Shares of supermarket giant Tesco (LSE: TSCO) rose by 10% this morning after the group announced a £3.7bn merger deal with wholesaler Booker Group (LSE: BOK). Tesco also confirmed that, as expected, it will restart dividend payments in the 2017/18 financial year.
As a Tesco shareholder myself, I’m pleased with today’s news. But the supermarket’s share price has now risen by 33% in six months. After such strong gains, is Tesco still a buy? Let’s take a closer look.
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What’s on offer?
For each share they hold, Booker shareholders will receive 42.6p in cash and 0.861 new Tesco shares. At Tesco closing price of 189p yesterday, this represents a price of 205.3p per Booker share, or £3.7bn in total.
If Tesco shares hold onto today’s gains, then the deal will be worth more for Booker shareholders. As I write, Booker’s share price is up by 15% to 211p. This represents a 25% gain since Christmas!
This merger should work
Tesco’s turnaround seems to be going well. The group’s Christmas trading statement showed that like-for-like sales rose by 1.5% during the third quarter. But growth is difficult. The UK supermarket sector is very competitive, and is pretty much saturated.
By acquiring Booker, Tesco is gaining access to two new areas of the market. Booker’s wholesale customers are typically restaurants, cafés and takeaways. They include chains such as Carluccios and Wagamama. So Tesco will now be able to sell food to people who are eating out, as well as eating at home.
The second new group of customers for Tesco will be Booker’s convenience store customers. Booker currently supplies about 4,900 convenience stores under the Premier, Londis and Budgens banners. That’s more than double the number of small stores operated by Tesco.
Today’s deal will give Tesco a much bigger share of the convenience store market, assuming the Competition and Markets Authority (CMA) is happy to allow the deal to go through.
Do the numbers add up?
Booker is a well-run profitable company. The group has no debt and reported an adjusted operating margin of 3.8% last year, well above Tesco’s equivalent figure of 2.2%.
Booker’s £5bn annual sales will add about 10% to Tesco’s total revenue. I estimate that this will be enough to offset the dilution caused by the new Tesco shares issued to Booker shareholders. My calculations suggest that the initial effect on Tesco’s earnings per share will be neutral.
The opportunities for Tesco lie in economies of scale and the continued growth of Booker’s businesses. Tesco has already identified about £400m of potential cost savings. The firm believes that more will be possible during the first three years of ownership.
Acquiring Booker should give Tesco what it most needs — an opportunity to deliver growth and higher profit margins.
Is Tesco a buy?
After this morning’s gains, Tesco shares trade on a 2017/18 P/E of about 20. Today’s confirmation that dividend payments will restart means that the stock should yield about 1.8% this year.
That’s not obviously cheap, but Tesco is targeting an operating margin of 3.5-4.0% by 2019/20. If it succeeds, I estimate that earnings per share could reach 20-25p by 2020. On this basis, Tesco could still be good value at current levels.