and substantial job losses (under the guise of ‘cost-saving synergies’). Even turning a blind eye to the corporate rhetoric/spin, this isn’t a merger in the classic corporate sense and the ethos isn’t necessarily to ‘slash and burn’.

These are two businesses that have drastically rationalised and streamlined their operational and head office bases in recent years and there can be precious little fat left. There may be some central cost savings to be made and some de-duplication of roles, but these alone are not the main rationale for the deal.

Q How will the deal affect the grocery landscape?

A Substantially. As the biggest deal to ever materialise in the UK grocery market, the knock-on effects would be huge. The Combined Group would operate a network of more than 2,800 stores and achieve annual revenues of ca. £50 billion.

The media have made much – too much – of the fact that the Combined Group would usurp Tesco’s long-held position as the market leader in the UK grocery market.

Notionally, this would appear to be true. The latest data from Kantar (from April 2018) shows that Tesco has a 27.6% share, while Sainsbury's and Asda have 15.8% and 15.6% respectively.

But there are two significant moving parts here; Tesco will gain share as it integrates Booker, while Sainsbury’s/Asda will lose some if it has to make store divestments. In the final analysis, we would actually expect Tesco to retain market leadership in food, albeit by a fairly fine margin.

The Sainsbury’s/Asda deal may spark further consolidation, as we will go on to address. But media suggestions that the move may trigger a "price war" are frankly laughable – this is the very last thing that a merged Sainsbury's/Asda would look to achieve. And every other operator will likewise avoid at all costs.

Q Is the deal all about scale and market share?

A Not necessarily. Larger businesses obviously enjoy greater economies of scale, particularly in the power they hold with suppliers. But it's worth stressing that neither Sainsbury's or Asda are exactly minnows in isolation, so Sit's difficult to imagine them securing substantially better buying deals in unison.

In the case of Asda it would actually be downscaling its buying muscle, if, as we are to presume, it is extricating itself longer term from Walmart's largest-in-class sourcing capabilities.

If there is one lesson that the UK grocers have learnt from the trials and tribulations of recent years, it is that the relationship with their suppliers needs to change. The Big Four have increasingly come to understand the value of closer working relationships, rather than treating suppliers as mere objects of negotiation.

Tesco, in particular, has partially built its recovery on forging closer supplier relations rather than playing hard ball, as it did so often in the past. Against this backdrop of growing collaboration, it seems unlikely that a merged Sainsbury’s/Asda will abuse its greater scale to merely beat up suppliers.

To my mind, the positive rationales for the deal are far broader than the obvious areas of scale and pricing. On the one hand, it is about improving Asda's core food offer. We have long-argued that Asda's recovery needs to be food-led, Sainsbury's would be far better placed to drive this than Walmart.

Secondly, it is about non-food. Asda has historically been far stronger in this market, but Sainsbury's (even excluding Argos) has made huge inroads in recent years. Throw Argos into the mix and you have a general merchandise business (the largest non-food retailer in the UK, even?) with huge potential – with a downside risk that achieving that potential is a massive corporate distraction.

Q Will the deal be subject to investigation by the competition authorities?

A Categorically, yes. The CMA is very much the ‘elephant in the room’ in the whole merger proposal. The CMA inadvertently opened the door to this deal by its surprisingly 'hands-off' approach to the Tesco/Booker merger and Sainsbury's clearly saw an opportunity to test the CMA's resolve further.

But it is absolutely inconceivable that the CMA will not at least investigate a merger of this size and significance. After all, this is an industry body that even saw fit to investigate something as innocuous as Poundland’s takeover of 99p Stores.

And, if past experience is anything to go by (with Morrison’s takeover of Safeway the best proxy), the CMA investigation will be a very protracted process, possibly lasting as long as 18 months/two years before a full ruling is reached.

Unsurprisingly, the market is awash with speculation of further consolidation in the wake of the Sainsbury’s/Asda proposal

Q How will the CMA rule?

A A compromised, “middle ground” ruling. It is notoriously difficult to second-guess the CMA, but we can Booker was surprisingly given unconditional approval by the CMA. If Tesco/Booker received the green light, why not Sainsbury’s/Asda too? That is effectively the gauntlet that is being laid down to the CMA.

Q What are the terms of the deal?

A Fairly straightforward, on paper. The terms of the merger are ‘friendly’ – this is not a hostile takeover. The plan is to retain the two brands and run them as complementary businesses with little front-end crossover (Argos implants in Asda stores notwithstanding). Both head offices will be retained, with Sainsbury’s CEO Mike Coupe being CEO of the Combined Group and Asda’s CEO Roger Burnley (formerly of Sainsbury’s) continuing to run the Asda brand from Leeds.

