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What will Asda merger mean for the Sainsbury’s share price?

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With hindsight (which is a wonderful thing), it’s perhaps not surprising to see consolidation in the supermarket sector now that Sainsbury’s has confirmed plans, reported over the weekend, to merge with Asda. When a major sector like this is highly competitive with everyone essentially selling the same things, bigger is usually better in the race to compete on price.

Sainsbury’s tries to position itself a little upmarket, but I honestly don’t rate the products on offer at my local store as anything better than Asda, Tesco, or even Lidl and Aldi.

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The new deal would combine the UK’s second and third largest supermarkets to create a new giant that would leapfrog Tesco into first place, with a market share of 31% — and combined 2017 revenues of approximately £51bn.

With the economies of scale possible for such a huge operator, the firms reckon prices will fall at both Sainsbury’s and Asda and the two brands will remain separate.

Share structure

For Sainsbury shareholders, my first fear was that they might end up with shares in Asda owner Walmart and would face all sorts of related complications. But that’s not going to happen, and Walmart is to take 42% of the combined UK business plus nearly £3bn in cash, with Sainsbury’s current chief executive Mike Coupe retaining the helm of the enlarged operation.

That is, if the Competition and Markets Authority gives its nod — the deal is widely expected to need its approval. I can’t see it actually being declined, especially as Aldi and Lidl, together with a number of smaller chains, are still providing strong competition.

While all this has been going on, you might not have noticed full-year results from Sainsbury, released the same day.

Underlying pre-tax profit for the year of £589m marks a return to growth, geared to the second-half which showed an 11% rise. But reported pre-tax profit fell from £503m to £409m, and EPS dropped from 17.5p to 13.3p. The full-year dividend is unchanged at 10.2p per share, for a yield of 3.8% on Friday’s closing share price, which I think is perhaps overly generous.

Heavy debt

Cash generation rose by £113m to £432m, and that same £113m was knocked off the net debt figure, which stood at £1,364m at 10 March — approximately double the company’s underlying operating profit. Although Sainsbury has no liquidity problems, with £1.6bn of its £4.1bn facilities currently not drawn, that does disturb me.

We heard that the “ratio of lease adjusted net debt to earnings before interest, tax, depreciation and rent (EBITDAR) has improved to 3.2 times from 3.7 times a year ago,” and though that’s heading in the right direction, I see it as still too high and would prefer to see further falls — maybe some of that dividend cash could have been put to better use?

We need to see what the new business will look like on the financial front.

Will the merger be good for Sainsbury shareholders? I’m convinced it will, as the enlargement is surely what’s needed to take on the might of Tesco and the rapid growth of the new interlopers. Investors seem to think the same too, and as I write these words shortly after market opening, the Sainsbury share price is up 16% to 313p.

Would I buy Sainsbury shares? No, for pretty much the same reasons I wouldn’t buy Tesco.

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Alan Oscroft has no position in any of the shares mentioned. The Motley Fool UK has recommended Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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