Why It Would Be Nuts For Tesco plc To Buy WM Morrison Supermarkets plc

The latest rumour doing the rounds is that Tesco (LSE: TSCO) is going to team up with a private equity consortium to buy smaller supermarket chain Wm Morrison Supermarkets (LSE: MRW).

Any such union of the two troubled firms would be nuts, in my opinion!

Long-term decline

Both Tesco and Wm Morrison own businesses on the back foot. These two firms are fighting fires, shedding assets and taking drastic actions such as cutting selling prices and costs to try to negotiate a knife-edge between profit and loss that straddles the economic abyss — one false move and it could be game over.

The onslaught to the sector from low-cost competitors Aldi and Lidl is relentless. These two firms already control upwards of 10% of Britain’s grocery market and they are expanding by double-digit percentages. Aldi and Lidl are rewriting the rules of the game. Tesco and Wm Morrison are struggling to catch up and finding themselves with expensive and outdated business models that could sink them. The faster Aldi and Lidl expand, the faster the clock ticks for Tesco and Wm Morrison, and it’s Aldi and Lidl that setting the timetable.

I have no doubt that Tesco and Wm Morrison, with their current operating models, are stewards of businesses in long-term decline. So, faced with problems and challenges of managing contraction, why would Tesco want to double up on its risks by adding another struggling business in the same sector to its portfolio? It doesn’t make sense.

Tesco is financially strapped

Tesco set out the scale of its problems back in October when it released its interim report. The firm said it needs to regain competitiveness in its core UK business, protect and strengthen its balance sheet, and to rebuild trust and transparency.

These are big issues, because a firm is in dire straits if it has lost its competitive advantage, has a weak and threatened balance sheet, and when its customers, investors and partners no longer trust it. However, in terms of Tesco’s ability to buy out Wm Morrison, the balance sheet is the biggest hurdle. Tesco’s borrowings run around 20 times the level of this year’s anticipated pre-tax profit — that’s a high level of debt. Tesco is weak financially and forward earnings are uncertain.

Tesco doesn’t make an attractive partner for private equity because the firm’s existence looks precarious. There seems little prospect of Tesco finding the means to carry off a deal with Wm Morrison on its own either.

A better way

The last thing Tesco needs is to expand within the challenged supermarket sector in any way, given it’s already stretched-to-breaking point balance sheet and questionable forward profit sustainability — even if exterior finance were to partner with any deal.

For a better solution to Tesco’s problems I think we should look to what fellow challenged supermarket chain J Sainsbury is doing with its proposed takeover of Argos brand owner Home Retail. With that deal, J Sainsbury hopes to diversify away from grocery provision. The firm’s plans may or may not work out, but I think that’s a better way forward than doing more of the same in a dying sector.

I won't be buying Wm Morrison shares or Tesco shares based on the current takeover rumours. Instead, I'd rather invest in the firms covered in this Motley Fool wealth report. Our top analysts scoured the market to find companies with reliable cash flow, solid trading positions and great prospects. These firms don't operate in structurally challenged sectors, and they offer solid dividend and capital growth potential. You can find out more about them by clicking here

Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.