Walmart will hold 42% of the Combined Group’s issued share capital, although it will hold no more than 29.9% of total voting rights. Reading between the lines, the US giant will have very limited involvement in the day-to-day running and strategic direction of the Combined Group. Its ongoing involvement is largely notional and it will probably sell its stake at an appropriate juncture in the future.

A merger on this scale has predictably given rise to alarmist media headlines of widespread store closures, rationalisation and substantial job losses (under the guise of ‘cost-saving synergies’). Even turning a blind eye to the corporate rhetoric/spin, this isn’t a merger in the classic corporate sense and the ethos isn’t necessarily to ‘slash and burn’.

These are two businesses that have drastically rationalised and streamlined their operational and head office bases in recent years and there can be precious little fat left. There may be some central cost savings to be made and some de-duplication of roles, but these alone are not the main rationale for the deal.

Q How will the deal affect the grocery landscape?

A Substantially. As the biggest deal to ever materialise in the UK grocery market, the knock-on effects would be huge. The Combined Group would operate a network of more than 2,800 stores and achieve annual revenues of ca. £50 billion.

The media have made much – too much – of the fact that the Combined Group would usurp Tesco’s long-held position as the market leader in the UK grocery market.

Notionally, this would appear to be true. The latest data from Kantar (from April 2018) shows that Tesco has a 27.6% share, while Sainsbury's and Asda have 15.8% and 15.6% respectively. But there are two significant moving parts here; Tesco will gain share as it integrates Booker, while Sainsbury’s/Asda will lose some if it has to make store divestments. In the final analysis, we would actually expect Tesco to retain market leadership in food, albeit by a fairly fine margin.

The Sainsbury’s/Asda deal may spark further consolidation, as we will go on to address. But media suggestions that the move may trigger a "price war" are frankly laughable – this is the very last thing that a merged Sainsbury's/Asda would look to achieve. And every other operator will likewise avoid at all costs.

Sainsbury's/Asda deal through. As they are both largely single-branded businesses (Argos and the c-store businesses aside), it doesn't have the option of decreeing that certain fascias or divisions are excluded from the deal.

So, there are only two options: it opposes the deal outright or it undertakes a catchment-by-catchment competition analysis and stipulates store disposals in areas where the merged business has an overdominant position.

I doubt the CMA will block the deal outright. If they did, both companies would have serious comeback in the form of the precedents set in the Tesco/Booker deal (could they even ask for a re-review?).

The second option seems far more likely, but is a hugely complicated and long-drawn exercise. Have we been there before? Most certainly, when Morrison's took over Safeway in the early 2000s. But that was tangibly different in that both those businesses were a lot smaller and the foodstore "space race" still had a long way to run. The competitive landscape is vastly different now.

Some of the parameters applied back then (e.g. 10/15 minute drivetimes) may still be employed, but others will need to be revisited and revised (e.g. number of competitors within said drivetime, who those competitors are (just Big Four or other players too?), cut-off store size (15,000 sq ft again?). To throw in a further curve ball, it is not beyond the realms of possibility that the CMA may launch a separate enquiry on the non-food side.

Q Will there be store closures?

A Store divestments, but not store closures. There will inevitably be some store disposals, but given the number of working parts and uncertainties around what parameters will be set, it is impossible to predict the scale of these at this stage. Also important to stress is that store disposals are not the same as store closures – many of those outlets identified will simply pass ownership to other operators.

We maintain our view that there will be minimal foodstore closures as a result of the proposed merger. Mike

Coupe himself has provided assurances to the same effect. Despite cynical cries of “he would, wouldn’t he”, we believe this accurately reflects the combined group’s strategic intention. The combined group would not close many (if any) stores of its own volition. However, the CMA may well stipulate otherwise.

The likely CMA investigation will be undertaken on an asset by asset basis – each and every store will be analysed in the context of its local catchment. The exact parameters that the CMA will employ have yet to be determined. But there are precedents.

In reviewing the takeover of Safeway by Morrisons in 2003, the Competition Commission (the CMA’s predecessor) used the following metrics in its ‘Competition Test’:

• Focus solely on stores larger than 1,400 sq m (15,070 sq ft) – convenience stores were excluded from the analysis.

• Catchments defined by drivetime isochrones for each store – 10 minutes for stores in urban areas, 15 minutes for stores in ‘non-urban’ areas.

• Competitor set defined as Asda, Budgens, Booths, Co op, Morrisons, Sainsbury’s, Somerfield, Tesco and Waitrose – but not M&S, Aldi, Lidl or Iceland.

• Undertake a ‘Fascia Test’ in every catchment to assess the number of competing fascias (see above) and whether this changes as a result of the merger.

• Broadly speaking, catchments with three or more ‘competitor fascias’ were deemed to be ‘not a problem’ Generally, only catchments where the ‘Fascia Test’ saw the number of ‘competitor fascias’ reduced to one or two were store disposals enforced.

For the CMA's assessment of the Sainsbury’s/Asda portfolio, they may or may not employ a similar methodology, albeit with revised parameters. Overlapping Sainsbury’s/ Asda stores may not necessarily be at risk – particularly if they have a strong competitor set.

‘Vulnerable’ stores are those in catchments which contain only an Asda and a Sainsbury’s store, with limited external competition the case of Safeway/Morrisons, Morrisons was forced to divest 48 stores. Without knowing the CMA’s parameters, it is impossible to rule on Sainsbury’s/ Morrisons at this stage. For the stores Morrisons was forced to divest, the strict process (controlled by the OFT) set out:

• Purchaser to be approved by the OFT to maintain as a foodstore and valued at open market value (with some competitive bidding)

• Can be forced to sell for grocery use with no minimum price if little interest

• Can be forced to sell to alternative use

• Can be forced to sell alternative store in same catchment if no interest.

Q Where are there question marks?

A Contrasting market positionings. A generation ago, most would have called the proposed merger into question on the basis that there was limited fit between the two suitors, Sainsbury's effectively being far more upmarket than the more value-led Asda. The reality is that the two are now both mass-market operators and that the gap, while still there to some degree, is narrower now than it once was.

You could even argue that their areas of geographic strength are actually complementary. Both have evolved to become national players, but in general terms, both continue to trade best in their respective homelands – Sainsbury's in the Home Counties and Asda in Yorkshire and the North. Geographic compatibility is one of the areas where the deal actually makes most sense.

Running a dual-brand strategy still requires a very fine balancing act. If Sainsbury’s becomes too much like Asda, it will alienate large sections of its core customer base.

And vice versa. But the flipside is that if both are kept totally separate from each other, there will be limited synergy and there is no point in merging in the first place, so this is effectively a circular argument. The best case scenario? Sainsbury’s quality at Asda prices.

But so much easier to achieve on paper than in practice.

Q What are the downside risks?

A Indigestion and shortcomings in execution generally. The merger may be defensive, but it is at the same time a very bold move and certainly not a ‘no brainer’. Do not under-estimate the scale of the task in integrating the two businesses and the considerable scope for getting it wrong.

Lest we forget, the integration process for Argos is still far from complete. One of the main concerns at the time of that acquisition was that integration could prove a major distraction and take up a disproportionate amount of management time. To date, the Argos integration appears to have been executed well. However, assimilating Asda will be a far greater challenge – if Sainsbury’s had bitten off more than it could chew with Argos, Asda would lead to outright indigestion.

Historic precedents do not augur well. Morrisons struggled desperately to integrate Safeway and the merger destabilised performance for years, not months. And Asda and Sainsbury’s are both far bigger entities than Morrisons and Safeway, so the downside risks are potentially far greater. But Sainsbury’s is not Morrisons so it may not necessarily suffer the same fate, but nagging doubts remain nonetheless.

Q How may the other foodstore operators react?

A Further deals? Unsurprisingly, the market is awash with speculation of further consolidation in the wake of the Sainsbury’s/Asda proposal. Morrison’s is the subject of a large proportion of this conjecture, principally because it will be left adrift as by far the smallest of the Big Three. Other potential protagonists in any consolidation activity include the Co op, Iceland, Ocado and possibly even Waitrose.

This speculation is being driven partly by historic corporate logic – any large deal will provoke similar defensive action amongst other players. But this logic is underpinned by the premise that scale is everything in business. As we have already discussed, scale is still significant, but its value in UK grocery has diminished.

The best performers are actually the smaller, more dynamic players – particularly Aldi and Lidl, but also Morrison’s in its own way. Morrison’s may go on to do a deal of some description, but it doesn’t necessarily need to in order to stay competitive.

As ever, Amazon’s name is never far away from any speculation. If Amazon were serious about making major inroads into the UK grocery market, it would struggle to do so organically from its existing toehold (Amazon Fresh + Wholefoods).

If it were to go down the acquisition route, the obvious suitors would be Morrisons or Ocado; Morrisons on the basis that the two already have a collaboration agreement, Ocado on the basis that its pure-play model complements its own, but with expertise in food (although it seems odd that if Amazon were interested in Ocado, it would have moved before now).

There have also been somewhat misguided suggestions that Amazon may yet scupper the Sainsbury’s/ Asda deal by counter-bidding for Asda. As if Walmart would sell Asda to its biggest global competitor, whatever it was willing to pay. But could Amazon bid on the combined Sainsbury’s/Asda group, now or in the future?

No reason why not, if it so wished. But why stop there, why not bid for Tesco instead? Personally, I’d rather second-guess the vagaries of the CMA than the motives of Amazon.